Market failure – when the outcome of a free market differs from the
socially optimal outcome (when price mechanism leads to an inefficient
allocation of resources and a deadweight loss of economic welfare);
results in allocative inefficiency (underallocation/overallocation); when the
market fails to consider society as a whole
Negative Production Externalities
- Occurs when a production activity imposes costs to anyone not in
control of the decision-making process
- Producers do not bear the whole cost of the production and there
are spillover costs
- Social costs (external costs + private costs) > private cost (cost to
decision-maker)
- Private costs of producing the good are too low from society’s
standpoint, the good is overproduced
- Society demands less than what is produced
- Government intervention – impose bans/taxes to increase private
costs (internalize external effect)
- E.g. industrial pollution (affects the surrounding environment),
nuclear power generation (radiation leaks), transport of goods
(traffic congestion)
Positive Production Externalities
- E.g. honey (pollination)
Negative Consumption Externalities
- Occurs when a consumption activity imposes costs to a third-party
- Consumers bring costs to others without realising
- Leads to spillover costs
- Private costs of consuming the good are too low, the good is
overconsumed
- Society demands less than what is consumed
- E.g. alcohol (drinker may bring about social disturbance and public
safety), driving (traffic congestions), smoking (passive smoking)
Positive Consumption Externalities
- Occurs when a production activity imposes benefit to a third-party
- Social benefits (external benefits + private benefits) > private
benefits (benefits received by decision-maker)
- Private benefits of consuming the good are low for the consumer
compared to the social benefits, consumers demand less, producers
produce less (free market), the good is underproduced
- Society demands more than what is produced
- E.g. vaccination, education
- Government intervention – provide tax exemptions/subsidies to
increase private benefits
Merit Goods
- Goods that are more beneficial to consumers than they realise
(normative, decided by politicians)
- Imperfect information
o Information failure – incomplete/lack of information/ignored
information
o Asymmetric information – information is not shared equally
between two parties
- Positive externality
- Producers/consumers do not realize the benefit brought to society
by producing/consuming the good
- Producers and consumers make irrational decisions due to lack of
information
- Producers produce less/consumers demand less, the good is
underproduced and underconsumed
Demerit Goods
- Goods that are more harmful to consumers than they realise
- Imperfect information
- Negative externality
- Producers/consumers do not realize the harm brought to society by
producing/consuming the good
- Producers produce more/consumers consume more, the good is
overproduced and overconsumed
Public Goods
- Non-exclusion goods
o People who don’t pay cannot be excluded from enjoying the
good, e.g. streetlights, national defence
o Difficult to charge a price (no efficient way/expensive to price)
- Non-rivalry goods (shared consumption)
o People who enjoy the good will not ruin the good for other
people
o The quantity of the good does not diminish upon consumption
- Quasi-public goods
o Goods that show characteristics of both public and private
goods, e.g. roads (toll roads are excludable, congested roads
during peak times are rival)
- Free rider problem – individuals are incentivised to not contribute
and benefit from others’ contributions
- Firms do not produce public goods since there is no profit (no
consumers are willing to pay) – complete market failure (missing
market)
- Solutions
o Governments provide public goods using tax revenues
o Agreeing to private provision of public goods, e.g. hotel-owned
beaches accessible only to hotel guests
o Develop technology for more efficient/cost-effective ways of
pricing, e.g. electronic scanners for toll roads
*Note: Specify the market when drawing a diagram
