According to economic theory, the price mechanism in a free market will always allocate scarce resources efficiently for all goods and services. Evaluate the validity of this statement. [25]

This essay question was adapted from an actual H2 A level economics examination question

This economics essay evaluates whether the price mechanism in a market economy will always allocate scarce resources efficiently for all goods and services. This essay argues that, on the one hand, the price mechanism working in a free market economy will indeed allocate scarce resources efficiently, according to standard economic theory, because of the price mechanism can achieve productive and allocative efficiency. On the other hand, the allocation of scarce resources may not always be efficient, especially when there are market failures and resources are not allocated efficiently, leading to a situation of allocative inefficiency, which distort the workings of the free market.

First, we need to deal with the central problem of economics. Human wants are unlimited, while the earth's factors of production of land, labour, capital, and entrepreneurship are limited. Land refers to gifts of nature such as physical land, natural resources, and oil and gas, among other examples. Labour refers to human ingenuity, effort, time, and talent in the form of “human capital”. Capital in economics often refers to goods that are used to produce yet other goods. And entrepreneurship is the risk-taking, decision-making element that coordinates the other factors of production in an economy. This situation of limited factors of production that could potentially be allocated to different outputs, and the context of unlimited human wants, results in a situation of scarcity. It is important to note that economic scarcity necessitates choice, usually made between competing uses. 

Tutor’s Question: What economics diagram do you think should be drawn here? And how would this diagram back up your arguments?

The price mechanism, through the intersection of demand and supply, determines the optimal price and output and it is from the rational choices of millions of suppliers, producers, and firms meeting the requirements of millions of consumers, individuals, and households that eventually leads to the free market determining what to produce, how to produce, and for whom to produce. Demand is defined as the willingness and ability to purchase a good or service, ceteris paribus, while supply is defined as the willingness and ability to produce a good or service, also ceteris paribus. Oftentimes, one major assumption for this economic theory to work is the situation of perfect competition, where there are many buyers and sellers in a market, selling a homogeneous and non-differentiated good or service, and there are no (or very low) barriers to entry into the market.

Under the market price, consumers seek to maximise utility, and will therefore only consume if they are able to have a positive net benefit from the consumption of these goods and services. Those who are willing and able to pay will obtain the good and service. And the resources used to produce these goods and services will also be efficiently allocated, as producers maximise their profits. As a result, there is productive efficiency, since goods will be produced at the lowest cost combination to ensure profits are maximised, and price will be equal to marginal cost. On the whole, there is also allocative efficiency, since society’s welfare is maximised, and the Pareto efficient situation is reached, where we can only make some people better off by making others worse off in such an economic situation.

On the other hand, there are market failures in the real world, which may impede the efficient allocation of scarce resources. Market failure is the situation where the free market fails to allocate resources efficiently, and there is allocative inefficiency and deadweight loss to society. There are many types of market failure, such as the lack of provision of non-rival and non-excludable public goods, under-consumption of merit goods but over-consumption of demerit goods, externalities both positive and negative and also in consumption and production, imperfect competition leading to excessive market power in a market, imperfect information, factor immobility, and income and wealth inequality in a free market.

One major example is the under-consumption of merit goods. Because rational consumers seek to maximise their own welfare, they do not account for the positive externalities associated with the consumption of their good or service, which could be a merit good. There are many definitions of a merit good, but one definition is that a merit good is a good defined by society or the government to be beneficial to society, often because they bestow positive externalities on society when they are consumed. Externalities are defined as spillover effects to third parties not involved in the production or consumption of the good. Vaccinations provided by the National Health Service (NHS) are examples of merit goods, because they confer positive externalities on society, as when people who are vaccinated help by not infecting others and by making UK society healthier as a whole. However, an individual consumer only considers his marginal private benefit from getting vaccinated, and does not consider the positive externalities his vaccination confers on society – he would not take the positive externalities into account when making his economic decision. This decision results in an under-consumption of the merit good of vaccination, if the decision is left to the workings of the free market, and there is therefore dead-weight loss, as society’s welfare has yet to be maximised due to this under-consumption.

Tutor’s Question: What economics diagram do you think should be drawn here to support the merit good argument, which shows that markets do not always work efficiently?

Another example is the failure of the free market to produce public goods if there is no government intervention. A public good is one that is non-rival and non-excludable. Non-rival in consumption means that one person’s consumption of the good will not result in less of the good being available to others – or the consumption of the good does nothing to reduce the quality or quantity of the good for others, such as public lighting in the streets, where the amount of light cannot be “used up”. As a result, the marginal cost of the next user is theoretically zero, and if allocative efficiency means to produce where price equals to the marginal cost, and the marginal cost of producing the good is zero, then it follows that no private firm would produce the good only to  charge zero dollars (at the allocative efficiency level). And non-excludable means that non-payers cannot be excluded from consuming the good, for example national defence – it defends everyone in the country, including those who have not paid for it, such as foreigners or travellers, such as tourists. Therefore a rational firm would not produce this good because of the problem of free riders, where one who has not paid for the good has the ability to consume it. The government is the only decision-making body that has the willingness and ability to produce a public good, like street lighting and defence, as it has the mandate to do so for the welfare of its citizens (and therefore the willingness) and can raise the revenues to do so from compulsory taxes (and therefore the ability to do so).

In conclusion, while the price mechanism allocates scarce resources efficiently according to economic theory, this may not always be the case in reality, as there are market failures that challenge the assumptions upon which the efficiency of the price mechanism is predicated. Some government intervention is required in the free market to make it genuinely “free”, and to let the price mechanism work as it should. In the real world, with market failures such as the failure of the free market to produce public goods or the underconsumption of merit goods, or imperfect competition in the market, there is a strong need for government intervention in the free market to reduce or eliminate market failures so that the free market can go a long way to produce the optimal outcomes that the free market economists promise.

Economics Tutor's Comment - This is a top-quality, excellently-argued, and very strong economics essay which covers quite a few important points and arguments. The candidate's use of economic theory for market failure is quite strong in this economics essay and the anti-thesis arguments have been well-explained. Could more real-life examples have been used to demonstrate the arguments or the strength of the points? What else would make this economics essay even better than it is currently? Thank you for reading, and cheers! 

JC Economics Essays - This economics essays blog helps economics students with the A-Levels Economics examinations (Cambridge, A1/S, A2, H1/H2 A levels), and the international AS level economics examinations. IB students can also benefit from the economics materials and content in JC Economics Essays. This economics blog provides a range of useful and relevant economics essays, learning materials, study tips and techniques, and model economics essays that students in the United Kingdom, Malaysia, and Singapore, as well as worldwide, can use to excel in their studies and economics examinations.

This model economics essay was contributed by WT, our resident expert who helps students understand the beauty of Economics. She has wide-ranging academic interests in Econometrics, Economic History, International Trade, and Game Theory. And as always, SS, the editor of JC Economics Essays, edited this economics essay and also provided comments and pointers. Several editions and versions of this economics essay have been very popular, but do not accept them at face value and always think about how you would approach this economics question instead. Thank you for reading and cheers. 

Explain with real world examples why markets might fail in the case of public goods and where information is imperfect. [10]

This paper explains, using real world examples, the market failures caused by public goods and imperfect information. Market failure refers to the situation where the free market fails to achieve the socially optimal outcome that maximises society’s welfare, and therefore fails to allocate resources efficiently. The market is said to be allocative inefficient. There are several sources of market failure, which include positive and negative externalities; the underconsumption of merit goods but overconsumption of demerit goods; the lack of production of public goods if they are left to the free market; market dominance, such as the existence of monopolies and oligopolies; the presence of imperfect and asymmetric information; and the immobility of the factors of production. Public goods and imperfect information would be the focus of this essay.

A public good refers to a good which is non-excludable and non-rival. Some common and popular examples of public goods include national defence and street lighting. "Non-excludable" means that it is impossible or impractical to prevent a person who has not paid from consuming the good. This implies that consumers would be unwilling to pay, as they are able to enjoy the benefits without paying, thus giving rise to “free riders”, resulting in firms lacking an incentive to produce the good and therefore a missing market. 

"Non-rival" means that the consumption of the good by a person does not diminish the quantity or quality of the good available to others. "Non-rival" implies that, once the good is produced, the Marginal Cost (MC) of allowing an additional person to consume the good is zero. Therefore, if the allocative efficient level of consumption is where Price (P) = MC, and MC = 0, then P = MC = 0 suggests that the good should be optimally provided for free, necessitating government provision. 

Hence, public goods are a form of market failure and government provision is required. Governments have the willingness and ability to produce public goods due to their non-profit nature, and unlike private firms, are able to raise compulsory taxes which citizens are compelled to pay, for the production of the public good. 

On the other hand, imperfect information refers to the situation where an agent lacks all relevant information with which to make a rational decision. 

Negative externalities refer to the adverse effects imposed on third parties arising from the production or consumption of a good. A demerit good is an undesirable good which the state believes will be over-consumed and over-produced if left to the workings of the free market. In the case of negative externalities and demerit goods, some consumers may be unaware or may underestimate the harm done to themselves and to others when certain goods are consumed or produced, and thus do not take into account the costs for themselves and on larger society. In other words, due to imperfect information, some individuals may be unable to factor in the full private costs of consumption – perceived Marginal Private Cost (MPC) is less than the actual MPC. This is shown in the above diagram, where the actual MPC, which is also the Marginal Social Cost (MSC), lies above the perceived MPC. The private outcome is Qp where perceived MPC = Marginal Private Benefit (MPB), whereas the social outcome is Qs where Marginal Social Benefit (MSB) = MSC. Between Qs and Qp, because MSC > MSB, the shaded area representing the negative welfare, the deadweight loss, can be eliminated if output were reduced from Qp to Qs. Since Qp > Qs, the good is overconsumed. Cigarettes are an example of a demerit good with negative externalities in consumption. Due to a possible lack of knowledge of the adverse effects arising from the consumption of cigarettes, smokers place themselves and nearby passive smokers at risk from suffering future health problems. 

THINK: What economics diagram should be drawn here, and what should the diagram show?

Positive externalities refer to the benefits enjoyed by third parties arising from the production or consumption of a good. A merit good is a desirable good which the state believes would be under-consumed or under-produced if left to the workings of the free market. In the case of positive externalities and merit goods, some consumers may be unaware or may underestimate the benefits enjoyed by themselves and to others when certain goods are consumed or produced, and thus do not take into account the benefits for themselves and on larger society. Training of workers are an example of a merit good with positive externalities in production as it generates a positive benefit for other firms when these workers work there. However, due to imperfect information, companies may be unwilling to send their own workers for upgrading, thus leading to the good being under-produced and therefore market failure.

In conclusion, the free market may experience market failure due to other sources besides public goods and imperfect information. Hence, the government could decide to intervene to establish allocative efficiency as part of their micro-economic goals.

JC Economics Essays - This A level economics essay response was contributed by Wilson YWS, and is one of the best essays that he has written. The response is clear, simple to understand, and shows that the student understands what the economics question demands. 

However, the major issue with it is that the real world examples could be better used to bring out and illustrate the various elements of the theories. 

Looking closely at this essay, how could the real world examples be better used to show that there really is market failure? Merely stating the examples or bringing them out piece-meal would not be a very constructive approach. However, overall, this essay is still a strong piece of work on balance but one that could be even better if it were improved. 

Thank you very much for reading, and cheers. 

Should governments always intervene in the markets to correct problems when free markets fail to allocate resources efficiently? [15]

What is market failure? Market failure is defined as the situation where the free market fails to achieve allocative efficiency – the market fails to achieve an outcome that maximizes society’s welfare. Government intervention during market failure may in certain cases be justified, but in other cases unjustified. This essay intends to discuss if government intervention in markets that fail is justified and effective, by addressing and focusing on the economic problem of externalities, demerit goods, and the lack of provision of public goods. 

Governments can utilise various methods to address externalities and demerit goods. Externalities are third party spillover effects, and can be both positive and negative, and can come from consumption or production sides. Demerit goods are goods that either cause negative externalities, or are goods that governments deem unacceptable for their citizens, for instance smoking and gambling. In the case of negative externalities and demerit goods, when goods are over-consumed as their marginal social costs exceed the marginal social benefit, the government may adapt the use of an output tax to prevent the over-consumption of the good. 

[Insert a diagram on output tax showing how this policy cures the problem]

Imposing a tax per unit that is equal to the MEC shifts the MPC to the left. The new private equilibrium now coincides with the new social equilibrium Qs where MSB = MSC. Allocative efficiency is achieved as the output has been reduced to the social optimal level and therefore government intervention is justified.

Alternatively, the government may also impose an output quota which is defined as the limit for the quantity that the industry can legally produce, therefore effectively reducing the over-consumption of the good generating either negative externalities or demerit goods.

[Insert a diagram for output quota showing how this policy cures the problem]

The original equilibrium is determined by the intersection of MSC and MSB. When the government imposes a quota, the new equilibrium price increased while output falls. Therefore, the quota effectively increases the equilibrium price and decreases the equilibrium quantity of the good.

In the case of positive externalities and merit goods, the government may choose to adopt the policy of subsidies to effectively reduce the extent of under-consumption of the good, to raise the consumption or production of a good to bring about a more socially desirable outcome.

[Insert diagram on subsidies showing how this policy cures the problem]

Giving producers a per unit subsidy that is equal to MEB lowers their production costs and shifts the MPC to the right. The initial social equilibrium of Qs where MSB = MSC now coincides with the new private equilibrium. Allocative efficiency is now achieved as output is now raised to the socially optimal level.

Alternatively, the government may also provide for the good completely free to the society, so as to reduce the extent of under-consumption of the good that brings about positive externalities or merit goods. Also, in the case of public goods, there is a missing market and usually governments have to provide the good for society. Public goods are goods that are non rival and non excludable, which means that they cannot be "used up" when someone consumes them, such that there is less of the good for others, and which means that no one can be excluded from the consumption of the good, respectively. For instance, defence and street lighting are both public goods because they are non rival and non excludable goods. These two conditions of non-rivalry and non-excludability imply that the good has MC = 0, and also that there will be free riders, and therefore profit oriented companies simply will not produce the good as they are assumed to be profit driven. 

[Insert diagram on free provision of goods showing how this policy cures the problems (plural)]

For free provision, the social outcome where output is at Qs, is when MSB = MSC. When the output is subsidized, MSC shifts to the right, where the socially optimal output of Qs is achieved. Therefore the effective price of the good is now zero and the entire cost of the good generating positive externalities or merit goods is now absolutely borne by the government.

However, although government intervention in the market may seemingly be beneficial in helping to shift prices and output to the socially desirable outcomes, they may not always be justified, as there are limitations to it as well. In the case of demerit goods and externalities, high implementation, enforcement and mentoring costs may be incurred by the government in fulfilling its role as an interventionist and thus the total administrative costs may exceed the benefits from implementing such measures, leading to an overall decline in society’s welfare. Taxing the public may also be politically unpopular and therefore hinder governments from implementing such measures by placing political interest over economic ones. 

Moreover, in the case of merit goods and positive externalities, using subsidies to resolve the problems posed may be economically costly and full provision may lead to over-production and over-consumption beyond the socially optimal level and therefore lead to allocative inefficiency as well, therefore proving that government intervention is not justifies and not effective to a large extent. 

Hence, in the final analysis, whilst government intervention in the case, where market failure arises, may be beneficial to a limited extent in helping society to maximize its welfare, in the long term, the costs of government intervention may far exceed the short term benefits enjoyed by society as seen in the limitation of using subsidies, quotas, taxes and free provision. Therefore, markets should be rid of government intervention to a maximal extent, because it is only effective in the short run and to minimal extents and therefore is unjustified as a whole.

JC Economics Essays - H1, H2 A level Economics - tutor's comments on the essay: This economics paper is clear cut, direct, and to the point, and tries its best to answer the question. There are of course a few improvements which can be made to it - try to think about what the improvements are. However, more importantly, as this is a 15 mark examination question, it is the part (b) from another part (a) question, and therefore linked to it in a particular way. Economics exam questions on market failure at H1 and H2 levels often ask for explanation in part (a) of the question, followed by deeper analysis and more evaluative comments on the same topic in the second part of the essay. This is an important thing to note - explanation will not get the highest marks here, but analysis and deeper thinking. Perhaps you could focus on the essay's well-written conclusion, which evaluates market failure and the impact of government intervention. This makes this economics essay come to a well-reasoned, nuanced, balanced, evaluative conclusion, which greatly helps the essay get higher examination marks. Thanks for reading and cheers. Special thanks to AG, who will surely be an outstanding undergraduate candidate at Nanyang Technological University, and the other students who made this essay possible: SH, JC, NT, M, and SS. Thanks for reading and cheers. 

H2 Explain the difference between public goods and merit goods, using examples from the United Kingdom. [10m]

Market failure refers to a situation where the free market fails to achieve an outcome that maximises  society’s welfare. Such a society is said to be allocatively inefficient. This paper delves into detail regarding the difference between public goods and merit goods, using examples from the UK. 

A public good is defined as a good that is non-excludable and non-rival; non-excludable means that it is impossible to prevent someone who has not paid from consuming the good while non-rival means that the consumption of the good by one person does not diminish the amount or quality available to others. 

On the other hand, a merit good refers to a good 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. This means that the perceived marginal private benefit is less than the actual marginal private benefit and the good is under-consumed. 

Due to the non-excludable and non-rivalrous characteristics of public goods, consumers are unwilling to pay because they are able to enjoy the benefits as “free-riders”. Firms are unable to charge a price and so they find the good unprofitable to produce. Under a free market, production does not occur and total market failure arises. 

When this happens, the government must fully finance the production of the good in which the cost of financing such good is funded from general taxation. In the case of UK, the flood control defence is funded by the government. It is non-excludable as people in the country who did not pay for the flood control system will get to enjoy the same level of safety from floods. It is non-rivalrous too as such security against these natural hazards does not diminish even if the population increases. 

Merit goods may also exhibit positive externalities, or alternatively, due to imperfect information, may be under-consumed as a result. Thus, society’s welfare is not maximised. To correct such market failure, the government must raise consumption through subsidies. In the case of the UK, the entry to national museums and art galleries is free and tickets to the opera are subsidised as the government recognizes the under consumption of art among the people. Individuals may fail to factor in the private benefits of consuming such a good such as providing an alternative form of escapism from the hectic life of city dwellers through the appreciation of art. To raise the consumption, the UK government subsidizes the entry tickets to art galleries to point of being free so as to raise the overall welfare of the society. 

Public goods defer from merit goods as the former exhibit non-excludability and non-rivalrous characteristics. On the other hand, the latter are private goods which exhibit excludability and rivalrous characteristics. Merit goods are provided by private producers as they are able to set a price on the good. There is no “free-riders” problem in the case of merit good whereas there exists such a problem in the case of public goods. As such, a public good is provided by the government directly whereas merit goods tend to be subsidised or partially provided. The argument on merit good focuses is more on individuals undervaluing private benefits while the “free-riders” problem plays a significant role in the argument on public good. 

JC Economics Essays - Economics Tutor's Comments: This is a simple, clear cut, and well presented Economics essay that is fairly accurate, direct, and to the point. This essay addresses the question posed directly. However, the usual question applies: how could you improve upon this Economics essay to make it better, or even more accurate or precise? How could you further develop the essay's paragraphs? Special thanks to S YQ for this excellent piece of economic writing. Thanks for reading and cheers. 

(a) Explain ‘public goods’ and ‘merit goods’, making clear how these cause markets to fail. [10] (Adapted from the A levels)

(a) Explain ‘public goods’ and ‘merit goods’, making clear how these cause markets to fail. [10]

Adapted from an actual Economics Examination: November 2008, H1, A-Level

A public good is a good that is not produced by the free market despite it being beneficial or desirable to society. This is because a public good is non-rivalrous or non-diminishable, meaning that its supply is not depleted by an additional user and consumption by one does not reduce the amount available to others. Also, it is non-excludable, meaning that it is impossible or costly to exclude non-payers from consuming the good.

By being non-rivalrous, it means that the marginal cost of allowing an additional consumer to share in the usage of such a good is zero, and so is the marginal cost of serving an additional user. Hence, since at the socially optimum level, P=MC, if MC=0, then the price of the public good is also equal to 0. Hence, none of the good will be supplied by profit-motivated private suppliers as they have no incentive to do so.

By being non-excludable, consumers do not have much incentive to pay for the good and suppliers will find it difficult or impossible to collect fees for the benefits they provide; this is the problem of free riders. When large numbers of people become free riders, there is virtually no incentive for consumers to offer to pay for the good. This non-expression of demand makes it impossible for profit-motivated private suppliers to charge a market price for the public good, leading to either none or not much of the public good being produced. This situation leads to a missing market for public goods. Hence, there is no provision of the public good in the free market, resulting in market failure as there is allocative inefficiency when resources are not allocated to producing public goods, which are essential or beneficial to society.

Figure 1 –Imperfect Information when Consuming Merit Goods

A merit good is a good or service that a paternalistic government perceives as beneficial for individuals consuming them because of the information failure causing them to under-estimate their private benefits in consuming them. An alternative view is that merit goods generate positive externalities in consumption. As consumers underestimate their private benefits when consuming merit goods, if left wholly to the private sector, it is likely they will be under-consumed because individuals do not understand or appreciate the good effects that can result from consumption. Examples of merit goods include healthcare and education. Because knowledge of these benefits is an ongoing process, individuals themselves will tend to underestimate the long term private gains from a proper education or proper healthcare. If the consumers were fully informed of the additional private benefits, the demand curve would be D (perfect info) and the equilibrium output Y as shown in figure 1, where the true and full information value of an extra unit of good equals to its Marginal Social Benefit. However, the free market equilibrium occurs at output Z since consumers cannot individually discover the benefits associated with the particular good, such as the fact that proper education allows consumers to have higher potential earnings over one’s working life and be employed. Hence, imperfect information incurs a welfare cost ABC when the uninformed consumers use the wrong marginal valuation of benefits of the good.

Figure 2 –Positive Externality in Consuming Merit Goods

At the same time, merit goods also create a positive externality in consumption, assuming perfect competition and that the Marginal Private Cost curve is the same as the Marginal Social Cost Curve, as shown in figure 2. Since the consumption of the good generates positive externalities, otherwise known as Marginal External Benefit (MEB), the Marginal Social Benefits arising from individual’s consumption of the good (MSB) is higher than Marginal Private Benefit (MPB) by the amount of the MEB, creating a divergence between MSB and MPB. The free market equilibrium is at Em with output Qe units; however, the socially desired output level is Qs units.  From society’s point of view, there is under-consumption of the good by QeQs units, and too little resources are channelled to its production. This is a situation of allocative inefficiency. The money value of benefits from output QeQs =Area QeREsQs, and the money value of resources from output QeQs =Area QeEmEsQs. Hence there is a deadweight loss in not producing output QeQs = equal to Area EmREs. This shows that there is market failure in consuming merit goods as they incur a positive externality.

JC Economics Essays: Tutor's Comments - This is an Economics answer based on an actual A level Economics examination, but it has been amended and changed to fit this blogpost as well as show the answering technique and approach. This is a very well written answer that is to the point and analyses the diagrams (they were drawn in the actual answer); yet, the usual tutor's question applies: how would you improve upon this Economics answer? Let me give you a hint from an Economics tutor's point of view - whilst this is an excellent theoretical answer, perhaps it lacks consistent application of real world examples...? Yes, you should include more real world examples such as national defence. By the way, this is the basic questioning approach that I take in this site: imagine you are an Economics tutor or examiner, and as a tutor or examiner - what would you like to see in the answer? Think about this question and think of the implications for how you would approach Economics essays. Also do note that there are many other public goods and merit goods essays in this site here, so do explore and compare and contrast various questions and the concomitant answers. Thanks for reading and cheers. 

"Education is a Merit Good; The Government Should Pay for Education." Discuss. [25] (Rephrased Economics Question)

“Since education is a merit good, the government should pay for the people’s education up to, and including, tertiary education, such that education is free”. Discuss.  [25]

A merit good can be defined as a good that society deems desirable, or a good that has positive externalities to society. Education is definitely a merit good given that it is desirable to society, and certainly it seems to confer positive externalities to society as educated people are generally more cultured, logical, and reasonable, and are thus less likely to contribute to crime and social disorder. This paper discusses the issue that, since education is a merit good, the government should pay for education up to and including tertiary (university) education. While it is true that education is indeed a merit good and the first part of the statement is definitely true, it does not follow that the government should do more than merely subsidise education. In fact, governments should only provide or pay for public goods which are not produced by the free market, and since education is not a public good it should not be provided free.

Education as merit good – and the government should subsidise merit goods

It can be argued that a good that has positive externalities to society can be considered a merit good. An externality is a third party spill-over effect, or an effect that affects third parties not involved in the production and consumption of the good in question, and can be negative or positive. Positive externalities are positive third party spill-over effects. As people do not consider the positive externalities to society, but rather consider private benefits and private costs, they under-consume merit goods. The government can subsidise merit goods in order to boost their consumption, which is good for society.

Alternatively, a merit good can be thought of in terms of imperfect information – people do not have perfect information about the nature of the good, and thus they misjudge its merits and demerits. Hence, this leads also to the under-consumption of merit goods. The government by providing education at low cost (or even providing education free) can be seen as trying to mitigate this informational failure.

According to the diagram below, there is a divergence caused by the externality between the marginal social benefit (MSB) and the marginal private benefit (MPB), assuming that marginal social cost equals marginal private cost (MSC = MPC). Hence, clearly the government should directly subsidise merit goods, which would shift the MPB to the MSB. In this case, a subsidy here is a government payment directly to the consumer of education, which would shift the demand curve to the right. The famous economist Milton Friedman once suggested that an education voucher could be given to students, which would have the effect of shifting the MPB to the right to eliminate the externality. If, on the other hand, an indirect subsidy was given, meaning a subsidy was given to the producer of education, then the MSC curve would shift to the right.

Economics diagram - what diagram should be drawn here?

The Government Should Not Pay Entirely for Merit Goods

On the other hand, the government should not pay entirely for merit goods. Governments should pay for public goods which are non-rivalrous and non-excludable because public goods cannot be produced by the free market without government intervention, whereas merit goods can be produced by the free market. Non-rivalry is the condition that consumption of a good by one person does not reduce the amount of that same good for another person. Non-excludable is the condition that a consumer cannot be excluded from consuming a good. These two conditions lead to the situation where a free market does not produce public goods because of the free-rider problem and because the allocative efficient outcome leads to marginal cost being zero (MC = 0).

There are also other major issues on having free education, other than the fact that education is not a public good. First, there is the issue of opportunity cost. Opportunity cost is the cost of the next best alternative forgone. The problem is that if resources are devoted to making education free, then there are alternative uses for those resources that are forgone, such as national defence, healthcare, and infrastructural investments. Hence, subsidising education would make more economic sense rather than providing it entirely free. Second, the government is not the only possible provider of education – private agencies or public-private-partnerships (PPP) can also provide education. For instance, in many countries around the world, there are private agencies that provide education for profit.

Conclusions

In conclusion, while the government could possibly provide merit goods, such as education, for free in order to solve the market failure of positive externalities not being taken into account by individuals, and to overcome the informational failures associated with merit goods because people misperceive their benefits, there are other issues that need to be seriously considered like opportunity cost and alternative financing methods such as private provision with some government intervention and public-private-partnerships. However, in my opinion, the most important reason why governments should not provide merit goods is that they are not public goods which are not provided by the free market, and as such market-based policies should be used to encourage a higher consumption of education rather than direct government provision of education.

JC Economics Essays – Tutor's Commentary: This Economics paper was written under examination conditions by one of my former economics students, GSW. Putting yourself into your Economics tutor’s shoes, how would your Economics tutor make this essay even better? Hint: Any good Economics tutor would suggest using properly-labelled diagrams, with the curves moving to demonstrate a point, to make a good economics argument. Having said that, this economics site does not feature diagrams - so what else can be improved on, other than the usual "draw a diagram"? In fact, this economics essay is rather well written, and an excellent example of how a hardworking student from a humble background can learn and improve in his studies! This is a economics good paper. Yet, there are other approaches. How would YOU approach this question? Would you go for a more direct approach, or a more indirect approach, compared to this Economics answer? While I would not have answered this Economics question in this particular way, this approach is still workable and can be utilised to get a good grade in Economics examinations. Thank you for reading, and cheers. 

(a) What are the various sources of market failure? [10]

(a) What are the various sources of market failure? [10]

Market failure is the failure of the free market to allocate goods in an efficient manner. In a free market economy, there are many types of market failure. This economics paper focuses on three main types of market failure, namely: externalities, both positive and negative, public goods, and imperfect competition in the market. This paper argues that market failure or the inefficient allocation of resources occurs when production is not at the socially optimum level.

First, externalities are said to exist when the actions of producers or consumers affect third parties who are offered no compensation for sustaining the loss generated. Externalities can be known as external diseconomies and economies as well as third party spillover effects. They exist because the market cannot deal properly with the side effects of many economic activities. Externalities involve an interdependence on utility and production functions. An external benefit or a positive externality refers to the benefit from production or consumption experienced by people other than the producers or consumers. This occurs when an externality-generating activity raises the production or the utility of the externality-affected party. Hence, the economic activity provides incidental benefits to others for whom they are not specifically intended.

Suggested Market Failure Figure 1: External cost in production

A negative externality or external cost refers to the cost of production or consumption borne by people other than the consumers or producers. The undesirable effects on the allocation of resources by an externality can be explained by the Marginal Social Cost (MSC). The Marginal Social Cost is a sum of the Marginal Private Cost (MPC) and the Marginal External Cost (MEC). MPC is a share of marginal cost caused by an activity that is paid by the people who carry out the activity and MEC is the share borne by others. When the firm’s activities generate negative externalities, its MSC will be greater than MPC. Since, in equilibrium, the market will yield an output at which consumers marginal benefit is equal to a firm’s MPC. Thus, as shown in Figure 1, MPB is less than MPC, hence the costs that is incurred to society outweighs the benefit derived from the good. Consider the soap industry which, in a free market would discharge waste products into the air and into rivers. The owners of soap factories being profit maximisers will only consider their private costs and ignore the wider social costs of their activities. Thus, MSC is more than MPC.

Suggested Market Failure Figure 2: External benefit in consumption.

An example of an activity which generates an external benefit in consumption is vaccination. If an individual makes a decision to be inoculated against a particular disease, then he will receive the private benefit of not being infected by that particular disease. However, there are also other possible benefits to all others with whom he comes into contact as they will not contract the disease from him. The vaccination protects not only the person who is vaccinated but also the entire community that person lives in, by preventing the spread of contagious diseases. Thus, MSB is greater than MPB. The individuals consider only private benefits and costs in their consumption decisions. Hence, they will consume OQ1 units where MPB=MPC. However, the socially efficient output occurs at OQ2, where MSB=MSC. There is thus an underconsumption of Q1Q2 of the good which results in a deadweight loss equal to the area of E2BE1. Insufficient scarce resources are being devoted to the production of this product. The market has failed to allocate resources efficiently.

Secondly, one major source of market failure is the failure of the free market to provide public goods without government intervention. Economic goods can further be subdivided into public and private goods. A public good is one that has two characteristics that private goods do not. Firstly, public goods are non-exclusive. This means that a producer or seller cannot separate nonpayers from benefiting from the good, so that someone who has not paid for the good cannot be prevented from consuming it. As a result, the payer too, eventually does not want to pay, because of the so-called free rider problem. As a consequence, the market will not produce a public good. This is market failure.

Using the concept of externality for public goods, there are no private benefits or revenue for the producer at all but more benefit for the society. Examples of public goods are street lighting, defence and radio broadcasts. The second characteristic is that public goods are non-exhaustible or non-rival. This means that the use of the good by one person does not reduce the quality or the amount available to another. As a result, there is no rivalry in consumption. As a result, there is no additional opportunity cost for the second and third person to use. Assuming that the allocative efficient level is P = MC, and MC = 0, then it stands to reason that P = MC = 0, and the good should be provided free of charge if it is to be produced at the socially optimal level. 

Third, there is the existence of imperfect competition which distorts a free market economy. In a free market economy, there is nothing to prevent the emergence of oligopolies and a monopoly in various industries. An oligopolistic market can be defined as a market structure where there are a few dominant firms which are rivals to each other, each producing either homogeneous or differentiated products, while a monopoly can be defined as one dominant firm producing a highly differentiated good with no close substitutes. The more successful firm (or firms) acquires other firms or puts them out of business. When these imperfect market structures occur, there will be allocative inefficiency because they generate shortages in order to hike up prices and increase profits.

Insert Economics diagram. Either oligopoly or monopoly diagrams. 

Hence, market failure usually results from the presence of externalities, the lack of provision of public goods and the allocative inefficiencies from imperfect competition. Thus there is a role for government intervention in the market to achieve a better outcome in terms of allocation of resources.

JC Economics Essays: Tutor's Comments - This economics response is a well-written and well-crafted Economics essay, that was written under model examination conditions; good work MJ! Special thanks to MJ for her kind contribution. Excellent. NOTE: This economics essay has been edited to make the language flow better but the main points were still written under examination conditions. Thank you for reading and cheers.