Why Market Failure Happens - The Good, the Bad, and the Unpriced

Why Market Failure Happens – The Good, the Bad, and the Unpriced

So, you’re walking through your local park - it’s clean, peaceful, and full of joggers and dog walkers. You didn’t pay to get in, but you’re enjoying it all the same. Congratulations, you’ve just stumbled into a positive externality. Welcome to the strange world of market failure.

But what is market failure, really? Why does it matter if people overeat burgers or don’t get their flu jabs? And what’s the deal with things like merit goods, demerit goods, and social surplus?

Let’s break this down like economists.

First of All, What Is Market Failure?

Market failure occurs when the price mechanism - that invisible hand juggling supply, demand, and incentives - fumbles the ball. This means resources are not allocated in a way that maximises societal welfare.

You’ll know it’s happening when we get:

• Not enough of some goods being produced or consumed

• Too much of other goods being churned out

• Externalities being completely ignored

• People acting on private gain without thinking of social impact

In short: when Marginal Social Cost (MSC) doesn’t equal Marginal Social Benefit (MSB), we’re no longer in that beautiful state of allocative efficiency.

The Social Efficiency Equation: MSC = MSB

Let’s talk about this efficiency stuff. The dream scenario in economics is when the marginal social benefit of a good is exactly equal to its marginal social cost. This is the point of social efficiency, or what we might call a fair deal for everyone.

If:

• MSB > MSC → We should be doing more of that activity.

• MSB < MSC → We’re probably overdoing it and hurting society in the process.

When that delicate balance is off, either we’re wasting precious resources, or someone else is paying the price - often without realising it.

Enter: Externalities (a.k.a. Uninvited Guests)

Externalities are the costs or benefits from an economic activity that spill over onto third parties.

Positive Externalities: The Good You Didn’t Pay For

These are things that help society more than they help the individual.

• Education: You get a degree, sure, but society gets a more skilled workforce.

• Vaccination: You stay healthy, but also protect vulnerable people.

• Public Parks: You relax, but so does everyone else.

When left to the market, we don’t get enough of these goods because individuals only see their private benefit - not the social one.

Negative Externalities: The Costs We Ignore

These are the hidden costs others bear due to your actions.

• Air pollution from factories: Profits for them, health issues for everyone else.

• Traffic congestion: You’re in a rush; the rest of us miss dinner.

• Smoking in public: You feel relaxed; others get asthma.

In free markets, negative externalities are rarely paid for, which means these goods are overproduced and overconsumed.

Merit Goods vs. Demerit Goods: Society's Secret Favourites (and Least Favourites)

Merit Goods

These are products that are under-consumed in a free market but hugely beneficial to society.

Examples: Education, vaccines, healthcare.

Why the under-consumption? Because people:

• Undervalue the benefits (especially long-term ones)

• May not be able to afford them

• Are uninformed or short-sighted

Governments usually step in here to promote them - think subsidies, free schooling, and ad campaigns.

Demerit Goods

These are the reverse: over-consumed goods that cause harm to individuals and society.

Examples: Alcohol, junk food, gambling, cigarettes.

Why the over-consumption?

• Consumers ignore or underestimate the risks

• Addiction or habit

• Market pricing doesn’t reflect the true social cost

Governments deal with these through taxes, regulations, warning labels, or outright bans.

What's Social Surplus, and Why Should I Care?

Social surplus (a.k.a. community surplus) is the sum of consumer surplus (what buyers gain) and producer surplus (what sellers gain).

At the point of allocative efficiency (MSB = MSC), this surplus is maximised. Everyone’s winning.

But once externalities creep in - pollution, passive smoking, under-vaccination - this surplus takes a hit. And that’s when economists start waving their interventionist flags.

So What Causes Market Failure?

Here’s your cheat sheet:

Positive externalities → Goods / services under-consumed (e.g., education)

Negative externalities → Goods / services over-consumed (e.g., cigarettes)

Merit goods → Under-produced and undervalued

Demerit goods → Over-produced and over-promoted

Missing markets → No supply for essential services (e.g., public defence)

Imperfect information → Consumers make poor choices (e.g., health risks)

Market power / monopoly → Prices manipulated away from efficiency

Final Thought: Why It All Matters

If Economics had a villain, it wouldn’t be inflation or unemployment - it would be market failure. Why? Because it represents a breakdown in our most trusted system: the market.

It’s the reason we end up with:

• Too many SUVs and not enough solar panels,

• Overfilled A&Es and underfunded schools,

• Corporations making billions while communities breathe in smog.

Understanding how and why this failure happens is the first step to making better policies - and, hopefully, better decisions.