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Explain, with relevant examples, the situations when prices determined by the intersection of demand and supply do not correctly reflect the costs and benefits, and how these situations lead to market failure in the free market.


The topic addressed in this economics paper is market failure in competitive markets. Prices do not always accurately reflect the costs and benefits of the market, thus leading to market failure in the case of positive and negative externalities, merit and demerit goods. This essay aims to identify the circumstances when prices do not correctly reflect the costs and benefits of the market and explain how markets fail as a result.
Firstly, negative externalities are defined as the adverse spillover effects on third parties arising from the production or consumption of a good. Third parties refer to people who are not directly involved in the transaction of a good. An example of negative externalities would be evident in the case of production, where plants may discharge industrial waste into the environment and therefore cause health and environmental risks to nearby residents. In addition, in the case of consumption, the existence of alcoholics may pose as a threat to the peace and security of law abiding people and society at large. Therefore, negative externalities result in the marginal social costs exceeding the marginal private costs in society, causing deadweight loss.

[Insert diagram for negative externality in production]
Without government intervention, the private equilibrium occurs where MPB = MPC, but the social equilibrium occurs where MSB = MSC. Between Qs and Qp, since MSC > MSB, the triangle pointing towards Qs represents the negative welfare generated and therefore the good is over-produced in the case of negative externalities, leading to market failure. 
Positive externalities, on the other hand, refer to the benefits enjoyed by third parties from the production and consumption of the good. In the case of production, for example, receiving a complete education up till or beyond the tertiary level will not only benefit the student himself but also the society collectively as a whole due to his contribution to the society through application of his knowledge. Likewise, in the case of consumption, for example, vaccination not only reduces the risk of contracting a disease in the vaccinated person, but also reduces the risk of diseases for third parties coming into contact with him. Thus there are greater marginal social benefits than costs but the good may be under-consumed by the society.

[Insert diagram on positive externality in production]
When there is no government intervention, the private equilibrium is where MPB = MPC. The social equilibrium however is at MSB = MSC. Between Qp and Qs, as MSB > MSC, the loss in potential welfare of the society is represented by the triangle pointing towards Qs. Therefore the good is under-produced in the case of positive externalities, leading to market failure.
Furthermore, merit goods refer to goods in which the state believes will be under-consumed if left to the free market because some individuals are unable to factor in the full private benefits of consumption. For example, a student may decide to leave school early to work as he perceive the short term benefits of working to be greater than the long term benefits of receiving a complete education, therefore unknowingly undermining the marginal private benefits he has brought to himself.

[Insert diagram on merit good]
For merit good, the private outcome is Qp where MPB = MPC, whereas the social outcome is Qs where MSC = MSB. Between Qp and Qs, since MSB > MSC, there is a loss in potential welfare represented by the triangle pointing towards Qs, and the good is under-consumed, thereby leading to market failure. 
Demerit goods are goods that the state believes will be over-consumed if left to the free market forces because some individuals are unable to factor in the dull private costs of consumption. For example, goods like alcohol and cigarettes may result in severe health and financial problems when excessively consumed and since there are people that still consume them thinking that the marginal private costs do not exceed the marginal private benefits, when it is in reality, thus results in market failure. 

[Insert diagram on demerit good]
For demerit good, the private outcome is when MPC = MPB at Qp, while the social outcome is at Qs when MSC = MSB. Between Qp and Qs, since MSC > MSB, this results in a deadweight loss represented by the triangle pointing towards Qs, where the good is over-consumed in the case of demerit goods. 
In conclusion, prices do not always accurately reflect their costs and benefits of the market. As seen in the cases of merit goods and positive externalities, the goods are under-consumed by the society although the marginal social benefits outweigh the marginal social costs, and in the case of negative externalities and demerit goods, the marginal social costs outweigh the marginal social benefits and the goods are over-consumed. Therefore, the deadweight loss – the loss in potential welfare of the society due to the over-consumption and under-consumption of goods leads to market failure.

JC Economics Essays - H1, H2, H3 sample essays - tutor's comments: Market failure and the operation of the free market under conditions of perfect competition are important economics topics for both Economics at A levels and introductory undergraduate economics courses, and as such this might be a useful topic to prepare for examinations. It might be a good idea to get a firm understanding of how markets operate and how market failure distorts the workings of the price mechanism as it allocates resources. In this section on comments on the above economics paper, instead of providing general feedback or pointing out what went well and went not so well with it, I will ask questions instead: using Bloom's taxonomy as an intellectual framework to address this economics essay, has the student identified the topic properly, defined and explained key terms, drawn the right diagrams, explained the economic theory with real world examples, explained the diagrams drawn, and come to a reasoned, fair, nuanced conclusion? What has the essay writer done well, and what has the essay writer got to improve on and make better? Are there economics materials that you would have added, and why are these additional concepts, ideas, and arguments important and relevant? Think through these issues. I should give a hint for an important enduring understanding: structure is important to good essay writing, and this economics paper is well structured and well laid out. Always remember to improve on your writing skills, and craft well-thought-out, clear economics essays. Special thanks to S S and A G once again for their useful, relevant, and interesting contributions. Thanks for reading and cheers. 

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