1.5.1 Market failures and externalities


    Private costs – costs internal to a business (raw materials, equipment etc.) and the   price/income given up by consumers – people involved in transactions.

    Private benefits – sales revenue for the firm and the pleasure/ease gained for consumer  through the product

    Externalities – the cost or benefit of an economic action that affects a third party not   involved in the transaction

    Social cost – the total cost to society (private cost + negative externality)


    • They mostly work as the profit signalling mechanism leads to an efficient allocation of resources.
    • The market forces respond to changes in the factors of demand and supply, adjusting output accordingly to the needs of the consumers.
    • Competition is good as it drives does costs and increases efficiency. This drives down prices and encourages companies to make better, more innovative products to attract sales.
    • The allocation of resources reflects both consumers’ choices and production costs.


    Markets are working well when social costs are equal to social benefits. This is when the resources chosen to produce what we consume is equal to the value of the products we choose. This happens especially when there are few externalities and impacts are on the producer and consumer.


    Market failure – the inefficient allocation of resources


    This occurs when there are more social costs than benefits meaning that resources are not being allocated efficiently and consumers are not paying for the external costs.



    • Negative externalities create spill-over effects g. pollution, which are not included on the price of the product. If the price that was charged was the full social cost, then demand would be lower; there is over-consumption and over-production of these products.
    • Some very desirable products such as healthcare and education will not be provided in a market economy – the under-provision of public goods which are non-excludable and non-rival but will be unobtainable unless provided by the state.
    • Some firms will gain market power and some markets will become less competitive than others and prices will become higher than necessary. The price mechanism is no longer efficient.
    • Market forces do not guarantee a standard of living and will likely lead to inequality.


    Please enter your comment!
    Please enter your name here