Correction of market failure

There are various measures a government could undertake to correct market failure: for example, indirect taxation, subsidies, tradable pollution permits, the extension of property rights, regulation, buffer stocks and minimum prices. The relative merits of each measure are now considered in relation to different types of market failure.

Indirect taxation

Indirect taxes are taxes levied on the expenditure of goods or services.  The government often imposes taxes on goods which have significant external costs, such as petrol, alcohol and tobacco.

The following diagram shows the market for petrol, including both the marginal private cost curve (MPC) and the marginal social cost curve (MSC). In a free market the equilibrium price is OPe and the equilibrium quantity is OQe. However, the socially optimal price is OP1 and the socially optimal quantity is OQ1, where marginal social cost equals marginal social benefit for the last unit produced. THe vertical distance ZY represents the external cost (air pollution) for each litre of petrol consumed.

By placing a tax equal to the external cost of ZY per litre, the government successfully internalises the pollution. The total tax collected is shown by the area P1YZW. Both producers and consumers pay the tax depending on the relative elasticites of demand and supply. The consumer tax area is YP1PeT and the producer tax area is PeTZW.

[diagram on page 48]

Advantages of indirect taxes to correct market failure

  • Indirect taxes are based on the principle the the polluters pay: both the consumer and the producer.
  • Indirect taxes work with market forces, helping to internalise the external costs while maintaining consumer choice.
  • The level of pollution should fall as output of the good or service is reduced and the price increased. The socially optimal level of MSB = MSB can be achieved.
  • Tax funds are raised for the government and these can be used to clean up the environment or to compensate the victims of pollution.

Disadvantages of indirect taxes to correct market failure

  • It is difficult to quantify the pollution and then place a monitary value upon it. Consequently, the socially optimal level is hard to achieve.
  • Indirect taxed increase the costs of production for firms, making them less competitive, compared to forms in other countries where such taxes are not applied. Therefore firms may relocate.
  • The demand for the good or service may be price inelastic and so the overall reduction in pollution levels may be small.
  • The tax revenue raised may not be used to compensate victims or clean up the environment.
  • It might encourage the development of illegal markets: for example, tobacco and alcohol smuggling to avoid high taxes.


A subsidy is a grant provided by the government to encourage the production of a good or service. Subsidies are often applied on goods or services with significant external benefits, such as education and healthcare. They may also be given to alternative forms of economic activity  which create less pollution, such as public transport or renewable energy.

Diagram (a) below shows the application of a unit subsidy to the market for electricity from renewable energy sources. The effect of a subsidy is to lower the price of each kilowatt of energy from Pe to P1 and increase the quantity from Qe to Q1.

The subsidy per unti is AB and the total subsidy area is ABCP1. Part of the subsidy is passed onto consumers in the form of lower priced energy, equal to the area AGPeP1. The other portion of the subsidy GBCPe remains with the producer. The lower price of electricity from renewable energy sources will help decrease the demand for energy from non-renewable sources from D to D1 (diagram (b)).

[diagram on page 49]

Advantages of subsidies applied to renewable energy markets

  • They reduce air pollution
  • Using renewable energy sources helps to promote sustained economic growth
  • The rate of consumption of non-renewable energy sources is reduced.
  • Subsidies work with the market. They help to internalise the external benefits from renewable sources of energy.

Diadvantages of subsidies applied to renewable energy markets

  • There is an opportunity cost to government subsidies. It may lead to higher taxes or cuts in government spending elsewhere.
  • Firms may become inefficient in production if they rely on subsidies
  • Wind power may be a less reliable source of energy than traditional fossil fuels

Tradable pollution permits

In 2005 the European Commission set up an emissions trading system (ETS) in an attempt to limit greenhouse gases from heavy industry. Its main focus is to curb carbon dioxide emissions by major polluters in the EU, such as power generators, steel, paper, cement, and ceramics industries. It is intended to include the aviation industry by 2012.

The ETS is a ‘cap and trade’ system. Each year, the EC allocates a set amount of carbon dioxide permits to national governments,  which then divide up the allowances among the firms covered by the scheme. This ‘caps’ the amount of carbon emissions for the year. The pollution permits are tradable, which means firms can buy and sell the allowances between themselves.

Most of the permits have been given free to industry and allocated on the basis of the amount of pollution generated before the scheme was created. However, national governments are able to retain 10% of the permits and offer them for sale depending on the level of scarcity. THe ETS gives an incentive to firms to invest in green technology and so reduce carbon emissions in the long term.

The ETS allows firms to invest in schemes that reduce carbon dioxide emissions outside the EU: for example, in India and China. The savings in carbon emissions can then be offset against their own emissions in the EU.

Advantages of tradable pollution permits

  • A market is created for buying and selling carbon permits, just like other goods and services. In effect, the price mechanism is used to internalise the external costs associated with carbon emissions
  • Pollution permits can be reduced over time as part of a coordinated plan. FOr example in 2008 the EC cut the allocations by 5%.
  • National governments can raise funds by selling their 10% of the pollution permits to the industry. The revenue could then be used to clean up the environment or compensate victims.
  • Forms have an incentive to invest in clean technology.
  • Production costs will increase for forms that exceed their pollution allowances, since they have to purchase additional permits and this provides a source of revenue to cleaner firms that can sell their exces pollution permits.
  • The ETS may act as a foundation for a global scheme. It has attracted interest from developed countries outside of the EU. The US state of California  intends to join the scheme.
  • Firms may be able to bank their excess pollution permits for future years.

Disadvantages of tradable pollution permits

  • The EC may allocate too few carbon permits so that production costs for EU firms increase rapidly, reducing their international competitiveness. Some firms may even relocate outside of the EU to reduce production costs.
  • Disputes have arisen over the allocation of carbon permits to forms. Some companies believe they should receive larger allowances and have taken legal action against the EC.
  • Firms may pass the cost of purchasing pollution permits onto the customer leading to higher prices of essential goods. This is more likely to happen if demand is inelastic.
  • There is less pressure on major polluting forms to clean up their act if it is easy to buy permits from elsewhere.
  • The price of pollution has fluctuated considerably since the schemes inception in 2005. For example, the price of carbon emissions varied from €25 to less than €1 per tonne. This has created uncertainty among firms about wether to invest heavily in carbon reducing technology.
  • Pollution permits may create an entry barrier for new firms to enter the industry, so restricting competition
  • There is a cost to the government of monitoring pollution emissions
  • Not worldwide – China and the US still polluting

Unstable commodity markets

Commodities refer to raw material used in the production of goods. They may be minerals and metals such as oil, coal, tin and cooper or agricultural hoods such as wheat, coffee, tea and sugar. Typically, commodities are used to manufacture goods and services.

Commodity markets are characterised by fluctuating prices, and producers incomes which make it difficult to plan future investment programmes and production. This is best shown in agricultural markets where the climate may effect supply in any one year. In the following diagram, initially, planned output is Qe and price Pe, leading to a planned total revenue of OPeXQe.

However, ideal weather increases supply to S1, causing price to all to P1. Supply is drawn as perfectly price inelastic, since the length of the growing season means no more can be produced until the following year. Total revenue also falls to OP1YQ1 since demand for agricultural commodities tends to be price inelastic as agricultural goods tend to be used in the production of food – a necessity. A ‘good’ harvest is a paradox, since farmers are likely to see a fall in revenue and profits.

[diagram on page 45]

The next figure shows a poor harvest due to bad weather, which decreases supply to S2, causing a rise in price to P2. Total revenue also increases to OP2WQ2 since demand for agricultural goods tends to be price inelastic. The ‘poor’ harvest is a paradox, since farmers are likely to experience a rise in revenue and profits.

[diagram on page 45]

The significance of price and income elasticity of demand

The problem of uncertain supply of commodities in any one year is compounded by the tendency for demand for these type of goods to be price inelastic. As shown previously, a good harvest will lead to a large fall in price and revenue whereas a poor harvest will lead to a larger rise in price and revenue. Consequently, farmers may make huge profits one year, and huge losses the next. It gives rise to market failure.

In the long run, the supply of agricultural commodities has increase dramatically due to major technological innovations: for example, genetically modified crops which increase yield and resistance to droughts and pests. However, the growth in demand has not been matched by a similar growth in supply. Commodities tend to be income inelastic in demand as each individual has a limited food intake. These implications point to further decreases in the real price of commodities and decreases in revenue for farmers.

However, the rapid economic growth of China and India has helped to increase the demand for commodities and so push up prices and revenues over recent years. The growth in use of biofuels has led to higher food prices – this is called composite demand.

The significance of time lags

The length of the growing season for agricultural commodities meas theere are time lags between farmers making the decision to sow seeds or raise livestock and the actual harvest of the crops or sale of meat. In a free market this may cause cyclical prices and farm incomes.

Labour immobility

The mobility of labour refers to the ability of workers to change from one job to another, both geographically and occupationally. There are more than 29 million people working in the UK labour markets producing a wide range of goods and services. However, around 1.5 million are also unemployed, indicating that labour markets do not always operate efficiently.

Some of the unemployed may simply be changing jobs and so register as out of work for a short period of time. After all, an economy is dynamic and specialised, so we should expect some unemployment since jobs are continuously being created and ended. Unemployment while people search for jobs and gill them is known as frictional unemployment.

However, a more serious type of unemployment is due to a mismatch in skills and location between job seekers and job providers. This gives rise to immobility of labour and structural unemplyment.

Geographical immobility refers to the obstacles which prevent labour moving from one area to another to find work. There are several causes, such as family and social ties, the financial costs involved  with moving house, imperfect market knowledge on available work, regional variations in house prices and the cost of living. The biggest problem tends to be lack of affordable housing in many parts of the UK, but especially the southeast region.

Occupational immobility refers to the obstacles which prevent labour from changing their type of occupation to find work. There are several causes, including sufficient education, training, skills, and work experience.

Government measures to increase labour mobility

There are various measures that a government might undertake to increase the geographical mobility of labour, and these include:

  • Relaxation of planning laws which enable construction firms to build housing, especially in the greenbelt areas and the southeast of England.
  • Increasing the construction of social housing, such as council properties and charities (housing associations). Rental costs also tend to be more affordable than mortgages.
  • Offering housing subsides to certain groups of workers where acute shortages exist, such as teachers, nurses and firefighters in southeast England. Subsidies may include mortgage relief, shared ownership and relocation grants.
  • Improving the operation of Job Centers so that more information is available on job vacancies in any area.

The measures a government might introduce to increase the occupational mobility of labour include:

  • Increasing the provision of training schemes, especially for the unemployed. This might include subsidies to private sector companies to offer training services.
  • Increasing the provision of further education.  Vocational education courses offer training in specific work-based skills and work experience to students.
  • Increasing the provision of higher education. There has been a rapid expansion in the the number of students in the sector over recent years. Increasing access to student loans and limiting tuition fees might help.

Imperfect market knowledge

Symmetric information

In the study of competitive markets it is often assumed that consumers and producers have perfect market information upon which to make their economic decisions. This is known as symmetric information – where consumers and producers have perfect and equal market information on a good or service. Assuming that consumers and producers act in a rational way, it will leas to an efficient allocation of resources.

Asymmetric information

In reality, consumers and producers have imperfect and unequal knowledge upon which to base their economic decisions, and this could lead to a inefficient allocation of resources, or market failure. This is known as asymmetric information.

Often producers may know more than consumers about a good or service. A second-hand car salesman, for example, may have a greater knowledge of the history of the vehicles for sale, as well as more technical knowledge than the consumer. This could lead to the consumer paying too much for a poor-quality car.

Sometimes consumers may have more market information than producers. For example, a consumer may purchase an insurance policy concealing information about himself or simply know more about his intended actions. This might include a risky lifestyle.  This is why insurance salesmen cover their backs by selling insurance policies at huge prices to young drivers, because they assume asymmetric information and factor that into their pricing.

When there is imperfect market information, markets are likely to fail. This can be seen in the under-consumption of healthcare, education and pensions (sometimes known as merit goods) or the over-consumption of tobacco, alcohol and gaming (sometimes known as demerit goods).

Public and private goods

Some goods may not be produced at all through the markets, despite offering significant benefits to society. When this occurs, it is known as a ‘missing market’ and the goods are called public goods. These goods involve a large element of collective consumption: for example, national defence, flood defence systems, the criminal justice system, and refuse collection.

Public goods are defined by their characteristics of non excludability and non-rivalry.

  • Non-excludability means that one a good has ben produced for the benefit of one person, it is impossible to stop others from benefitting
  • Non-rivalry means that as more people consume a good and enjoy its benefits, it does not reduce the amount available to others. In effect, it is non-diminishable.

Once a public good has been provided, the cost of supplying it to an extra customer is zero. Further examples include firework displays, lighthouses, public beaches, public parks, and street lighting.

Private goods

Private goods are the opposite of public goods. They display characteristics of rivalry and excludability in consumption. An example of  a private good is a Mars bar. The consumption of which directly excludes others other people from consuming that particular bar. The owners of private goods are able to use private property rights which prevent other people from consuming them. Provate goods can also be rejected which means one has a choice in wether to consume them or not.

The under-provision of a public good

Public goods are under-provided due to two problems.

  1. The free rider problem. Once a public good has been provided for one individual, it is automatically provided for all. The market fails because it is not possible for forms to withhold the good from those consumers who refuse to pay for it. Examples are national defence and security along a street.
  2. The rational customer wait for someone else to provide the good, and then reap the rewards by consuming it for fre. However, if everyone waits for others to supply a public good, then it may never be provided. The non-excludability characteristic means that the price mechanism cannot develop as free-riders will not pay.

  3. The valuation problem. It is difficult to measure the value obtained by the consumers of public goods and hence it becomes hard to establish a market price for them. It is in the interest of consumers to under-value the benefit gained from a public good so that they pay less for it; but it is in the interest of producers to over-value the benefit obtained from a public good in order to charge more for it. The uncertainty over valuation may deter firms from providing public goods.

Government provision of public goods

In a mixed economy, the government tends to provide public goods in order to correct market failure. It raises funds from general taxation to pay for their provision. Without government intervention, public goods may be under-provided or not provided at all. The actual quantity provided will be les than the amount required for achieving the socially optimum provision.


Externalities are the costs or benefits which are external to an exchange. They are effects which are ignored by the price mechanism.

Externalities are also known as indirect costs and benefits, or as spillovers from production or consumption of a good or service. In effect, external costs are negative externalities and external benefits are positive externalities.

External costs

External costs may occur in the production and in the consumption of a good or service. An example of an external cost in production is a chemical firm polluting a river with its waste. This cause an external cost to the  fishing and water supply industries. Fish catches may be reduced and it may become very expensive to purify water to meet the European Commission safety standards.

An example of external costs in consumption is a person is a person smoking tobacco, polluting the air for others. The effect is to cause passive smoking, where non-smokers may suffer the same illnesses as smokers.

Private costs

In a free market, producers are only concerned with the private costs of production. These include wages for workers, rent of buildings,  payment for raw materials, machinery costs, electricity and gas costs, insurance, packaging and transport costs. Private costs may also refer to the market price that a consumer pays for a good or service.

Social costs

By adding private costs to external costs we obtain social costs. This means that external costs are the difference between private costs and social costs. The marginal private cost and marginal social cost curves often diverge, indicating that external costs increase disproportionally with output. However, it is possible that external costs per unit remain constant, in which case the marginal private cost and marginal social costs are drawn parallel to each other. The relationship between private cost, external cost and social cost is shown below.

[diagram on page 38]

Note that the Edexcel specification focuses on diagrammatic analysis of externa; costs in production.

External benefits

External benefits occur in the production and consumption of a good or service. An example of an external benefit in production is the recycling of waste material such as newspapers, glass and tins. It has the benefit of reducing the amount of waste disposal for landfill sites, as well as re-using materials for production. It helps to promote sustainable economic gorwoth.

An external benefit in consumption is the vaccination of an individual against various deseases. It reduces the possibility of others catching the deseases who come in contact with the vaccinated individual.

Private benefits

In a free market, consumers are only concerned with the private benefits or utility from consuming a goo or service. Economists assume this can be measured by the price that consumers are prepared to pay for the good or service. Private benefits may also refer to the revenue that a firm obtains from selling a good or service.

Social benefits

By adding private benefits to external benefits we obtain social benefits. this means external benets are the difference between private benefits and social benefits.  The marginal private benefit and marginal social benefit curves often diverge, indicating that external benefits increase disproportionally with output consumed. However, it is possible that external benefit per unit consumed will remain constant – the the marginal social benefit an the marginal private benefit curves are drawn parallel to each other.

[diagram on page 39]

The free-market equilibrium

The supply curve for a firm is the marginal private cost curve (MPC).  The addition of all MPC curves in the market for a particular good or service will form the market supply curve.

The demand curve for consumers is the marginal private benefit curve (MPB). Economists assume that it is possible to measure the benefit obtained for consuming a good by the price people are prepared to pay for it. As an individual consumers more unit of good, the marginal benefit (marginal utility) will fall. This is why the demand curve slopes downwards from left to right. The addition of all the consumers’ MPB curves for a particular good or service will form the demand curve.

Market equilibrium occurs where marginal private benefit equals marginal private cost.

The socially optimal equilibrium

The socially optimal level of output or price for a good or service occurs when marginal social costs equals marginal social benefit. The social cost of producing a the last unit of output equals the social benefit from consuming it. When the socially optimal level is reached in a market, welfare is maximised.

External costs and the triangle of welfare loss

[diagram on page 40]

The free market ignores negative externalities. However, adding external costs on to the production of a good or service, such as the production of chemical hoods, the socially optimal price is at OP1, and quantity OQ1. When external costs are ignored there is under-pricing, and over-production. There is an excess of social costs over social benefits for the marginal output between Qe and Q1.

The marginal social cost of the output slice o QeQ1 is QeWYQ1m which exceed the marginal social benefit of the output QeXYQ1. The excess social costs over social benefits is shown by the triangle XWY. This is the area of welfare loss to society, the market has failed since negative externalities are ignored.

External benefits and the triangle of welfare gain

The free market ignores positive externalities. However, adding external benefits on to the consumption of a good or service, suc as the consumption of vaccinations, causes the demand curve to shift to the right and become the marginal social benefit curve, shown in the diagram below.

Assuming there are no external costs in the consumption of vaccinations in a free market, the socially optimal price in the consumption of vaccinations is at OP2, and quantity is at Q2. When external benefits are ignored, there is under-pricing and under-production. There is an excess of social benefits over social costs for the marginal output between Qe and Q2. Thus, by raising output from 0Qr to 0Q2, welfare could be increased.

The marginal social benefit of the output slice QeQ2 is QeMTQ2, which exceeds the marginal social cost of this output QeZTQ2. The excess of social benefits over social gains is shown by the triangle MTZ. This is the area of welfare gain to society; the market has failed since these positive externalities are ignored.

[diagram on page 41]