Market Failure —
every type, every diagram

Two marks means two separate things to say, and the second is not a rewording of the first. The specification defines this term by a quantity rather than by a description of a market in difficulty, so decide first what the quantity is being compared against, and make sure that comparison appears in your answer. Too much or too little of a good is produced and/or consumed (1 mark), compared with the socially optimal level of output (1 mark). The second mark is the comparison: an answer that says the market produces the wrong amount without saying wrong compared with what has given one half of the definition. Descriptions of a market collapsing, of prices being unaffordable or of firms making losses are not this term.

An Explain of a reason needs a two-stage chain, so plan both links before you start writing. The first link is about who pays what; the second is about what that does to the relationship between two things the question names. Keep the two costs clearly separated throughout — using one word for both is what makes this answer collapse into one stage. An external cost is a cost of producing the good that falls on people outside the transaction (1 mark), such as dust and noise falling on households near a works (1 mark). The producer pays only the private cost — inputs, wages, machinery — so that cost alone is what the supply curve is built from (1 mark). Social cost is private cost plus external cost, so it exceeds private cost by the value of what falls on the third party (1 mark). An answer that says social cost is "different from" private cost has not said in which direction or by how much.

Three figures are wanted and each one depends on the one before, so work down the page in stages rather than trying to reach the last of them directly. Two of the three are quantities and you find each by deciding which pair of curves meets there — and the two pairs are not the same pair. The third is an area, so once you have both quantities ask yourself what shape it is before reaching for any arithmetic. Appendix 6 defines Calculate as a calculation involving several stages and advises showing workings, and here the workings are what let each stage stand on its own. Market quantity: set MPB equal to MPC, so 60 − 0.5Q is 10 + 0.5Q, giving Q of 50 tonnes a day (1 mark). Marginal social cost is MPC plus the external cost, so MSC is 20 + 0.5Q (1 mark). Socially optimal quantity: set MPB equal to MSC, so 60 − 0.5Q is 20 + 0.5Q, giving Q of 40 tonnes a day (1 mark). Welfare loss is the triangle between MSC and MPB across the 10 tonnes between the two quantities: half of $10 times 10, which is $50 a day (1 mark). Note that this is not the total external cost, which is $10 across all 50 tonnes, or $500 a day.

This is a shorter calculation than it looks, and the risk is doing the harder one by mistake. Read carefully which quantity the question is asking you to apply the external cost to, and notice that it is asking about a cost borne rather than about a welfare effect — those are two different areas on the same diagram and only one of them is wanted here. The external cost per tonne is constant, so the total is that cost multiplied by the quantity produced: $10 times 50 tonnes (1 mark), giving $500 a day (1 mark). This is the band between MPC and MSC over every tonne made, not the welfare loss triangle, which is bounded by the social optimum and the market quantity and is $50 a day.

Market failure happens when a free market, left to itself, does not allocate resources efficiently. In a perfectly functioning market, resources flow to where marginal social benefit (MSB) equals marginal social cost (MSC). When the price mechanism fails to reflect all costs and benefits — for example because of externalities, missing information or public goods — the market produces too much or too little of a good and total welfare falls.

For WEC11 (Unit 1: Markets in action) the spec lists five sources of market failure: externalities, the free-rider problem and non-provision of public goods, imperfect market information, moral hazard, and speculation and market bubbles. Two things work differently from UK A-level: mark schemes credit “external benefits or costs of consumption” rather than “merit good” or “demerit good”, and moral hazard plus market bubbles sit inside Unit 1 here. Monopoly power is examinable too, but as Unit 3 (WEC13) market structures rather than WEC11 market failure.

Textbooks often give four: externalities, public goods, information failure and market power. For Edexcel IAL WEC11, learn the specification’s own list instead: externalities, the free-rider problem and public goods, imperfect market information, moral hazard, and speculation and market bubbles. Market power is examined in Unit 3 (WEC13), not as a WEC11 source of market failure.

Five is the number the Edexcel IAL specification uses for WEC11: (1) externalities, (2) the free-rider problem and non-provision of public goods, (3) imperfect market information, (4) moral hazard, (5) speculation and market bubbles. When you write about externalities, split them into costs and benefits, of production and of consumption.

Six-type lists in general textbooks add categories the Edexcel IAL specification does not use. For WEC11, stick to the specification’s five sources — externalities, the free-rider problem and public goods, imperfect market information, moral hazard, and speculation and market bubbles — and write about externalities in its terms: external costs and benefits of production and of consumption. Monopoly power is not examined until Unit 3.

Partial market failure is when a market exists but produces the wrong quantity — for example, a market for cigarettes overproduces because of negative externalities. Complete market failure is when a market fails to exist at all — for example, no private firm will supply national defence, because of the free-rider problem in pure public goods.

Governments use indirect taxes (to reduce consumption of goods with external costs), subsidies (to encourage goods with external benefits), regulation and legislation (minimum standards, quotas, bans), direct provision of public goods, and information campaigns to reduce information failure. Every intervention carries risks — poor information, unintended consequences and regulatory capture can all lead to government failure.

The standard market failure diagram shows marginal private and marginal social curves, with the gap between them indicating the externality. For a negative externality of production, MSC sits above MPC and the welfare loss is the triangle between MSC and MPB, from the social optimum out to the free-market quantity. For a positive externality of consumption, MSB sits above MPB and the welfare gain the market leaves untaken is the triangle between MSB and MSC, from the free-market quantity out to the social optimum.

They are related but not identical. Market inefficiency is any departure from allocative or productive efficiency. Market failure is a specific cause of inefficiency, where the free market mechanism itself is unable to reach the socially optimal outcome without intervention.