1.3.1 Types of Market Failure

Edexcel A-Level Economics (9EC0) | Theme 1.3.1

Specification Coverage: Students must understand how markets may fail due to externalities, public goods, and information gaps. This includes analysing diagrams of positive/negative externalities and evaluating government responses to market failure.

Understanding Market Failure

Definition: Market failure occurs when the free market leads to a misallocation of resources, resulting in either:

  • Under-provision of socially beneficial goods (e.g., healthcare)
  • Over-provision of socially harmful goods (e.g., cigarettes)
Contemporary Example: UK plastic waste increased 6% in 2023 despite recycling campaigns - a market failure where private costs < production externalities.
Diagram Alert: Insert production possibility frontier showing allocative inefficiency (point inside curve) vs social optimum.

1. Externalities

Definition: Costs/benefits imposed on third parties not involved in the economic transaction. Measured by the difference between private and social costs/benefits.

Type Consumption Example Production Example 2023 UK Data
Positive Vaccinations reduce disease spread (MSD estimates £9 return per £1 spent) Bee-keeping improves crop pollination (worth £690m/year to UK agriculture) Social benefit > private benefit
Negative Fast food contributes to £6.5bn NHS obesity costs Fossil fuel plants cause £5.3bn/year health damages (DEFRA) Social cost > private cost
Diagram Alert 1: Insert negative externality diagram (MPC/MSC divergence) with welfare loss triangle.
Diagram Alert 2: Insert positive externality diagram (MPB/MSB divergence) showing under-consumption.
Examiner Insight: 2023 papers required specific numerical examples of externalities. Always quote recent data (e.g., "UK carbon pricing at £47/tonne in 2024 addresses 76% of CO2 externalities").

2. Public Goods

Definition: Goods with non-excludability and non-rivalry characteristics, leading to free-rider problems.

Key Characteristics

Non-Excludability

Cannot prevent non-payers from benefiting (e.g., street lighting)

Non-Rivalry

One person's consumption doesn't reduce availability (e.g., national defence)

Quasi-Public Goods: London's Ultra Low Emission Zone (ULEZ) exhibits partial excludability (pay to enter) but non-rivalry in cleaner air benefits.

3. Information Gaps

Definition: When buyers/sellers have asymmetric information, distorting price signals and quantities.

Type Example Consequence
Adverse Selection Health insurance markets where high-risk individuals don't disclose conditions Market collapse (US individual mandate repealed in 2019 increased premiums 15%)
Moral Hazard Bankers taking excessive risks knowing they'll be bailed out 2008 financial crisis cost UK £137bn in bailouts (NAO)
Evaluation Point: Information gaps are worsening with digital markets - 73% of consumers can't identify greenwashing claims (CMA 2023).

Exam Preparation Toolkit

Recent Exam Questions:
  1. "Evaluate whether information gaps are the most significant cause of market failure in the financial services sector" (Edexcel 2023, 25 marks)
  2. "Using diagrams, analyse how negative externalities in production lead to welfare loss" (Edexcel 2022, 15 marks)
  3. "Discuss the view that public goods could be efficiently provided by the private sector" (Edexcel 2021, 20 marks)

Advanced Evaluation Framework

Market Failure Government Solution Limitation
Negative Externalities Carbon taxes (UK £47/tonne in 2024) Regressive impact - poorest spend 3× more as % of income
Public Goods State provision (UK NHS costs £190bn/year) Opportunity cost - could divert funds from education