Market Failures

The topic of Market Failures prepared by our JC Economics Tutor Simon Ng from Economicsfocus focuses on the ineffective functioning of the price mechanism due to certain factors, like the presence of externalities, absence of public goods and imperfect market condition. Find out how governments intervene to correct different forms of market failures, such as the use of direct provision, taxation, subsidies, moral suasion and legislation.

economics tuition notes definition


What is cost-benefit analysis?

-Cost-benefit analysis (CBA) is a systematic process for comparing costs and benefits of a policy or initiative. CBA will determine if the work is justifiable or feasible.

What is market mechanism?

-It focuses on the use of the market forces of demand and supply to allocate resources so to attain social optimization where there is maximization of net social benefit gain without incurring any deadweight loss. While the market demand reflects the consumers' willingness and ability to purchase, the market supply reflects the producers' willingness and ability to produce. In this price mechanism, the equilibrium price and output level is attained whereby the market demand is equal to the market supply when the demand curve intersects the supply curve.

What is a free market economy?

-A free market is a market structure by which the output level and price of goods are solely dependent on market demand and supply and is unaffected by government policies or external regulations.

What are the features of a free market economy?

Private ownership of property

•Freedom of choice and enterprise

•Competition (keen or high degree of competition)

•Maximization of personal benefits

•Price is determined freely by market demand and supply

What are the advantages of a free market economy?

-Reduced welfare loss

-Firms are more efficient due to higher competitiveness

What are the disadvantages of a free market economy?

-Prone to market failure

-Public goods will not be produced

-Merit goods under consumed and demerit over consumed

What is market failure?

-Market failure refers to the failure of price mechanism to conduct efficient resource allocation and thus, calls for the intervention of the government. The price mechanism will fail under the conditions when there is absence of the provision, the presence of externalities and the presence of imperfect market. It is also a condition of market failures when the society is unable to reduce the extensive disparity in the distribution of the net social benefit gain when there is extensive unequal distribution of income

What is moral suasion?

-Moral suasion is a persuasion tactic used by an authority (i.e. Federal Reserve Board) to influence and pressure, but not force, banks into adhering to policy. Tactics used are closed-door meetings with bank directors, increased severity of inspections, appeals to community spirit, or vague threats.

What are the benefits and limitations of moral suasion?


- Provide discretionary power to solve some of the complexity of the issue as it possesses

- Prevent complete loss of welfare

- Raise the standard of living of the poor as these public goods like public facilities will make their lives more convenient and comfortable


- May not possess the technology to provide the goods and services Lack of funds

- Need to increase tax or raise loans - Incurring internal loan would add on the tax burden of the future generation while incurring external loan would deplete future earnings

- May create a glut or shortage due to the inherent problems of the government inefficiency – insufficient information on the needs of the facilities may lead to unnecessary production

- If provision is free to the public, there may have excessive consumption above socially optimal levels, leading to deadweight loss

How does carbon permit works in curbing air pollution?

-The carbon permit involves the government taking over the production of goods to ensure that the negative effects of the production will not affect the society as the level of consumption and production will set at the social optimal level. (e.g. nuclear plant)

Why does the government conduct direct provision of public museums but not university education?

- Public museums have a higher marginal social benefit than university education

- Public museums have the problem of non-rivalry and non-excludability, making it hard for private producers to produce the goods at a price.

- University education is rivalrous and excludable as there are limited vacancies and consumption is only for students who attain the necessary grades.

Why is government intervention ineffective in solving market failure?

Distortions that Arise because of Intervention

- Government policies do not provide a complete solution to the problem as it may create new problems for the economy.  E.g. Imposition of taxes to reduce traffic jam will discourage workers from working hard.

- Abuse of government policies to gain votes as the policies for correcting externalities may undermine certain segments of the population for the mass population’s interest

Information Asymmetry

- Lack of information on the part of government causes the incorrect policy decision

- Hard to assess the impact of the policies

Bureaucracy and Inefficiencies of Government

- The government may themselves be inefficient due to administrative paths and costs

Time Lags

- Time lags from the implementation of policies to act, may render them to be less effective.

Cost of financing

- Concern over budget position may incur budget deficit, which leads to a rise of public debt

Lack of expertise

- Services or good will be provided by private sector and distributed by the government

Why parks and overhead bridges public goods are while hospitals and primary school education merit goods?

- Parks and overhead bridges have features of non-excludability and non-rivalry, which makes it difficult for private producers to produce.

- Hospitals and primary schools education have greater marginal social benefit than marginal private benefit which the society fails to realise. Hence, subsidies employed encourages consumption.

- However, it cannot be provided as a public good as over-consumption may incur.

What is bureaucratic inefficiency?

-Bureaucratic inefficiency arises from the problems of cumbersome administrative paths and unnecessary costs, under a set of fixed and strict order and rules.

What is Income Elasticity of Demand?

-Income elasticity of demand measures the responsiveness of change in quantity demanded due to a change in the income of the consumer.

What is Cross-Elasticity of Demand?

-Cross elasticity of demand measures the responsiveness of change in quantity demanded as a result of change of price of other good.

What are the determinants of income elasticity of demand?

-The Proportion of Income Spent on the Good

-The Price of the Good and the Level of Consumer Income

What are the determinants of cross elasticity of demand?

-Relationship of the Goods

-Market Classification

What are the uses of income elasticity of demand?

-Provide information on how the firm can respond in relation to the change in economic growth of the country

-Provide information about the consumer’s degree of price sensitivity and thus help to determine the price strategy

What are the uses of cross elasticity of demand?

-To Determine the Relationship of Goods

-To Help to Determine the Degree of Competition and Develop Nature of Competition

What is the formula of Income elasticity of demand? How to calculate the income elasticity of demand?

-YED =  Percentage change in quantity demanded of good concerned

                     Percentage change in the level of consumer income

What is the formula of Cross Elasticity of Demand? How to calculate the cross elasticity.

-CED = Percentage change in quantity demanded for the good concerned

                    Percentage change in the price of another good