Markets usually allocate resources well, but not always. Sometimes a market left to itself produces too much of a harmful good, too little of a useful one, or none of a good that everyone needs. When that happens, economists speak of market failure, and governments step in. This topic explains why markets fail, what externalities are, and the tools and arguments governments use when they intervene.
The syllabus lists all three strands: market failure, types of externality and intervention. Expect definition questions in Section A and discussion questions in Section B, so learn the causes, the types and the policy tools in full.
In 30 seconds
Market failure is a situation in which the market does not produce an efficient outcome. Its main sources are market power, externalities, public goods, common property resources and unequal information. An externality is an unpaid side-effect of one party’s activity on another, and it can be negative or positive. Governments respond with taxes, subsidies, price ceilings and floors, tradeable permits, direct provision of public goods, information and regulation.
They justify it on grounds of efficiency, equity and ethics, including the idea of merit and demerit goods.
Market failure
Market failure describes circumstances in which market equilibrium cannot be relied on to give an efficient, or Pareto optimal, outcome. An outcome is Pareto efficient when nobody can be made better off without making someone else worse off. Market failure occurs when the conditions for efficiency, such as perfect competition and full information, do not hold.
Sources of market failure
| Source | What goes wrong | Example |
|---|---|---|
| Market power | A few sellers can influence price. They sell less at a higher price than a competitive market would, and the lost output that consumers value above its cost is a welfare loss | Monopolies and oligopolies |
| Externalities | The activity of one party affects another and the market price does not reflect it | Smoke from a factory harming nearby residents |
| Public goods | A good that one person can use without stopping others. Private firms will not supply enough, because people can benefit without paying | Street lighting, national security |
| Common property resources | Resources owned collectively with open access. When they become scarce, each user’s private cost is less than the social cost of use, so they are overused | Forests, fishing grounds, grazing land |
| Asymmetric information | One side of a deal knows more than the other. The market cannot price differences in quality that buyers cannot see | A used car whose real condition only the seller knows |
Public goods in more detail
A public good is one that, when one person uses it, does not prevent others from using it. Its key quality is non-rivalry: one person’s enjoyment does not reduce what is left for others. Private goods are different. The price mechanism excludes anyone who has not paid. For many public goods exclusion is impossible, or too costly to be worth doing.
Where people cannot be excluded, they can enjoy the good without paying, which is why private firms under-supply it and why governments usually pay for it through taxes.
Externalities
An externality is an effect that flows from the production or consumption of a good by one economic unit into the welfare or profit of another, without payment or compensation. It is an unintended side-effect, and the market does not price it.
Causes
- Production externalities. People living near a production site gain or lose from its activity without being paid or paying. Oil exploration brings jobs and trade to a community and also danger and pollution.
- Consumption externalities. The benefit or harm of one person’s consumption reaches others who cannot be charged or compensated. One person’s use of a good affects the satisfaction of others.
Types
| Type | Meaning | Example |
|---|---|---|
| Negative externality | A loss imposed on others that the producer or consumer does not pay for | Noise from trains and jets. Smoke from vehicles. Pollution of a river |
| Positive externality | A benefit to others that the producer or consumer is not paid for | A new expressway that opens up markets for nearby villages. Research that other firms can use |
With a negative externality, social cost is greater than private cost, because social cost includes the harm to others. The market then produces too much.
Government intervention
Government intervention is any regulatory action by government to influence the decisions of individuals, groups and firms on social and economic matters. For negative externalities such as pollution, government can discourage the activity with taxes, fines, levies or laws. For positive externalities, it can support the activity with subsidies, for example to firms that carry out research.
| Tool | How it works | Example |
|---|---|---|
| Ad valorem tax | A percentage of the price. Raises revenue or makes the producer pay for external cost | A percentage tax on cigarettes to fund health care and discourage smoking |
| Specific tax | A fixed amount per unit. Often aimed at a particular market | A fixed tax per litre of petrol |
| Subsidy | Financial help from government to encourage production or use. Corrects under-supply, positive externalities and supports key industries | Agricultural subsidies that keep food supplies steady |
| Maximum price (ceiling) | A legal limit set below the equilibrium price to protect buyers | Rent control |
| Minimum price (floor) | A legal limit set above the equilibrium price to support producers | Guaranteed minimum prices for cocoa, groundnut, cotton and palm oil in Nigeria |
| Tradeable pollution permits | Government gives firms permits to release a set amount of pollution. Firms can buy and sell them, so those that cut emissions cheaply profit from selling | The European Union Emissions Trading System |
| State provision of public goods | Paid for from taxes and available to all | Street lighting, parks, national security |
| Provision of information | Gives consumers the facts they need to choose well | Laws requiring ingredients and nutrition on food labels |
| Regulation | Rules and standards that markets must follow | Consumer rights, environmental and safety standards, financial regulation |
See Market structures and price controls for the shortages and surpluses that ceilings and floors cause.
A tax on a negative externality: a numerical example
| Item | ₦ per unit |
|---|---|
| Private cost of producing a unit | 400 |
| External cost (harm to neighbours) | 100 |
| Social cost | 500 |
Left alone, the firm counts only ₦400. A specific tax of ₦100 a unit makes the firm’s cost equal to the social cost, so it produces less and the cost of the pollution is paid by the one who causes it. This is called internalising the externality. An ad valorem tax of 20% on a price of ₦500 gives the same ₦100 per unit at that price.
Why governments intervene
Efficiency arguments
Market failure leads to a poor allocation of resources, so the mix of goods the economy produces is not the mix that best satisfies consumers. Productive efficiency occurs when resources are fully and efficiently used, which means producing on the production possibility curve. Allocative efficiency occurs when the economy produces, on the curve, the mix of goods that best meets consumers’ wishes.
Equity arguments
- Vertical equity: income is redistributed from richer to poorer households, through taxes and transfers.
- Horizontal equity: people with similar needs are treated alike, for example in access to health care and education.
- Social inclusion: everyone has access to money, opportunities and services that let them take part in society.
- Intergenerational equity: balancing the needs of present and future generations. Government is often seen as better placed to invest for the future.
Ethical arguments
Some goods are judged unsuitable to leave wholly to the market. Merit goods are seen as good for people and society, so government encourages their use by providing them free, subsidising them, or requiring them. Demerit goods are seen as harmful, so government taxes, restricts or bans them.
| Merit goods | Demerit goods |
|---|---|
| Education, health services, clean water and sanitation, public housing, environmental conservation | Tobacco, alcohol, illicit drugs, sugary drinks, single-use plastics |
Worked example: choosing the right tool
Scenario. A chemical plant dumps waste into a river and harms fishing families downstream. A university plans a free vaccination research programme that will benefit the whole country. For each, name the externality and recommend an intervention.
| Case | Externality | Recommended intervention | Why |
|---|---|---|---|
| Chemical plant | Negative production externality | A specific tax per unit of waste, fines for breaches, or tradeable permits | It makes the firm bear the harm it causes and cuts output to a level that is better for society |
| Vaccination research | Positive externality, since the benefit reaches people who do not pay | A subsidy or public funding | Without help, too little research will be done, because the funder cannot charge everyone who benefits |
Market failure in more detail
Why the free market can fail
A competitive market allocates resources efficiently only if buyers and sellers bear all the costs and receive all the benefits of their choices, there are many buyers and sellers, and information is complete. When these conditions fail, prices stop reflecting true costs and benefits, so too much of some things and too little of others is produced. That is market failure, and it is the usual reason for government intervention.
Externalities with numbers
A negative externality. A plant’s private cost per tonne is ₦400 and the pollution harm to neighbours is ₦100 per tonne, so social cost is ₦500. The market price covers only ₦400, so the plant produces too much. A specific tax of ₦100 per tonne makes the plant face the full social cost.
A positive externality. Vaccination gives a private benefit of ₦600 per person, and each person vaccinated also protects others by ₦150, so the social benefit is ₦750. Left to the market, too few are vaccinated. A subsidy of ₦150 per vaccination encourages the socially best number.
Public goods and the free rider problem
Because a public good is non-rival and cannot easily exclude non-payers, each person has a reason to let others pay and enjoy it free. This is the free rider problem. If everyone reasons this way, nobody pays and the good is not supplied, so government provides it from taxes. Street lighting and national defence are typical examples.
Asymmetric information and its remedies
When sellers know more than buyers, as in the used car market, buyers cannot tell good from bad, so they offer low prices, and good sellers leave the market. Remedies include disclosure rules (labels, warranties), certification and standards, independent inspection and consumer protection laws.
Merit and demerit goods: the logic of the response
People may under-consume merit goods, such as education, because they underrate the benefit or cannot afford them, so government provides or subsidises them. They may over-consume demerit goods, such as tobacco, because they ignore harm to themselves or others, so government taxes, restricts or bans them.
When intervention fails
Intervention is not free of cost. Government may lack the information to set the right tax or price, may be influenced by pressure groups, may create shortages and black markets through price controls, and may impose administration costs. A tax set too high can drive activity underground, and subsidies can encourage dependence. A good policy compares the cost of the market failure with the cost of the intervention.
Common mistakes in the exam
- Confusing a public good with a good provided by the public sector. The test is non-rivalry and the difficulty of exclusion.
- Treating all externalities as bad. Positive externalities exist and call for subsidies.
- Naming a tool without saying how it corrects the failure.
- Mixing ad valorem and specific taxes. Ad valorem is a percentage. Specific is a fixed amount per unit.
- Forgetting that a ceiling below equilibrium causes a shortage and a floor above it causes a surplus.
- Giving only efficiency arguments. Equity and ethics are also grounds for intervention.
Quick revision
- Market failure: an inefficient market outcome. Sources: market power, externalities, public goods, common property resources, asymmetric information.
- Externality: an unpaid side-effect. Production or consumption. Negative or positive.
- Negative externality: social cost exceeds private cost, so the market produces too much.
- Public goods are non-rival, and exclusion is impossible or too costly.
- Tools: ad valorem and specific taxes, subsidies, ceilings and floors, tradeable permits, public provision, information and regulation.
- Arguments: efficiency, equity (vertical, horizontal, social inclusion, intergenerational) and ethics (merit and demerit goods).
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.
Section A style: multiple choice
Question 1. A public good is best described as a good that:
- Is provided only by government
- One person can use without preventing others from using it
- Is always sold at a low price
- Is consumed by only one person
Show the answer
B. The defining quality is non-rivalry. Whether government provides it is a separate question.
Question 2. Pollution from a factory that harms nearby residents is an example of:
- A positive consumption externality
- A negative production externality
- A public good
- A merit good
Show the answer
B. The harm arises from production and is imposed on others without payment.
Question 3. A tax of a fixed amount on each litre of petrol is a:
- Ad valorem tax
- Specific tax
- Subsidy
- Price floor
Show the answer
B. A specific tax is a fixed amount per unit. An ad valorem tax is a percentage of the price.
Question 4. Which of the following is a merit good?
- Tobacco
- Education
- Alcohol
- Single-use plastics
Show the answer
B. Education. The other three are demerit goods.
Question 5. A buyer cannot tell the true condition of a used car, while the seller can. This is a source of market failure called:
- Market power
- Asymmetric information
- A public good
- A consumption externality
Show the answer
B. One party knows more than the other, so the market cannot price quality correctly.
Question 6. Government subsidises research and development by firms mainly because research creates:
- Negative externalities
- Positive externalities
- Demerit goods
- Monopoly power
Show the answer
B. Others benefit from research without paying, so firms would otherwise do too little of it.
Question 7. A subsidy per vaccination equal to the external benefit is meant to deal with:
- A negative externality
- A positive externality
- A public good
- Market power
Show the answer
B. Too few vaccinations are bought because others gain too.
Question 8. The free rider problem arises because public goods are:
- Rival
- Non-excludable
- Always free
- Always expensive
Show the answer
B. People cannot easily be excluded, so they can ride free.
Question 9. Which of these helps to reduce asymmetric information in a market?
- Secrecy
- Product labelling and warranties
- Higher taxes
- Price controls
Show the answer
B. Disclosure helps buyers judge quality.
Question 10. A cost of government intervention can be:
- Perfect information
- Shortages and black markets from price controls
- Lower tax revenue only
- No cost at all
Show the answer
B. Price controls can cause these.
Section B style: written questions
Question 11 (10 marks). Explain what is meant by market failure and describe four of its sources.
Show the marking guide
Meaning (2 marks). A situation in which the market does not produce an efficient (Pareto optimal) allocation of resources.
Sources (8 marks, 2 each). Market power, externalities, public goods, common property resources, asymmetric information. For each, 1 mark for naming and 1 for explaining, with an example.
Question 12 (20 marks). A chemical plant pollutes a river and harms fishing families downstream.
(a) Distinguish between production and consumption externalities, and between negative and positive externalities, with an example of each type. (6 marks)
(b) Explain how a specific tax, regulation and tradeable permits could each reduce the pollution. (8 marks)
(c) Explain the efficiency and equity arguments for government intervention. (6 marks)
Show the marking guide
(a) 6 marks. Production externality: arises from production activity (1). Consumption externality: arises from consumption (1). Negative: a loss imposed on others (1). Positive: an unpaid benefit to others (1). One example of each of two types (2).
(b) 8 marks. Specific tax: a fixed amount per unit makes the firm pay for the harm, so it produces less (3). Regulation: legal limits and standards on discharge, with fines (2). Tradeable permits: a limited number of permits that firms can buy and sell, which rewards firms that cut pollution cheaply (3).
(c) 6 marks. Efficiency: market failure misallocates resources, and intervention moves the economy towards productive and allocative efficiency (3). Equity: vertical equity redistributes to poorer people, horizontal equity treats people with like needs alike, and intergenerational equity protects the future (3).
A further written question
Question 13 (10 marks). Explain, with examples, the possible disadvantages of government intervention in markets.
Model answers
Show the model answer to Question 11
Market failure is a situation in which the market does not produce an efficient (Pareto optimal) allocation of resources. Its main sources are these. Market power: a monopoly or a few sellers can restrict output and raise price. Externalities: unpaid side-effects on others, such as pollution. Public goods: goods that are non-rival and from which people cannot easily be excluded, so private firms under-supply them, such as street lighting.
Common property resources: shared resources with open access, which are overused, such as fishing grounds. Asymmetric information: one party knows more than the other, as with a used car whose condition only the seller knows.
Show the model answer to Question 12
(a) Externalities. A production externality arises from producing a good, for example pollution from a factory. A consumption externality arises from consuming it, for example smoke from cigarettes harming others. A negative externality is an unpaid cost imposed on others, such as river pollution. A positive externality is an unpaid benefit to others, such as research that other firms can use.
(b) Tools. A specific tax of a fixed amount per unit of waste makes the firm pay for the harm and reduces output. Regulation sets legal limits and standards on discharge, with fines for breach. Tradeable permits limit the total pollution and let firms trade rights, so those who cut pollution cheaply profit from selling permits.
(c) Efficiency and equity. Efficiency: market failure misallocates resources, and intervention can move the economy towards productive and allocative efficiency. Equity: vertical equity redistributes from richer to poorer, horizontal equity treats those with similar needs alike, and intergenerational equity protects the future.
Show the model answer to Question 13
Intervention can fail for several reasons. Poor information: government may not know the right level for a tax, subsidy or price, and may set it too high or too low. Unintended effects: a price ceiling set below the market price causes shortages, queues and black markets, as with rent control. Administrative cost: regulation and enforcement cost money and time.
Political influence: pressure groups may capture a policy, so it benefits them and not the public. Reduced incentives: subsidies can encourage inefficiency and dependence. A good decision weighs the cost of the market failure against the cost of the intervention.
Pathfinder on market failure, externalities and government intervention
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the earlier Business, Management and Finance paper. Government measures against imports, the effects of a falling exchange rate, and the economic effects of removing a fuel subsidy. Revise the intervention tools and the arguments for intervention.
Revise first: Government intervention
From the earlier Business, Management and Finance paper. Part (c) asks for reasons behind a policy of subsidising imported petroleum, which draws on subsidies and the arguments for intervention.
Revise first: Why governments intervene
Multiple-choice questions can test public goods, externalities, merit and demerit goods and the intervention tools. Check Section A of every diet you practise for items on these points.
Revise first: Market failure
Source: ICAN Pathfinder, Business Environment. Diets covered: May Diet, 2021 to May Diet, 2026. November Diet, 2024 is not yet mapped.
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