Cambridge IGCSE Economics 0455
Syllabus points
- Define market failure.
- Explain the causes: externalities, merit and demerit goods, public goods, and abuse of monopoly power.
What is market failure?
Market failure occurs when the free market fails to allocate resources in the best interests of society — producing too much of some goods and too little of others.
Key definitions
| Term | Definition |
|---|---|
| Market failure | When the market allocates resources inefficiently, harming society's welfare. |
| Externality | A cost or benefit affecting a third party not involved in the transaction. |
| Merit good | A good that is better for people and society than they realise, so it is under-consumed. |
| Demerit good | A good more harmful than people realise, so it is over-consumed. |
| Public good | A good that is non-rival and non-excludable, so the market will not provide it. |
The main causes
- Negative externalities — pollution from a factory imposes costs on society (illness, dirty air) that the firm ignores, so the good is over-produced.
- Positive externalities — education benefits society as well as the student, but individuals under-value this, so it is under-consumed.
- Demerit goods (cigarettes, alcohol) — over-consumed because people ignore the harm to themselves and others.
- Merit goods (healthcare, education) — under-consumed because people undervalue the private and social benefits.
- Public goods (street lighting, defence) — non-excludable, so people free ride and the market provides none.
- Monopoly power — a dominant firm may charge high prices and restrict output.
Negative externalities → over-production; positive externalities and merit goods → under-consumption; public goods → not provided at all.
Worked example
A factory dumps waste in a river. The private cost to the firm is low, but the social cost (polluted water, dead fish, illness) is high. Because the firm ignores this external cost, it produces more than is good for society — a classic negative externality and market failure. The government may tax or regulate the firm to reduce output towards the socially desirable level.
Common exam mistakes
- Confusing merit goods (under-consumed) with demerit goods (over-consumed).
- Calling healthcare a "public good" — it is usually a merit good (it can be excluded and is rival).
- Forgetting to link the failure to over- or under-production.
Exam technique
Name the type of market failure, explain the gap between private and social costs or benefits, then suggest a government response (tax, subsidy, regulation, provision) — this sets up Unit 4.
Quick revision
- Market failure = inefficient allocation harming society.
- Causes: externalities, merit/demerit goods, public goods, monopoly power.