Market Failure

We have already learned from the previous lessons that individuals are always trying to maximise their satisfaction of wants. Individual Economics, therefore, is about managing resources available to him/her to satisfy as much wants as possible.
When we look into a higher level, a country also tries to maximise the best use of its resources to deliver the best outcome, that is the satisfaction of wants of its people in general. And that is how the types of economic systems have come into place.
We have also seen the types of economic systems and one of them is market economy. In a market economy, resources are allocated by the forces of demand and supply. When something is demanded by the consumers, suppliers try to produce that good. Therefore, in theory, it should deliver the maximum satisfaction of wants.
However, there are reasons why market forces may not always allocate resources efficiently. In this situation we say there is market failure.

Market failure could result in productive inefficiency which means the firms are not producing the best output from the resources they have.

Market failure could also result in allocative inefficiency. This means that businesses are not producing those goods which are most wanted and needed by the consumers. In this case satisfaction of wants of the people will not be as good as it ought to be.

Reasons for market failure

  1. Negative externalities – When production is done, there are two categories of costs that are incurred. They are, private costs and social costs. Private costs are those incurred by the business or individual who does the production. When production is done, the society as a whole also bears some costs. For example, air pollution. These are known as social costs or external costs. Negative externalities occur when the social costs exceed private costs.
  2. Positive externalities – Production gives benefits to the business or individual who does the production. This is known as private benefits. production also gives benefit to the society as a whole.
    This is known as social benefits. Social benefits = private benefits + external benefits. Positive externalities occur when the external benefits is greater than the private benefit. In this case the individual or the business may be discouraged to do the production, leading to fall in output.
  3. Public goods – Market forces may not be able to provide public goods. Goods like street lights, light houses, drainage system on the roads, cannot be provided by the private sector. For example, once a lighthouse is provided, the ships at sea cannot be prevented from benefiting from it, and there is no way to charge a price from the ships that benefit from the lighthouse. Therefore, public goods have to be provided by the government as the private sector has no incentive to produce/provide them.
  4. Imperfect information – For markets to work, there needs to be perfect and symmetric information ie consumers and producers must have the same level of knowledge about the products, and they must know everything there is to know about them. In many cases, however, information may be asymmetric (producers know more than consumers) or incomplete/imperfect. In these situations, we have market failure. In the private healthcare market, doctors know more than patients about healthcare and treatments (asymmetric information). There is an incentive, therefore, for doctors to prescribe more expensive treatment than that is necessary in order to increase their profits. This is an inefficient use of resources. Many consumers in the healthcare market take out insurance to help pay for treatment; this, however, leads to a problem of moral hazard, where they take more risks and therefore require more treatment because they are insured. Again, this is a consequence of asymmetric information in the market where consumers know more than insurers about their intended future actions.
    In many markets, such as the tobacco, alcohol or pensions markets, providers of these goods and services often withhold information deliberately from consumers. For example, many tobacco companies knew of the link between tobacco and lung cancer before consumers were aware of it, and they continued to advertise tobacco as being ‘healthy’ and ‘sociable’, leading to over-consumption of tobacco, and therefore market failure.
  5. Monopolies – A monopoly is a situation where there is only one seller in the market, and everyone else is a buyer. Free markets sometimes result in monopolies, which can charge high prices from consumers and there is under-production of the particular goods that the monopoly provides.
  6. Factor immobility – Factors of production, such as labour may not be able to move from one place to another for many reasons. If they cannot move to the place where production is done, then there will be unemployment.
  7. Unfair income distribution – When the production is done for those who can pay for the goods and services, this could leads to the rich becoming richer and the poor becoming poorer.
  8. Uncertainty – the price of certain goods are subject to fluctuations in the market, which leads to uncertainty for those who produce those goods.

Upload of Tutorials Under O Level Unit 7 is complete!

HDI components
Cambridge O Level Unit 7 – Developed and Developing Economies: trends in
production, population and living standards

Topics covered in this unit

  1. Why some countries are classified as developed and others are not
  2. Absolute and relative poverty
  3. Policies to alleviate poverty
  4. Factors affecting population growth
  5. Consequences of population changes at different stages of development
  6. The effects of changing size and structure of population on an economy
  7. Comparing developed and developing countries and regions within a country

Why some countries are classified as developed and others are not

What is a developed country?

Though there may not be a standard, set definition, a developed country is a country with a relatively high economic growth and security. Some of the most common criteria for evaluating a country’s degree of development are per capita income or gross domestic product (GDP), level of industrialization, general standard of living and the amount of widespread infrastructure. Increasingly other non-economic factors are included in evaluating an economy or country’s degree of development, such as the Human Development Index (HDI) which reflects relative degrees of education, literacy and health. The outcome of the development ultimately should be the desirability or how appealing it is to live in a particular country.

Characteristics of developed and developing economies

Developed economies Less developed economies
Population low birth rate

higher life expectancy

low death rate due to better medical facilities

ageing population


Developing countries have higher rate of natural increase. Death rates have fallen faster than birth rates; birth rates are significantly higher than in developed countries, whereas death rates are only somewhat higher than in developed countries. Tradition, lack of contraception, poverty and lack of education are the main causes of high population growth rate.
Education High level of literary, Highly trained workforce. Workers are paid high rates of wages. Low level of literacy with low skill levels of the workforce results in low wages of the workforce. Government is the main provider of education services and have low percentage of public expenditure allocated for education.
Economic structure These economies usually have a larger tertiary sector and most of the workforce is engaged in service industries. The country produces and exports high technology products or high value added goods. Primary sector is the major contributor to the GDP of the country. Low GDP per capita is there. Usually exports agricultural goods or natural resources and imports value added goods from developed countries.

Next topic: Absolute and relative poverty

Developed and developing economies

This is the 7th Unit in Cambridge O Level Economics. In this unit, we will try to understand the characteristics of developed and developing countries. Poverty, how to alleviate poverty, growth and population are also important topics to learn in this Unit.

  1. Why some countries are classified as developed and others are not
  2. Absolute and relative poverty
  3. Policies to alleviate poverty
  4. Factors affecting population growth
  5. Consequences of population changes at different stages of development
  6. The effects of changing size and structure of population on an economy
  7. Comparing developed and developing countries and regions within a country

Upload of Tutorials Under O Level Unit 6 is complete!

Maldives Inflation
O Level Unit 6: Economic Indicators

Topics covered in this unit

1. How a consumer prices index/retail prices index is calculated
2. Inflation
3. Deflation
4. Changing patterns and levels of employment
5. Causes and consequences of unemployment
6. Gross Domestic Product(GDP)
7. Recession
8. Measures and Indicators of comparative living standards


Deflation is the opposite of inflation. It refers to a general fall in the level of prices. Typically, this will occur when there is a general fall in demand for goods – for example, if people are spending less through uncertainties over rising unemployment.

Deflation is a phenomenon of persistent and continuous falling prices. In its initial and later stages it maybe respectively referred to as recession and depression

Causes of deflation

– Deflation is usually caused by falling aggregate demand, which means the total demand in the economy is not able to buy all(or enough) goods and services in the economy. When this happens, the prices will fall.

– Deflation can also happen if the productive potential of the economy increases, which leads to excess supply over demand.

– Excess use of deflationary fiscal and monetary policies also could lead to deflation. Governments often use deflationary monetary and fiscal policies to control inflation. However, when the government miscalculates and use those policies too much, deflation could happen.

Costs of deflation

1. Lower business incentive
When the prices fall, the incentive to invest and expand is less, therefore growth of business slows down, and sometimes there is negative growth if businesses start getting bankrupt. This is a very serious type of deflation.

2. Unemployment increases
When there is deflation, firms are often forced to lay-off workers in order to reduce loss. And when people become unemployed, their ability to demand for goods and services also decline.

3. Real cost of borrowing increases.
This can happen if the nominal interest rate remains the same. When deflation happens, returns to the investment declines, which could lead to difficulties in repaying the loans taken.

4. Holding back on spending
Consumers may opt to postpone demand if they expect prices to fall further in the future.

Is deflation always a problem?

Benign Deflation
If falling prices are caused by higher productivity, as happened in the late 19th century, then it can go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and persistent excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral of demand and prices. If the falling prices are simply the result of improving technology or better managerial practices, that is fine.

Malign Deflation
Malign deflation occurs when prices fall because of a structural lack of demand which creates huge excess capacity in an economic system. If there is a slump in demand, companies go out of business and sack people, and hence demand falls again – the negative multiplier effect starts to have its effect.

Next topic: Changing patterns and levels of employment

How a consumer prices index/retail prices index is calculated

Retail Price Index(RPI) and Consumer Price index(CPI) are both used to measure inflation. These indices measure changes in average prices over a year. Measurements are made by recording prices of goods and services that most people will be expected to buy, or put in an imaginary shopping basket. Government statisticians decide what goods to include in this basket. This list should be updated to take account of changing spending patterns. Most governments measure prices in similar ways.

A basket of goods

The imaginary shopping basket for a typical family contains, for example, milk, bottled water, sugar, tea, meat, cooking fuel, school books and mobile phone charges. The contents included in the basket are fixed in the short term, but the prices of individual goods change.

A price index uses a single number to indicate changes in prices of a number of different goods. This is calculated by comparing the price of buying the basket of goods with a starting period, called the base year. The base year is given a fi gure of 100. So if the average price of goods in the basket today is 10 per cent higher than the base year, the price index will be 110. Changes in average prices (the cost of the basket of goods) can be measured on a monthly, quarterly or annual basis.


Inflation is a persistent or sustained rise in the general level of prices over a period of time. So not every price will rise, but average prices will. The effect of this rise on ordinary people will vary, depending on what they buy.


The weighting is a figure given to a category of goods according to the percentage of a typical household’s income that is spent on it.

Calculating average price changes

Calculating average price changes will give the rate of inflation. The calculation involves two sets of data:
• The price data (collected each month).
• The weights (representing patterns of spending, updated each year).

With this data it is possible to construct a weighted price index.
A consumer spending survey has been carried out that shows the
percentage spend of typical households in an imaginary country. The
table below shows how the percentage spend forms the basis of
the weighting given to the categories.

Category Percentage spend Weight
Food 40 4
Clothing 20 2
Transport 10 1
Other household goods 30 3
Total 100 10

The next stage is to identify price changes in each of these product categories. Let us suppose that surveys carried out in supermarkets, shops and other retail outlets across the country show the following changes since the base year:
• Food prices have increased by 20 per cent.
• Clothing has increased by 10 per cent.
• Transport has fallen by 10 per cent.
• Other household goods have increased by 30 per cent.

To find out the average change in price we need to take account of each of these price changes in terms of how much consumers spend on that item (the weight). For example, the increase in food prices of 20 per cent will have a major impact on average prices because 40 per cent of household income is spent on food. In contrast, even though transport prices have fallen by 10 per cent, this will have a smaller impact on average prices because consumers only spend a tenth of their income on transport.
To create a weighted price index we need to multiply the weight for each item by the price index for that item. This is shown in the table below.

Product Category Weight Price Index Weighted Price Index
Food 4 x 120 480
Clothing 2 x 110 220
Transport 1 x 90 90
Other Goods 3 x 130 390
Total 1180


Finally, divide the weighted price index by the total number of weights:
= 118
This shows that prices have risen on average by 18 per cent (i.e. from the base year figure of 100 to 118 in the new year).

Next topic: Inflation