2.10 Market Failure

2026 Syllabus Objectives

By the end of this topic, you should be able to:

  • 2.10.1 Define market failure and explain key terms: public good, merit good, demerit good, social benefits, external benefits, private benefits, social costs, external costs, private costs.
  • 2.10.2 Explain the causes of market failure: public goods, merit and demerit goods, external costs and benefits, abuse of monopoly power, and factor immobility — with examples of each.
  • 2.10.3 Explain the consequences of market failure, focusing on the overconsumption of demerit goods and goods with external costs, and the underconsumption of merit goods and goods with external benefits.

2.10.1 Definition of Market Failure

https://cambridgeassistant.com

What Is Market Failure?

A free market is a system where buyers and sellers interact freely to decide prices and quantities — with little or no government involvement. Usually, this works well. However, sometimes the free market produces the wrong amount of certain goods, or it ignores important costs and benefits that affect society as a whole.

Market failure happens when a free market allocates resources in a way that is not best for society. In other words, the market produces too much of some things and too little of others — leading to a loss of well-being for people in society.

Key Terms You Must Know

Understanding market failure starts with knowing the difference between private, external, and social costs and benefits.

Costs

Private costs are the costs paid directly by the person or firm involved in an economic activity.

  • Example: A factory pays for raw materials, electricity, and workers' wages. These are its private costs.

External costs are costs that fall on people who are not involved in the activity — often called "third parties." The person causing the harm does not pay for it.

  • Example: That same factory dumps waste into a river. People living nearby suffer from polluted water. They did not choose to be involved, but they bear the cost.

Social costs are the total costs of an activity to society as a whole. They include both the private costs and the external costs.

📌 Formula: Social Cost = Private Cost + External Cost

Sign in to view full notes