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Market Failure: Merit & Demerit Goods ( AQA A Level Economics )

Revision note.

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Classification of Merit and Demerit Goods

Merit goods are products that are beneficial for society but the free market does not provide enough of them

Demerit goods are products which have harmful impacts on consumers or society  

Value judgements play a role in determining whether goods are classified as merit or demerit goods

Some goods are clearly defined as being a merit or demerit good, such as education (merit good) and illegal drugs (demerit good)

The classification of some goods can be unclear as it is based on a value judgement  

Classification of Goods Based on Value Judgements

Merit Goods

Consumers under-consume merit goods as they do not fully recognise the private or external benefits

Merit goods are often under-provided in a free-market and are a cause of partial market failure

Common examples include vaccinations, education and electric cars

Governments often have to subsidise these goods in order to lower the price and/or increase the quantity demanded

Diagram: Merit Goods in a Free Market 

Positive externalities from the consumption of merit goods

Diagram analysis

The marginal social costs (MSC) are assumed to be equal to the marginal private cost (MPC) as the focus is on the consumer (demand side) of the market

The optimal allocation of resources for society would generate an equilibrium where marginal social benefit (MSB) = MSC

 At P e Q e  where there is no market failure

The free-market equilibrium for merit goods is under consumed  as consumers fail to consider the external benefits from consumption

This is shown at P e Q e where the MPB=MSC

The quantity consumed at Q e is below the socially optimal level resulting in an under-consumption and a partial market failure . There is a deadweight loss  to society (pink triangle)

To be socially efficient , more factors of production should be allocated to producing this good/service

Worked Example

Which one of the following applies to merit goods?

They are always over consumed by individuals

They are likely to be provided by the market

They can only be supplied by the government

They are always free

B. They are likely to be provided by the market.

Merit goods (education and hospitals) can often be provided by the market.  They are beneficial to society and usually not enough are provided. 

Demerit Goods

Consumers over-consume demerit goods to a greater extent than is considered desirable by society

Consumers are unlikely to consider all of the consequences when making consumption decisions

The social costs of consumption outweigh the private costs 

Demerit goods are often over-provided in a free-market and are a cause of partial market failure

These goods are usually addictive and harmful for consumers, e.g. gambling, alcohol, drugs, sugary foods/drinks

Governments often have to regulate these goods in such a way that they raise the prices and/or limit the quantity demanded

The activities of producers can generate significant external costs, e.g. pollution caused by coal-burning power stations during the production of electricity

However, electricity is considered to be a merit good

The smoke is a by-product and not a good/service

For this reason, economists usually consider demerit goods to be goods used in consumption

Diagram: Demerit Goods in a Free Market 

Negative externalities from the consumption of demerit goods

The MSC is assumed to be equal to the MPC as the focus is on the consumer (demand) side of the market

The optimal allocation of resources for society would generate an equilibrium where MSB = MSC

At P e Q e where there is no market failure

The free-market equilibrium for demerit goods is over consumed  as consumers fail to consider the external costs from consumption

The quantity consumed at Q e is above the socially optimal level, resulting in overconsumption and a partial market failure . There is a deadweight loss  to society (pink triangle)

To be socially efficient , fewer factors of production should be allocated to producing this good/service

Examiner Tip

Not all products that result in positive or negative externalities in consumption are merit or demerit goods. This is a common misconception.

You should be able to illustrate the misallocation of resources resulting from the consumption of merit and demerit goods using diagrams showing marginal private and social cost and benefit curves.

Which of the following applies to demerit goods 

Their marginal private benefit is greater than their marginal social benefit

They are always under provided by the market

Their marginal social benefit is greater than their marginal private benefit

They have the characteristics of non-excludability and non-rivalry

A. Their marginal private benefit is greater than their marginal social benefit

Individuals may derive some private benefit from consuming demerit goods, but the overall social benefit is less due to the negative consequences on society. The MPB (the benefit to the individual consumer) tends to exceed the MSB (the benefit to society as a whole)

The other options are incorrect:

Demerit goods may tend to be over-provided and over-consumed by the free market

Demerit goods are associated with negative externalities, implying that the social benefit is less than the private benefit

Demerit goods can often be characterised by excludability and rivalry, meaning they can be restricted to to those willing and able to pay and their consumption by one person reduces its availability to others

Merit & Demerit Goods & Imperfect Information

A lack of information can make it difficult for consumers to make decisions about a good or service 

Due to imperfect information , consumers may have incomplete or inaccurate information about the external consequences associated with merit or demerit goods

Merit goods are often under-provided , due to a lack of demand. Consumers are often unaware of the positive effects of consuming such goods  

Demerit goods are often over-provided , due to high demand a s consumers are ill-informed regarding the consequences of consuming such goods

Efforts to educate the public by the government, such as public awareness campaigns can help consumers make more informed choices

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3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services

Learning objectives.

By the end of this section, you will be able to:

• Explain demand, quantity demanded, and the law of demand
• Explain supply, quantity supplied, and the law of supply
• Identify a demand curve and a supply curve
• Explain equilibrium, equilibrium price, and equilibrium quantity

First let’s first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.

Demand for Goods and Services

Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won't buy it. While a consumer may be able to differentiate between a need and a want, from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a person who does not have a drivers license has no effective demand for a car.

What a buyer pays for a unit of the specific good or service is called price . The total number of units that consumers would purchase at that price is called the quantity demanded . A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand . The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant.

We can show an example from the market for gasoline in a table or a graph. Economists call a table that shows the quantity demanded at each price, such as Table 3.1 , a demand schedule . In this case we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like Figure 3.2 , with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical axis. While economists often use math, they are different disciplines.)

Table 3.1 shows the demand schedule and the graph in Figure 3.2 shows the demand curve. These are two ways to describe the same relationship between price and quantity demanded.

Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.

Confused about these different types of demand? Read the next Clear It Up feature.

Clear It Up

Is demand the same as quantity demanded.

In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to a (specific) point on the curve.

Supply of Goods and Services

When economists talk about supply , they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service . A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply . The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant.

Still unsure about the different types of supply? See the following Clear It Up feature.

Is supply the same as quantity supplied?

In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that we can illustrate with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to a (specific) point on the curve.

Figure 3.3 illustrates the law of supply, again using the market for gasoline as an example. Like demand, we can illustrate supply using a table or a graph. A supply schedule is a table, like Table 3.2 , that shows the quantity supplied at a range of different prices. Again, we measure price in dollars per gallon of gasoline and we measure quantity supplied in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.

The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.

Equilibrium—Where Demand and Supply Intersect

Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.

Figure 3.4 illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to Figure 3.2 . The supply curve (S) is identical to Figure 3.3 . Table 3.3 contains the same information in tabular form.

Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in Figure 3.4 , is called the equilibrium . The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity . At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.

In Figure 3.4 , the equilibrium price is $1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal.

The word “equilibrium” means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.

Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. The dashed horizontal line at the price of $1.80 in Figure 3.4 illustrates this above-equilibrium price. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.

Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus .

With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium.

Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in Figure 3.4 shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.

When the price is below equilibrium, there is excess demand , or a shortage —that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which has been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level. Read Demand, Supply, and Efficiency for more discussion on the importance of the demand and supply model.

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Economics Essay Examples

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Team Merit and Demerit Goods Teachers

• 11 minutes reading time
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• Asymmetric Information
• Consumer Choice
• Economic Principles
• Factor Markets
• Imperfect Competition
• Labour Market
• Market Efficiency
• Antitrust Law
• Coase Theorem
• Common Resources
• Competition Policy
• Competitive Market
• Consumer Surplus
• Consumer Surplus Formula
• Correcting Externalities
• Deregulation of Markets
• Economics of Pollution
• Effects of Taxes and Subsidies on Market Structures
• Externalities
• Externalities and Public Policy
• Free Rider Problem
• Gains From Trade
• Government Failure
• Government Intervention in the Market
• How Markets Allocate Resources
• Imperfect Market
• Laffer Curve
• Market Failure
• Market Inefficiency
• Negative Externality
• Pigouvian Tax
• Positive Externalities
• Price Control on Market Structure
• Price Support
• Private Solutions to Externalities
• Privatisation Of Markets
• Producer Surplus
• Producer Surplus Formula
• Property Rights
• Public Goods
• Public Ownership
• Public Solutions to Externalities
• Public and Private Goods
• Regulation of Markets
• Social Benefits
• Social Costs
• Social Efficiency
• The Market Mechanism
• Tradable Pollution Permits
• Trade Policy
• Tragedy of the Commons
• Welfare in Economics
• Microeconomics Examples
• Perfect Competition
• Political Economy
• Poverty and Inequality
• Production Cost
• Supply and Demand

Jump to a key chapter

- John Maynard Keynes

Although some people, like John Maynard Keynes, search for facts and information, consumers generally do not have access or choose to ignore important information. This is known as the information problem. The information problem is a key reason behind why merit and demerit goods exist. Let’s study their characteristics.

The idea of merit good was coined by economist Richard Musgrave in the 1950s. He defined merit goods as commodities that individuals and society should be able to benefit from, regardless of their willingness and ability to pay.

What are merit goods?

Merit goods are goods or services that are considered to be beneficial to individuals and society as a whole, but are often under-consumed in a free market economy. These goods have positive effects on health, education, or the environment, but individuals may not consume them in optimal quantities.

Merit goods are goods for which the social benefits of consumption outweigh private benefits, as they are beneficial to both individuals and society as a whole.

Imagine that there is a town where most people drive cars to work every day, but there is also a good public transportation system available. The public transportation system is a merit good, as it has positive externalities such as reducing traffic congestion and air pollution, but many individuals may not use it due to lack of information. To encourage greater use of public transportation, the government could offer subsidies or other incentives to make it more attractive to consumers.

The classification of merit and demerit goods is based on value judgments.

Merit goods examples

Examples of merit goods include education, healthcare services, public transportation and renewable energy.

• Education is often considered a merit good because it provides benefits not just to the individual student, but also to society as a whole. Education can lead to higher levels of economic growth , increased civic engagement, and improved health outcomes.
• Access to healthcare services can improve the overall health of a population, which can lead to increased productivity and reduced healthcare costs over time. In addition, healthy individuals are better able to participate in the workforce and contribute to the economy.
• The use of renewable energy sources like solar, wind, and hydropower can help reduce greenhouse gas emissions and mitigate the negative effects of climate change. Investing in renewable energy can also create jobs and stimulate economic growth .
• Access to public transportation can reduce traffic congestion, air pollution, and travel costs, while also increasing mobility and access to job opportunities. This can lead to increased economic activity and a more connected and cohesive society.

The characteristics of merit goods

Let’s study the main characteristics of merit goods.

Merit goods and positive externalities

Consumption of merit goods benefits society as a whole. These benefits outweigh the private benefits enjoyed by the individual due to positive externalities .

Exploring the healthcare example in more detail, a consumer that consumes healthcare (merit good) also benefits the community, as they are less likely to spread diseases (positive externality). Therefore, the benefits to society outweigh the individual benefits. If healthcare was only provided privately, fewer people would benefit from it.

Let’s look at this example in a diagram. In Figure 1 below, S1 represents the market supply of healthcare. It represents the quantity of healthcare private healthcare providers are willing to supply at various price levels. D1 shows how much healthcare consumers are willing to buy. Q1 represents the quantity of private healthcare consumed at price P1.

On the other hand, D2 represents both the external benefits (positive externalities) and the individual benefits of consuming healthcare. Q2 shows the socially optimal level of healthcare, whereas Q1 shows the privately optimal level of healthcare. In the free market economy, the positive externalities of merit goods often go unnoticed, so consumption and production are under the socially optimal level.

The price of healthcare has to decrease to P2 in order to reach equilibrium at Q2. However, private suppliers are unwilling to supply at this price as it would decrease their profits significantly. T o increase the supply of healthcare to S2, governments subsidise it. The vertical distance between S1 and S2 represents the unit size of the subsidy.

Why are merit goods underprovided?

A merit good is under-provided and under-consumed because of the following factors:

• Imperfect Information : Consumers may not have access to all the information they need to make an informed decision about the benefits of the merit good, leading them to under-consume it.
• Presence of positive consumption externalities: The benefits of a merit good, such as education or healthcare, may extend beyond the individual who consumes it to society as a whole. However, these positive externalities are not factored into the individual's decision-making, resulting in an under-provision of the good.
• Poor decision-making : Individuals may prioritize short-term costs over long-term benefits, leading them to under-consume a merit good that would be beneficial in the long run. This can be exacerbated by factors such as income inequality, where individuals with lower incomes may prioritize immediate needs over long-term investments in merit goods such as education or healthcare.

What are demerit goods?

Demerit goods are the opposite of merit goods, as the social costs for the community are higher than the private costs for individual consumption. Private costs include the costs incurred by the individual for purchasing the good and the negative impact of the good on the individual. Social costs include the negative externalities that occur during the consumption of the good.

A demerit good is a good for which the social costs of consumption outweigh the private costs.

Social cost = external cost + private cost

Imagine that there is a town where there are many fast food restaurants, which offer unhealthy food options that can lead to health problems such as obesity and heart disease. Fast food is a demerit good, as it has negative externalities that impose costs on others beyond the individual consumer, such as increased healthcare costs. To discourage the over-consumption of fast food, the government could implement policies such as a tax on fast food or regulations requiring restaurants to offer healthier options.

Demerit goods examples

Examples of demerit goods that can have destructive impacts on individuals and society as a whole include alcohol, tobacco, fast-food, single-use plastics, and gambling.

• Tobacco products are widely recognized as a demerit good due to their negative effects on health, including an increased risk of lung cancer, heart disease, and other illnesses.
• Excessive consumption of alcohol can lead to a range of health problems, including liver disease, mental health issues, and an increased risk of accidents and injuries. Alcohol can also contribute to social problems such as violence and crime.
• Fast food and other high-calorie, low-nutrient foods are often considered demerit goods due to their contribution to obesity and related health problems. Overconsumption of these types of foods can also lead to increased healthcare costs and decreased productivity .
• Single-use plastics such as straws, bags, and packaging contribute to environmental pollution and harm wildlife. These plastics take hundreds of years to degrade and can end up in our oceans and waterways, causing serious harm to marine life.
• Gambling can be addictive and can lead to financial problems for individuals and their families. In addition, the promotion of gambling can lead to social issues such as crime and addiction.

The characteristics of demerit goods

Demerit goods and negative externalities.

As we know, demerit goods create negative externalities. Looking at Figure 2 below, we can see that the sale of tobacco at market prices results in over-consumption. A privately optimal level of tobacco consumption happens at Q1, where prices are at P1. This is higher than the socially optimal level of tobacco consumption (Q2). Providing tobacco at free-market prices, therefore, results in overconsumption and overproduction.

As a result, governments can introduce taxes on the consumption of tobacco in an attempt to decrease the demand . This results in the supply curve shifting from S1 to S2, raising prices from P1 to P2 and allowing consumption to fall back to the socially optimal level. The vertical distance between S1 and S2 represents the unit size of the tax.

Tax on demerit goods

Taxation on demerit goods is a policy tool used by governments to discourage the consumption of goods that have negative externalities. The idea is that by increasing the price of demerit goods, individuals will be less likely to consume them and the negative externalities will be reduced. Here are some examples of taxes on demerit goods from different countries:

• Tobacco taxes i n the United States: The United States has one of the highest tobacco taxes in the world, with federal and state taxes accounting for over half the retail price of a pack of cigarettes. The aim of these taxes is to discourage smoking, which has been linked to a range of health problems. According to the Centers for Disease Control and Prevention, higher tobacco taxes have been shown to reduce smoking rates, particularly among youth.
• Alcohol taxes i n Canada: In Canada, each province and territory sets its own alcohol taxes, with rates varying widely across the country. The aim of these taxes is to reduce excessive alcohol consumption, which can lead to a range of health and social problems. According to a report by the Canadian Institute for Health Information, higher alcohol prices have been linked to lower alcohol consumption and fewer alcohol-related problems.
• Plastic bag taxes in the United Kingdom: In 2015, the United Kingdom introduced a 5p (about 7 cents) tax on single-use plastic bags (increased to 10p in 2021) in an effort to reduce plastic waste.

Why are demerit goods overconsumed?

In the same way that merit goods are under-consumed, demerit goods are over-consumed. This is, again, due to imperfect information . Consumers often do not realise the extent of the harm caused by demerit goods which therefore leads to their over-consumption. Consumers also tend to ignore the negative externalities caused to society by consuming demerit goods.

In the early twentieth century, cigarettes were advertised as healthy and beneficial for certain health problems. This likely led to the overconsumption of cigarettes.

Merit goods, demerit goods, and value judgements

Value judgements are personal opinions that characterise what a particular person finds desirable or not.

Value judgments play a large role in determining which goods can be classified as merit and demerit goods. There are certain products that can clearly be defined as merit goods (like education and healthcare) and products that can clearly be defined as demerit goods (like tobacco and illegal drugs). However, due people’s different values and religions, there are certain goods for which the classification is not as easy. For example, some view contraception as a merit good and others as a demerit good. Therefore, the classification depends on the value judgment of the person making the classification.

Merit and Demerit Goods - Key takeaways

• Merit goods are goods for which the social benefits of consumption outweigh private benefits, whereas demerit goods are goods for which the social costs of consumption outweigh private costs.
• Merit goods are under-provided by markets .
• Healthcare and education are examples of merit goods.
• Demerit goods are over-consumed due to imperfect information .
• Examples of demerit goods include tobacco, alcohol and sugar.
• Demerit goods lead to negative externalities and are often taxed by the government.
• The information problem occurs when people make incorrect decisions as they do not have or choose to ignore important information.
• Value judgements are personal opinions that characterise what a particular person finds desirable or not. They play a large role in determining which goods are classified as merit and demerit goods.

Flashcards in Merit and Demerit Goods 1

positive externalities

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Frequently Asked Questions about Merit and Demerit Goods

What is the difference between demerit and merit?

Merit goods create social benefits, whereas demerit goods bring about social costs.

Which goods should be merit goods?

The question of which goods should be merit and demerit goods are based on value judgements, meaning it is up for interpretation. However, there are certain goods like healthcare and education that should be defined as merit goods.

Why do governments tax demerit goods?

Demerit goods create negative externalities. They are taxed since providing demerit goods at free-market prices would lead to their overconsumption and overproduction.

What is a merit and demerit good?

Merit goods are goods for which the social benefits of consumption outweigh private benefits, whereas a demerit good is a good for which the social costs of consumption outweigh private costs.

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ECONLIB Guides

Market Failures, Public Goods, and Externalities

Definitions and Basics

Definition: Market failure , from Investopedia.com:

Market failure is the economic situation defined by an inefficient distribution of goods and services in the free market. Furthermore, the individual incentives for rational behavior do not lead to rational outcomes for the group. Put another way, each individual makes the correct decision for him/herself, but those prove to be the wrong decisions for the group. In traditional microeconomics, this is shown as a steady state disequilibrium in which the quantity supplied does not equal the quantity demanded….

Externalities , by Bryan Caplan, from the Concise Encyclopedia of Economics

Positive externalities are benefits that are infeasible to charge to provide; negative externalities are costs that are infeasible to charge to not provide. Ordinarily, as Adam Smith explained, selfishness leads markets to produce whatever people want; to get rich, you have to sell what the public is eager to buy. Externalities undermine the social benefits of individual selfishness. If selfish consumers do not have to pay producers for benefits, they will not pay; and if selfish producers are not paid, they will not produce. A valuable product fails to appear. The problem, as David Friedman aptly explains, “is not that one person pays for what someone else gets but that nobody pays and nobody gets, even though the good is worth more than it would cost to produce.”… Research and development is a standard example of a positive externality, air pollution of a negative externality….

Public Goods and Externalities , by Tyler Cowen, from the Concise Encyclopedia of Economics

Most economic arguments for government intervention are based on the idea that the marketplace cannot provide public goods or handle externalities . Public health and welfare programs, education, roads, research and development, national and domestic security, and a clean environment all have been labeled public goods…. Externalities occur when one person’s actions affect another person’s well-being and the relevant costs and benefits are not reflected in market prices. A positive externality arises when my neighbors benefit from my cleaning up my yard. If I cannot charge them for these benefits, I will not clean the yard as often as they would like. (Note that the free-rider problem and positive externalities are two sides of the same coin.) A negative externality arises when one person’s actions harm another. When polluting, factory owners may not consider the costs that pollution imposes on others….

Markets can fail if there are no property rights and negotiation is costly. The Coase Theorem: Ronald H. Coase , biography from the Concise Encyclopedia of Economics

“The Problem of Social Cost,” Coase’s other widely cited article (661 citations between 1966 and 1980), was even more path-breaking. Indeed, it gave rise to the field called law and economics. Economists b.c. (Before Coase) of virtually all political persuasions had accepted British economist Arthur Pigou’s idea that if, say, a cattle rancher’s cows destroy his neighboring farmer’s crops, the government should stop the rancher from letting his cattle roam free or should at least tax him for doing so. Otherwise, believed economists, the cattle would continue to destroy crops because the rancher would have no incentive to stop them. But Coase challenged the accepted view. He pointed out that if the rancher had no legal liability for destroying the farmer’s crops, and if transaction costs were zero, the farmer could come to a mutually beneficial agreement with the rancher under which the farmer paid the rancher to cut back on his herd of cattle. This would happen, argued Coase, if the damage from additional cattle exceeded the rancher’s net returns on these cattle. If for example, the rancher’s net return on a steer was two dollars, then the rancher would accept some amount over two dollars to give up the additional steer. If the steer was doing three dollars’ worth of harm to the crops, then the farmer would be willing to pay the rancher up to three dollars to get rid of the steer. A mutually beneficial bargain would be struck….

Public Goods , by Tyler Cowen, from the Concise Encyclopedia of Economics

Public goods have two distinct aspects: nonexcludability and nonrivalrous consumption. “Nonexcludability” means that the cost of keeping nonpayers from enjoying the benefits of the good or service is prohibitive. If an entrepreneur stages a fireworks show, for example, people can watch the show from their windows or backyards. Because the entrepreneur cannot charge a fee for consumption, the fireworks show may go unproduced, even if demand for the show is strong….

Protectionism , by Jagdish Bhagwati, from the Concise Encyclopedia of Economics

Underlying both cases is the assumption that free markets determine prices and that there are no market failures. But market failures can occur. A market failure arises, for example, when polluters do not have to pay for the pollution they produce. But such market failures or “distortions” can arise from governmental action as well. Thus, governments may distort market prices by, for example, subsidizing production, as European governments have done in aerospace, as many other governments have done in electronics and steel, and as all wealthy countries’ governments do in agriculture. Or governments may protect intellectual property inadequately, leading to underproduction of new knowledge; they may also overprotect it. In such cases, production and trade, guided by distorted prices, will not be efficient….

Market-clearing vs. sticky prices: New Keynesian Economics , by N. Gregory Mankiw, from the Concise Encyclopedia of Economics

The primary disagreement between new classical and new Keynesian economists is over how quickly wages and prices adjust. New classical economists build their macroeconomic theories on the assumption that wages and prices are flexible. They believe that prices “clear” markets—balance supply and demand—by adjusting quickly. New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with “sticky” wages and prices . New Keynesian theories rely on this stickiness of wages and prices to explain why involuntary unemployment exists and why monetary policy has such a strong influence on economic activity….

In the News and Examples

Is defense a public good? Defense , from the Concise Encyclopedia of Economics

National defense is a public good . That means two things. First, consumption of the good by one person does not reduce the amount available for others to consume. Thus, all people in a nation must “consume” the same amount of national defense (the defense policy established by the government). Second, the benefits a person derives from a public good do not depend on how much that person contributes toward providing it. Everyone benefits, perhaps in differing amounts, from national defense, including those who do not pay taxes. Once the government organizes the resources for national defense, it necessarily defends all residents against foreign aggressors….

Is education a public good? An Education in Market Failure , by Morgan Rose.

The most fundamental question raised by the school choice controversy is broader than education itself. Before we can confront the subject of the state’s role in education, we first ought to address the proper role and justification for government intervention in market activities in general…. One rationale that economists often use involves externalities and the problems that markets can have in coping with them. It might be clearer to explain what externalities are by first explaining why they sometimes cause problems for markets…

How do we determine when a market has really failed? And Is Market Failure a Sufficient Condition for Government Intervention? by Art Carden and Steven Horwitz.

Is the Occupy Wall Street movement about market failures, government failures, or both? Makers vs. Takers at Occupy Wall Street , a LearnLiberty video at Youtube.

Cathy O’Neil on Wall St and Occupy Wall Street . EconTalk podcast.

Cathy O’Neil, data scientist and blogger at mathbabe.org, talks with EconTalk host Russ Roberts about her journey from Wall Street to Occupy Wall Street. She talks about her experiences on Wall Street that ultimately led her to join the Occupy Wall Street movement. Along the way, the conversation includes a look at the reliability of financial modeling, the role financial models played in the crisis, and the potential for shame to limit dishonest behavior in the financial sector and elsewhere.

Is smoking an example of a market failure? The Economics of Smoking , by Pierre Lemieux

After the economists’ analytical assault, the case for smoking regulations seemed pretty thin in the early 1990s. Then, a new argument was proposed by World Bank economist Howard Barnum. It relied on welfare economics, a field of neoclassical economic theory designed to show that “market failures,” created by external costs or other types of “externalities” (phenomena that bypass the market), prevent free markets from maximizing social welfare. The welfare-economics argument against smoking has since been refined by other economists working with the World Bank, and has provided the intellectual basis for the Bank’s 1999 report on the smoking “epidemic.”… The argument runs as follows. Smoking is not like other consumption choices, and the economic presumption of market efficiency does not apply. This is because, as the World Bank puts it, “many smokers are not fully aware of the high probability of disease and premature death,” and because of the addictive nature of tobacco.

Global warming and market failure. The Economics of Climate Change , by Robert P. Murphy

If the physical science of manmade global warming is correct, then policymakers are confronted with a massive negative externality. When firms or individuals embark on activities that contribute to greater atmospheric concentrations of greenhouse gases, they do not take into account the potentially large harms that their actions impose on others. As Chief Economist of the World Bank Nicholas Stern stated in his famous report, climate change is “the greatest example of market failure we have ever seen.”…

Monopoly and market failure. Monopoly , by George Stigler, from the Concise Encyclopedia of Economics

A famous theorem in economics states that a competitive enterprise economy will produce the largest possible income from a given stock of resources. No real economy meets the exact conditions of the theorem, and all real economies will fall short of the ideal economy–a difference called “market failure.”…

Externalities: When is a Potato Chip not Just a Potato Chip? a LearnLiberty video.

The Failure of Market Failure. Part I. The Problem of Contract Enforcement , by Anthony de Jasay

Received wisdom advances two broad reasons why government is entitled to impose its will on its subjects, and why the subjects owe it obedience, provided its will is exercised according to certain (constitutional) rules. One reason is rooted in production, the other in distribution–the two aspects of social cooperation. Ordinary market mechanisms produce and distribute the national income, but this distribution is disliked by the majority of the subjects (notably because it is ‘too unequal’) and it is for government to redistribute it (making it more equal or bend it in other ways, a function that its partisans prefer to call ‘doing social justice’). However, the market is said to be deficient even at the task of producing the national income in the first place. Government is needed to overcome market failure. A society of rational individuals would grasp this and readily mandate the government to do what was needful (e.g. by taxation, regulation and policing) to put this right….

The Failure of Market Failure. Part II. The Public Goods Dilemma , by Anthony de Jasay

Public goods are freely accessible to all members of a given public, each being able to benefit from it without paying for it. The reason standard theory puts forward for this anomaly is that public goods are by their technical character non-excludable. There is no way to exclude a person from access to such a good if it is produced at all. Examples cited include the defence of the realm, the rule of law, clean air or traffic control. If all can have it without contributing to its cost, nobody will contribute and the good will not be produced. This, in a nutshell, is the public goods dilemma, a form of market failure which requires taxation to overcome it. Its solution lies outside the economic calculus; it belongs to politics….

Moral externalities and markets. Satz on Markets . EconTalk podcast.

Debra Satz, Professor of Philosophy at Stanford University, talks with EconTalk host Russ Roberts about her book, Why Some Things Should Not Be For Sale: The Moral Limits of the Market. Satz argues that some markets are noxious and should not be allowed to operate freely. Topics discussed include organ sales, price spikes after natural disasters, the economic concept of efficiency and utilitarianism. The conversation includes a discussion of the possible limits of political intervention and whether it would be good to allow voters to sell their votes….

Is price gouging justifiable? Munger on John Locke, Prices, and Hurricane Sandy . EconTalk Podcast.

Mike Munger of Duke University talks with EconTalk host Russ Roberts about the gas shortage following Hurricane Sandy and John Locke’s view of the just price. Drawing on a short, obscure essay of Locke’s titled “Venditio,” Munger explores Locke’s views on markets, prices, and morality.

A Little History: Primary Sources and References

John Maynard Keynes , biography from the Concise Encyclopedia of Economics

… Why shouldn’t government, thought Keynes, fill the shoes of business by investing in public works and hiring the unemployed? The General Theory advocated deficit spending during economic downturns to maintain full employment.

Ronald Coase on Externalities, the Firm, and the State of Economics . EconTalk Podcast, May 2012.

Nobel Laureate Ronald Coase of the University of Chicago talks with EconTalk host Russ Roberts about his career, the current state of economics, and the Chinese economy. Coase, born in 1910, reflects on his youth, his two great papers, “The Nature of the Firm” and “The Problem of Social Cost”. At the end of conversation he discusses his new book on China, How China Became Capitalist (co-authored with Ning Wang), and the future of the Chinese and world economies.

Did Markets Fail in Post-Soviet Economies? , a LearnLiberty video.

Prof. Pavel Yakovlev argues that capitalism, to the extent that it has been tried, has improved post-Soviet economies.

Advanced Resources

The Demand and Supply of Public Goods , by James M. Buchanan.

People are observed to demand and to supply certain goods and services through market institutions. They are observed to demand and to supply other goods and services through political institutions. The first are called private goods; the second are called public goods…. Neoclassical economics provides a theory of the demand for and the supply of private goods. But what does “theory” mean in this context? This question can best be answered by examining the things that theory allows us to do. Explanation is the primary function of theory, here as everywhere else. For the private-goods world, economic theory enables us to take up the familiar questions: What goods and services shall be produced? How shall resources be organized to produce them? How shall final goods and services be distributed? Note, however, that theory here does not provide the basis for specific forecasts. Instead, it allows us to develop an explanation of the structure of the system, the inherent logical structure of the decision processes. With its help we understand and explain how such decisions get made, not what particular pattern of outcome is specifically chosen….

The Reason of Rules: Constitutional Political Economy , by Geoffrey Brennan and James M. Buchanan.

Since we are ourselves professional economists, we have been particularly mystified by the reluctance of our profession to adopt what we have called the constitutional perspective. Economists in this century have been greatly concerned with “market failure,” which was the central focus of the theoretical welfare economists that dominated economic thought during the middle decades of the century. This market-failure emphasis extended to both micro- and macro-levels of analysis. Scholars working at either of these levels showed no reluctance in proffering advice to governments on detailed market correctives and macroeconomic management. In retrospect, post-public choice, it seems strange that these scholars so rarely showed a willingness to apply their analytic apparatus to institutions other than the market; they paid almost no attention to politics and political institutions. Once a policy recommendation seemed to have emerged from their market-failure analytics, there was no subsequent analysis aimed at proving that persons in their political roles, as either principals or agents, would somehow behave as the economists’ precepts dictated. Implicitly, economists seemed locked into the presumption that political authority is vested in a group of moral superpersons, whose behavior might be described by an appropriately constrained social welfare function. Initial cursory attempts by a few public-choice pioneers to inject a bit of practical realism into our models of individual behavior in politics were subjected to charges of ideological bias. The myth of the benign despot seems to have considerable staying power, a phenomenon that we examine specifically in Chapter 3….

Related Topics

Supply and Demand, Markets and Prices

Roles of Government

Property Rights

Government Failures, Rent Seeking, and Public Choice

What is the role of markets in an economy?

Markets are places where buyers and sellers can meet to sell and purchase goods and services.

• Markets provide places for firms to sell their goods and gain revenue.
• Markets provide places for consumers to buy the goods and services that they need.

Markets are mostly self-regulated, relying on the principles of supply and demand to determine prices.

Why markets are important

1. Ration scarcity . Suppose a good is becoming scarce and close to running out, then the supply of the good will fall. Causing the price to rise.

The rise in price will deter consumers from buying and encourage them to look for alternatives. Also, as prices rise, it will provide incentives for firms to either find new supplies or create suitable alternatives. For example, if a new pest destroys wheat crops, the price of wheat will rise encouraging consumers to find alternatives like barley and rice. In the long-term, farmers will seek alternatives to wheat or new production methods that avoid the crop

2. Incentives . Markets create incentives for firms to respond to shortages and surpluses. Suppose a good becomes very popular, market forces will push up prices to P2.

However, this higher price acts as a signal for firms to increase supply to S2 – so other time the market responds to this change in demand. For example, in recent years, there has been growing demand for lithium batteries, this creates incentives for firms to build new lithium mines to meet growing demand.

For example, suppose there was excess supply of a good, such as rental housing. In the below case there are houses unoccupied.

Market forces will cause prices to fall. Firms cut the price of renting until they have let out their housing.

4. Efficiency . When a market is functioning properly, then consumers will have a choice about where to buy their goods and services. If one firm allows costs to rise or provides sub-standard services, then it will become unprofitable and go out of business. Therefore, in a market economy, there is a strong incentive for firms to be efficient, cut costs and offer a good service to consumer.

5. Consumer choice . Without markets, consumers would struggle to get the goods and services they need. Markets enable consumers to choose the cheapest (or best) product, leading to a greater range of choices. New markets can continually spring up offering consumers choices there were not aware of.

Types of markets

• Physical market. A traditional marketplace is a physical location where sellers and buyers can set up their stalls or shops.
• Global market. When markets have international sellers and international buyers, e.g. going to buy car, you can buy imports from abroad or Currency markets, where you can easily buy from a dealer in any country.
• Virtual markets. Increasingly the market is online with consumers able to visit sellers through the computer and internet. This has made markets more global.

Limitations of markets

• Public goods are not provided because there is no profit incentive to provide goods, which is difficult for firms to charge, e.g. street lighting is not practical because of who would pay towards it. If it is provided, consumers could free-ride (enjoy without paying) Other important public goods not provided by free market, include legal system, law and order and protection of private property.
• Externalities . A market is efficient at allocating resources if the costs are met by firm and consumer. However, many goods and services create external costs to other people in society. For example, when you generate coal-powered electricity, there are very substantial costs of pollution, global warming – for people around the globe. In a market, this external cost is not included in the price and so we get over-consumption of these goods with negative externalities.
• Positive externalities . Similarly, goods which have significant positive externality may be under-provided and under-consumed.
• Merit/demerit goods . These are goods where consumers may make poor choices due to lack of information or irrational behaviour. For example, addictive goods like smoking and gambling – in a free market, consumers may get caught in addictive consumption which reduces their personal welfare.
• Inequality . Markets provide goods and services – so long as people can afford them. If people are unemployed or have no income, then they may lack basic necessities because they can’t afford them. Inequality in a free market can increase because of monopoly power, monopsony employers, inherited wealth and unequal opportunities.
• Monopolies tend to work inefficiently . A firm with monopoly power can set high prices and not be subject to the same competitive pressures.

How to make markets work better

• Internalise externalities. A Pigovian tax makes consumers pay the full social cost of a good, rather than just a private cost, e.g. carbon tax .
• Government provision of public goods
• Remove monopoly power by encouraging competition
• Avoid unnecessary bureaucracy and red-tape.

Alternatives to markets

One thing about markets is that it is often hard to envisage any alternative. The two main options could be

• Gift-giving economy . Anthropologists state in some communities, there are not the same market forces. People contribute to the community and are happy to give excess wealth and food to those in need. There is an expectation that the ‘favour’ will be returned.
• Utopian socialism. Similar to the gift-giving economy is the ideals of ‘utopian socialism’ where people work for the common good and resources and distributed according to need.
• Centrally planned economy . Under communism in Soviet Union, the economy was arranged by central planning with planners deciding what to produce and who should get it. The aim was to create equality, but it also led to inefficiency, shortages and surpluses and inflexibility.

There are many limitations of markets, however, they can be part of the solution towards economic development and providing decent living standards. The economist Greg Mankiw’s sixth principle of economics is Markets are usually a good way to organize economic activity.

Most economists would agree with this to some extent. If only because there are few practical alternatives. However, very few economists would argue we should just rely on markets. There needs to be a balance with government intervention dealing with the worst excess of the markets, such as inequality and externalities.

Essay Curve

Essay on Market – 10 Lines, 100, 200, 500, 1500 Words

Essay on Market: The market is a bustling hub of activity where goods and services are bought and sold, creating a dynamic ecosystem of supply and demand. In this essay, we will explore the various aspects of the market, from its role in the economy to the impact of consumer behavior on pricing. We will also delve into the different types of markets, such as perfect competition and monopolies, and analyze their effects on both businesses and consumers. Join us as we unravel the complexities of the market in this insightful essay.

Table of Contents

Market Essay Writing Tips

1. Start by choosing a specific market to focus on. This could be a physical market, such as a farmer’s market or flea market, or a virtual market, such as an online marketplace like Amazon or eBay.

2. Begin your essay with an introduction that provides an overview of the market you will be discussing. Include information about its location, size, and the types of products or services that are sold there.

3. Research the history of the market to provide context for your essay. This could include information about when the market was established, how it has evolved over time, and any significant events or changes that have occurred.

4. Describe the layout and organization of the market. Discuss how vendors are arranged, what types of stalls or booths are used, and any unique features that set the market apart from others.

5. Provide details about the products or services that are available at the market. This could include information about the variety of goods sold, the quality of the products, and any specialties or unique items that are offered.

6. Discuss the atmosphere and experience of shopping at the market. Describe the sights, sounds, and smells that visitors might encounter, as well as any cultural or social aspects of the market that make it a unique and interesting place to visit.

7. Consider the economic impact of the market on the local community. Discuss how the market supports small businesses, creates jobs, and contributes to the overall economy of the area.

8. Explore the role of technology in the market, if applicable. Discuss how online marketplaces have changed the way people buy and sell goods, and how traditional markets are adapting to compete in the digital age.

9. Conclude your essay by summarizing the key points you have discussed and offering your own insights or reflections on the market. Consider how the market fits into the larger context of commerce and society, and what its future might hold.

10. Remember to proofread and revise your essay before submitting it. Check for spelling and grammar errors, and make sure that your ideas are clearly and logically presented.

Essay on Market in 10 Lines – Examples

1. A market is a place where buyers and sellers come together to exchange goods and services. 2. Markets can be physical locations, such as a farmer’s market or a shopping mall, or they can be virtual, like an online marketplace. 3. Markets play a crucial role in the economy by facilitating the flow of goods and services between producers and consumers. 4. Prices in a market are determined by the forces of supply and demand, with sellers looking to maximize their profits and buyers seeking the best value for their money. 5. Competition in the market helps to ensure that prices are fair and that consumers have a variety of choices. 6. Markets can be segmented based on factors such as the types of goods being sold, the target demographic, or the geographic location. 7. Market research is often conducted to understand consumer preferences and trends, helping businesses to better meet the needs of their customers. 8. Markets can also be influenced by external factors such as government regulations, economic conditions, and technological advancements. 9. Some markets are more competitive than others, with monopolies and oligopolies posing challenges to fair competition. 10. Overall, markets are dynamic and ever-changing, reflecting the constantly evolving needs and desires of consumers.

Sample Essay on Market in 100-180 Words

A market is a place where buyers and sellers come together to exchange goods and services. It is a crucial component of any economy as it facilitates the flow of goods and services, determines prices, and allocates resources efficiently.

In a market, buyers have the opportunity to choose from a variety of products and services, while sellers have the chance to reach a wide range of potential customers. This competition helps to drive innovation, improve quality, and keep prices competitive.

Markets can take many forms, from traditional physical marketplaces to online platforms. Regardless of the format, markets play a vital role in driving economic growth and development.

Overall, markets are essential for the functioning of an economy as they provide a platform for exchange, competition, and innovation. They are dynamic and constantly evolving, reflecting changes in consumer preferences, technology, and global trends.

Short Essay on Market in 200-500 Words

A market is a place where buyers and sellers come together to exchange goods and services. It can be a physical location, such as a farmer’s market or a shopping mall, or it can be a virtual marketplace, such as an online platform like Amazon or eBay. Markets play a crucial role in the economy by facilitating the allocation of resources and the distribution of goods and services.

In a market, buyers and sellers interact through the process of supply and demand. Sellers offer their products or services at a certain price, and buyers decide whether or not to purchase them based on their preferences and budget. The interaction between buyers and sellers determines the price of goods and services in the market. When there is high demand for a product and limited supply, prices tend to rise. Conversely, when there is low demand and excess supply, prices tend to fall.

Markets can be classified into different types based on the nature of the goods and services being exchanged. For example, a commodity market deals with raw materials such as gold, oil, and agricultural products. A financial market involves the buying and selling of financial instruments like stocks, bonds, and currencies. A labor market is where employers and employees negotiate wages and working conditions. Each type of market has its own set of rules and regulations that govern the exchange of goods and services.

In addition to facilitating trade, markets also serve as a mechanism for price discovery and competition. Prices in a market reflect the relative scarcity of goods and services and provide important information to buyers and sellers. Competition among sellers helps to drive down prices and improve the quality of products and services. This benefits consumers by giving them more choices and better value for their money.

Markets can also have social and cultural significance. They are often places where people come together to socialize, exchange ideas, and build relationships. Markets can be vibrant and colorful spaces that reflect the diversity and creativity of a community. In many cultures, markets are an integral part of daily life, where people gather to buy food, clothing, and other essentials.

Overall, markets are essential for the functioning of the economy and society. They provide a platform for buyers and sellers to exchange goods and services, determine prices, and foster competition. Markets play a crucial role in the allocation of resources and the distribution of wealth. Whether physical or virtual, markets are dynamic and ever-changing spaces that reflect the needs and desires of individuals and communities.

Essay on Market in 1000-1500 Words

A market is a place where buyers and sellers come together to exchange goods and services. It is a fundamental concept in economics, as it is the mechanism through which resources are allocated and prices are determined. Markets can take many forms, from traditional physical marketplaces to online platforms where transactions take place electronically. In this essay, we will explore the different types of markets, how they function, and their importance in the economy.

One of the key characteristics of a market is competition. Competition among buyers and sellers drives prices down to their equilibrium level, where supply equals demand. This ensures that resources are allocated efficiently, as goods and services are produced at the lowest possible cost. In a competitive market, firms are incentivized to innovate and improve their products in order to attract customers and increase market share. This benefits consumers, as they have access to a wide range of choices and can purchase goods and services at competitive prices.

There are several types of markets, each with its own unique characteristics. One of the most common types is the perfectly competitive market, where there are many buyers and sellers, homogeneous products, and free entry and exit. In a perfectly competitive market, prices are determined by supply and demand, and firms are price takers, meaning they have no control over the price of their products. This type of market is often used as a benchmark for analyzing other market structures.

Another type of market is the monopoly, where there is only one seller of a particular product or service. Monopolies have significant market power, as they are able to set prices and restrict output in order to maximize profits. This can lead to higher prices and lower quantities produced, which is detrimental to consumers. In order to prevent monopolies from abusing their market power, governments often regulate them through antitrust laws and other measures.

Oligopolies are markets where a few large firms dominate the industry. These firms have significant market power, but they must also take into account the actions of their competitors when making pricing and production decisions. Oligopolies often engage in strategic behavior, such as price matching and collusion, in order to maintain their market share and profits. This can lead to higher prices and reduced competition, which is harmful to consumers.

Monopolistic competition is a market structure that combines elements of both monopoly and perfect competition. In monopolistic competition, there are many firms selling differentiated products, which gives them some degree of market power. Firms in monopolistic competition compete on factors such as product quality, branding, and marketing, rather than just price. This type of market structure allows for some diversity and innovation in products, but it can also lead to higher prices and reduced efficiency.

In addition to these traditional market structures, there are also online markets, where transactions take place electronically. Online markets have become increasingly popular in recent years, as they offer convenience and access to a global customer base. Online markets can take many forms, from e-commerce platforms like Amazon and eBay to peer-to-peer marketplaces like Airbnb and Uber. These platforms have revolutionized the way goods and services are bought and sold, and have created new opportunities for entrepreneurs and consumers alike.

One of the key advantages of online markets is the ability to reach a larger audience and reduce transaction costs. By eliminating the need for physical storefronts and intermediaries, online markets can offer lower prices and greater convenience to consumers. This has led to the rise of online retail giants like Amazon, which have disrupted traditional brick-and-mortar retailers and changed the way people shop. Online markets also allow for greater transparency and competition, as consumers can easily compare prices and reviews before making a purchase.

However, online markets also present challenges, such as data privacy and security concerns. With the rise of e-commerce and digital payments, there is a growing need to protect consumers’ personal information and prevent fraud and identity theft. Governments and regulatory bodies are increasingly focused on regulating online markets to ensure fair competition and protect consumers from harm. This includes measures such as antitrust enforcement, data protection laws, and cybersecurity regulations.

In conclusion, markets are a fundamental concept in economics that play a crucial role in allocating resources and determining prices. There are many different types of markets, each with its own unique characteristics and implications for consumers and firms. Whether in traditional physical marketplaces or online platforms, markets are essential for promoting competition, innovation, and efficiency in the economy. By understanding how markets function and the various factors that influence them, we can better appreciate their importance and impact on our daily lives.

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15.1 The Role of Government in a Market Economy

Learning objectives.

• Discuss and illustrate government responses to the market failures of public goods, external costs and benefits, and imperfect competition and how these responses have the potential to reduce deadweight loss.
• Define merit and demerit goods and explain why government may intervene to affect the quantities consumed.
• Discuss ways in which governments redistribute income.

What do we want from our government? One answer is that we want a great deal more than we did several decades ago. The role of government has expanded dramatically in the last 75+ years. In 1929 (the year the Commerce Department began keeping annual data on macroeconomic performance in the United States), government expenditures at all levels (state, local, and federal) were less than 10% of the nation’s total output, which is called gross domestic product (GDP). In the current century, that share has more than tripled. Total government spending per capita, adjusted for inflation, has increased more than six fold since 1929.

Figure 15.1 “Government Expenditures and Revenues as a Percentage of GDP” shows total government expenditures and revenues as a percentage of GDP from 1929 to 2007. All levels of government are included. Government expenditures include all spending by government agencies. Government revenues include all funds received by government agencies. The primary component of government revenues is taxes; revenue also includes miscellaneous receipts from fees, fines, and other sources. We will look at types of government revenues and expenditures later in this chapter.

Figure 15.1 Government Expenditures and Revenues as a Percentage of GDP

Government expenditures and revenues have risen dramatically as a percentage of GDP, the most widely used measure of economic activity.

Source: U.S. Department of Commerce, Bureau of Economic Analysis, NIPA Tables 1.15 and 3.1.

Figure 15.1 “Government Expenditures and Revenues as a Percentage of GDP” also shows government purchases as a percentage of GDP. Government purchases happen when a government agency purchases or produces a good or a service. We measure government purchases to suggest the opportunity cost of government. Whether a government agency purchases a good or service or produces it, factors of production are being used for public sector, rather than private sector, activities. A city police department’s purchase of new cars is an example of a government purchase. Spending for public education is another example.

Government expenditures and purchases are not equal because much government spending is not for the purchase of goods and services. The primary source of the gap is transfer payments , payments made by government agencies to individuals in the form of grants rather than in return for labor or other services. Transfer payments represent government expenditures but not government purchases. Governments engage in transfer payments in order to redistribute income from one group to another. The various welfare programs for low-income people are examples of transfer payments. Social Security is the largest transfer payment program in the United States. This program transfers income from people who are working (by taxing their pay) to people who have retired. Interest payments on government debt, which are also a form of expenditure, are another example of an expenditure that is not counted as a government purchase.

Several points about Figure 15.1 “Government Expenditures and Revenues as a Percentage of GDP” bear special attention. Note first the path of government purchases. Government purchases relative to GDP rose dramatically during World War II, then dropped back to about their prewar level almost immediately afterward. Government purchases rose again, though less sharply, during the Korean War. This time, however, they did not drop back very far after the war. It was during this period that military spending rose to meet the challenge posed by the former Soviet Union and other communist states—the “Cold War.” Government purchases have ranged between 15 and 20% of GDP ever since. The Vietnam War, the Persian Gulf War, and the wars in Afghanistan and Iraq did not have the impact on purchases that characterized World War II or even the Korean War. A second development, the widening gap between expenditures and purchases, has occurred since the 1960s. This reflects the growth of federal transfer programs, principally Social Security, programs to help people pay for health-care costs, and aid to low-income people. We will discuss these programs later in this chapter.

Finally, note the relationship between expenditures and receipts. When a government’s revenues equal its expenditures for a particular period, it has a balanced budget . A budget surplus occurs if a government’s revenues exceed its expenditures, while a budget deficit exists if government expenditures exceed revenues.

Prior to 1980, revenues roughly matched expenditures for the public sector as a whole, except during World War II. But expenditures remained consistently higher than revenues between 1980 and 1996. The federal government generated very large deficits during this period, deficits that exceeded surpluses that typically occur at the state and local levels of government. The largest increases in spending came from Social Security and increased health-care spending at the federal level. Efforts by the federal government to reduce and ultimately eliminate its deficit, together with surpluses among state and local governments, put the combined budget for the public sector in surplus beginning in 1997. As of 1999, the Congressional Budget Office was predicting that increased federal revenues produced by a growing economy would continue to produce budget surpluses well into the twenty-first century.

That rather rosy forecast was set aside after September 11, 2001. Terrorist attacks on the United States and later on several other countries led to sharp and sustained increases in federal spending for wars in Afghanistan and Iraq, as well as expenditures for Homeland Security. The administration of George W. Bush proposed, and Congress approved, a tax cut. The combination of increased spending on the abovementioned items and others, as well as tax cuts, produced substantial deficits.

The evidence presented in Figure 15.1 “Government Expenditures and Revenues as a Percentage of GDP” does not fully capture the rise in demand for public sector services. In addition to governments that spend more, people in the United States have clearly chosen governments that do more. The scope of regulatory activity conducted by governments at all levels, for example, has risen sharply in the last several decades. Regulations designed to prevent discrimination, to protect consumers, and to protect the environment are all part of the response to a rising demand for public services, as are federal programs in health care and education.

Figure 15.2 “Government Revenue Sources and Expenditures: 2007” summarizes the main revenue sources and types of expenditures for the U.S. federal government and for the European Union. In the United States, most revenues came from personal income taxes and from payroll taxes. Most expenditures were for transfer payments to individuals. Federal purchases were primarily for national defense; the “other purchases” category includes things such as spending for transportation projects and for the space program. Interest payments on the national debt and grants by the federal government to state and local governments were the other major expenditures. The situation in the European Union differs primarily by the fact that a greater share of revenue comes from taxes on production and imports and substantially less is spent on defense.

Figure 15.2 Government Revenue Sources and Expenditures: 2007

The four panels show the sources of government revenues and the shares of expenditures on various activities for all levels of government in the United States and the European Union in 2007.

Sources: Survey of Current Business , July 2008, Tables 3.2 and 3.10.5; Paternoster, Anne, Wozowczyk, Monika, and Lupi, Alessandro, Statistics in Focus—Economy and Finance , Eurostat 23/2008. For EU revenues, “Taxes on production and imports” refers mainly to value-added tax, import and excise duties, taxes on financial and capital transactions, on land and buildings, on payroll, and other taxes on production. In the category “Current taxes on income, wealth, etc.” are taxes on income and on holding gains of households and corporations, current taxes on capital, taxes on international transactions, and payments for licenses. Capital taxes refer to taxes levied at irregular and infrequent intervals on the value of assets, or net worth owned, or transferred in the form of legacies or gifts. Social contributions cover actual amounts receivable from employers and employees.

To understand the role of government, it will be useful to distinguish four broad types of government involvement in the economy. First, the government attempts to respond to market failures to allocate resources efficiently. In a particular market, efficiency means that the quantity produced is determined by the intersection of a demand curve that reflects all the benefits of consuming a particular good or service and a supply curve that reflects the opportunity costs of producing it. Second, government agencies act to encourage or discourage the consumption of certain goods and services. The prohibition of drugs such as heroin and cocaine is an example of government seeking to discourage consumption of these drugs. Third, the government redistributes income through programs such as welfare and Social Security. Fourth, the government can use its spending and tax policies to influence the level of economic activity and the price level.

We will examine the first three of these aspects of government involvement in the economy in this chapter. The fourth, efforts to influence the level of economic activity and the price level, fall within the province of macroeconomics.

Responding to Market Failure

In an earlier chapter on markets and efficiency, we learned that a market maximizes net benefit by achieving a level of output at which marginal benefit equals marginal cost. That is the efficient solution. In most cases, we expect that markets will come close to achieving this result—that is the important lesson of Adam Smith’s idea of the market as an invisible hand, guiding the economy’s scarce factors of production to their best uses. That is not always the case, however.

We have studied several situations in which markets are unlikely to achieve efficient solutions. In an earlier chapter, we saw that private markets are likely to produce less than the efficient quantities of public goods such as national defense. They may produce too much of goods that generate external costs and too little of goods that generate external benefits. In cases of imperfect competition, we have seen that the market’s output of goods and services is likely to fall short of the efficient level. In all these cases, it is possible that government intervention will move production levels closer to their efficient quantities. In the next three sections, we shall review how a government could improve efficiency in the cases of public goods, external costs and benefits, and imperfect competition.

Public Goods

A public good is a good or service for which exclusion is prohibitively costly and for which the marginal cost of adding another consumer is zero. National defense, law enforcement, and generally available knowledge are examples of public goods.

The difficulty posed by a public good is that, once it is produced, it is freely available to everyone. No consumer can be excluded from consumption of the good on grounds that he or she has not paid for it. Consequently, each consumer has an incentive to be a free rider in consuming the good, and the firms providing a public good do not get a signal from consumers that reflects their benefit of consuming the good.

Certainly we can expect some benefits of a public good to be revealed in the market. If the government did not provide national defense, for example, we would expect some defense to be produced, and some people would contribute to its production. But because free-riding behavior will be common, the market’s production of public goods will fall short of the efficient level.

The theory of public goods is an important argument for government involvement in the economy. Government agencies may either produce public goods themselves, as do local police departments, or pay private firms to produce them, as is the case with many government-sponsored research efforts. An important debate in the provision of public education revolves around the question of whether education should be produced by the government, as is the case with traditional public schools, or purchased by the government, as is done in charter schools.

External Costs and Benefits

External costs are imposed when an action by one person or firm harms another, outside of any market exchange. The social cost of producing a good or service equals the private cost plus the external cost of producing it. In the case of external costs, private costs are less than social costs.

Similarly, external benefits are created when an action by one person or firm benefits another, outside of any market exchange. The social benefit of an activity equals the private benefit revealed in the market plus external benefits. When an activity creates external benefits, its social benefit will be greater than its private benefit.

The lack of a market transaction means that the person or firm responsible for the external cost or benefit does not face the full cost or benefit of the choice involved. We expect markets to produce more than the efficient quantity of goods or services that generate external costs and less than the efficient quantity of goods or services that generate external benefits.

Consider the case of firms that produce memory chips for computers. The production of these chips generates water pollution. The cost of this pollution is an external cost; the firms that generate it do not face it. These firms thus face some, but not all, of the costs of their production choices. We can expect the market price of chips to be lower, and the quantity produced greater, than the efficient level.

Inoculations against infectious diseases create external benefits. A person getting a flu shot, for example, receives private benefits; he or she is less likely to get the flu. But there will be external benefits as well: Other people will also be less likely to get the flu because the person getting the shot is less likely to have the flu. Because this latter benefit is external, the social benefit of flu shots exceeds the private benefit, and the market is likely to produce less than the efficient quantity of flu shots. Public, private, and charter schools often require such inoculations in an effort to get around the problem of external benefits.

Imperfect Competition

In a perfectly competitive market, price equals marginal cost. If competition is imperfect, however, individual firms face downward-sloping demand curves and will charge prices greater than marginal cost. Consumers in such markets will be faced by prices that exceed marginal cost, and the allocation of resources will be inefficient.

An imperfectly competitive private market will produce less of a good than is efficient. As we saw in the chapter on monopoly, government agencies seek to prohibit monopoly in most markets and to regulate the prices charged by those monopolies that are permitted. Government policy toward monopoly is discussed more fully in a later chapter.

Assessing Government Responses to Market Failure

In each of the models of market failure we have reviewed here—public goods, external costs and benefits, and imperfect competition—the market may fail to achieve the efficient result. There is a potential for government intervention to move inefficient markets closer to the efficient solution.

Figure 15.3 “Correcting Market Failure” reviews the potential gain from government intervention in cases of market failure. In each case, the potential gain is the deadweight loss resulting from market failure; government intervention may prevent or limit this deadweight loss. In each panel, the deadweight loss resulting from market failure is shown as a shaded triangle.

Figure 15.3 Correcting Market Failure

In each panel, the potential gain from government intervention to correct market failure is shown by the deadweight loss avoided, as given by the shaded triangle. In Panel (a), we assume that a private market produces Q m units of a public good. The efficient level, Q e , is defined by the intersection of the demand curve D 1 for the public good and the supply curve S 1 . Panel (b) shows that if the production of a good generates an external cost, the supply curve S 1 reflects only the private cost of the good. The market will produce Q m units of the good at price P 1 . If the public sector finds a way to confront producers with the social cost of their production, then the supply curve shifts to S 2 , and production falls to the efficient level Q e . Notice that this intervention results in a higher price, P 2 , which confronts consumers with the real cost of producing the good. Panel (c) shows the case of a good that generates external benefits. Purchasers of the good base their choices on the private benefit, and the market demand curve is D 1 . The market quantity is Q m . This is less than the efficient quantity, Q e , which can be achieved if the activity that generates external benefits is subsidized. That would shift the market demand curve to D 2 , which intersects the market supply curve at the efficient quantity. Finally, Panel (d) shows the case of a monopoly firm that produces Q m units and charges a price P 1 . The efficient level of output, Q e , could be achieved by imposing a price ceiling at P 2 . As is the case in each of the other panels, the potential gain from such a policy is the elimination of the deadweight loss shown as the shaded area in the exhibit.

Panel (a) of Figure 15.3 “Correcting Market Failure” illustrates the case of a public good. The market will produce some of the public good; suppose it produces the quantity Q m . But the demand curve that reflects the social benefits of the public good, D 1 , intersects the supply curve at Q e ; that is the efficient quantity of the good. Public sector provision of a public good may move the quantity closer to the efficient level.

Panel (b) shows a good that generates external costs. Absent government intervention, these costs will not be reflected in the market solution. The supply curve, S 1 , will be based only on the private costs associated with the good. The market will produce Q m units of the good at a price P 1 . If the government were to confront producers with the external cost of the good, perhaps with a tax on the activity that creates the cost, the supply curve would shift to S 2 and reflect the social cost of the good. The quantity would fall to the efficient level, Q e , and the price would rise to P 2 .

Panel (c) gives the case of a good that generates external benefits. The demand curve revealed in the market, D 1 , reflects only the private benefits of the good. Incorporating the external benefits of the good gives us the demand curve D 2 that reflects the social benefit of the good. The market’s output of Q m units of the good falls short of the efficient level Q e . The government may seek to move the market solution toward the efficient level through subsidies or other measures to encourage the activity that creates the external benefit.

Finally, Panel (d) shows the case of imperfect competition. A firm facing a downward-sloping demand curve such as D 1 will select the output Q m at which the marginal cost curve MC 1 intersects the marginal revenue curve MR 1 . The government may seek to move the solution closer to the efficient level, defined by the intersection of the marginal cost and demand curves.

While it is important to recognize the potential gains from government intervention to correct market failure, we must recognize the difficulties inherent in such efforts. Government officials may lack the information they need to select the efficient solution. Even if they have the information, they may have goals other than the efficient allocation of resources. Each instance of government intervention involves an interaction with utility-maximizing consumers and profit-maximizing firms, none of whom can be assumed to be passive participants in the process. So, while the potential exists for improved resource allocation in cases of market failure, government intervention may not always achieve it.

The late George Stigler, winner of the Nobel Prize for economics in 1982, once remarked that people who advocate government intervention to correct every case of market failure reminded him of the judge at an amateur singing contest who, upon hearing the first contestant, awarded first prize to the second. Stigler’s point was that even though the market is often an inefficient allocator of resources, so is the government likely to be. Government may improve on what the market does; it can also make it worse. The choice between the market’s allocation and an allocation with government intervention is always a choice between imperfect alternatives. We will examine the nature of public sector choices later in this chapter and explore an economic explanation of why government intervention may fail to move market solutions closer to their efficient levels.

Merit and Demerit Goods

In some cases, the public sector makes a determination that people should consume more of some goods and services and less of others, even in the absence of market failure. This is a normative judgment, one that presumes that consumers are not always the best judges of what is good, or bad, for them.

Merit goods are goods whose consumption the public sector promotes, based on a presumption that many individuals do not adequately weigh the benefits of the good and should thus be induced to consume more than they otherwise would. Many local governments support symphony concerts, for example, on grounds that the private market would not provide an adequate level of these cultural activities.

Indeed, government provision of some merit goods is difficult to explain. Why, for example, do many local governments provide tennis courts but not bowling alleys, golf courses but not auto racetracks, or symphony halls but not movie theaters? One possible explanation is that some consumers—those with a fondness for tennis, golf, and classical music—have been more successful than others in persuading their fellow citizens to assist in funding their preferred activities.

Demerit goods are goods whose consumption the public sector discourages, based on a presumption that individuals do not adequately weigh all the costs of these goods and thus should be induced to consume less than they otherwise would. The consumption of such goods may be prohibited, as in the case of illegal drugs, or taxed heavily, as in the case of cigarettes and alcohol.

Income Redistribution

The proposition that a private market will allocate resources efficiently if the efficiency condition is met always comes with a qualification: the allocation of resources will be efficient given the initial distribution of income . If 5% of the people receive 95% of the income, it might be efficient to allocate roughly 95% of the goods and services produced to them. But many people (at least 95% of them!) might argue that such a distribution of income is undesirable and that the allocation of resources that emerges from it is undesirable as well.

There are several reasons to believe that the distribution of income generated by a private economy might not be satisfactory. For example, the incomes people earn are in part due to luck. Much income results from inherited wealth and thus depends on the family into which one happens to have been born. Likewise, talent is distributed in unequal measure. Many people suffer handicaps that limit their earning potential. Changes in demand and supply can produce huge changes in the values—and the incomes—the market assigns to particular skills. Given all this, many people argue that incomes should not be determined solely by the marketplace.

A more fundamental reason for concern about income distribution is that people care about the welfare of others. People with higher incomes often have a desire to help people with lower incomes. This preference is demonstrated in voluntary contributions to charity and in support of government programs to redistribute income.

A public goods argument can be made for government programs that redistribute income. Suppose that people of all income levels feel better off knowing that financial assistance is being provided to the poor and that they experience this sense of well-being whether or not they are the ones who provide the assistance. In this case, helping the poor is a public good. When the poor are better off, other people feel better off; this benefit is nonexclusive. One could thus argue that leaving private charity to the marketplace is inefficient and that the government should participate in income redistribution. Whatever the underlying basis for redistribution, it certainly occurs. The governments of every country in the world make some effort to redistribute income.

Programs to redistribute income can be divided into two categories. One transfers income to poor people; the other transfers income based on some other criterion. A means-tested transfer payment is one for which the recipient qualifies on the basis of income; means-tested programs transfer income from people who have more to people who have less. The largest means-tested program in the United States is Medicaid, which provides health care to the poor. Other means-tested programs include Temporary Assistance to Needy Families (TANF) and food stamps. A non-means-tested transfer payment is one for which income is not a qualifying factor. Social Security, a program that taxes workers and their employers and transfers this money to retired workers, is the largest non-means-tested transfer program. Indeed, it is the largest transfer program in the United States. It transfers income from working families to retired families. Given that retired families are, on average, wealthier than working families, Social Security is a somewhat regressive program. Other non-means tested transfer programs include Medicare, unemployment compensation, and programs that aid farmers.

Figure 15.4 “Federal Transfer Payment Spending” shows federal spending on means-tested and non-means-tested programs as a percentage of GDP, the total value of output, since 1962. As the chart suggests, the bulk of income redistribution efforts in the United States are non-means-tested programs.

Figure 15.4 Federal Transfer Payment Spending

The chart shows federal means-tested and non-means-tested transfer payment spending as a percentage of GDP from 1962–2007.

Source: Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2004–2013 (Jan., 2003), Table F-10p. 157; thereafter January, 2008, Table F-10 with means-tested as medicaid plus income security and non-means tested everything else.

The fact that most transfer payments in the United States are not means-tested leads to something of a paradox: some transfer payments involve taxing people whose incomes are relatively low to give to people whose incomes are relatively high. Social Security, for example, transfers income from people who are working to people who have retired. But many retired people enjoy higher incomes than working people in the United States. Aid to farmers, another form of non-means-tested payments, transfers income to farmers, who on average are wealthier than the rest of the population. These situations have come about because of policy decisions, which we discuss later in the chapter.

Key Takeaways

• One role of government is to correct problems of market failure associated with public goods, external costs and benefits, and imperfect competition.
• Government intervention to correct market failure always has the potential to move markets closer to efficient solutions, and thus reduce deadweight losses. There is, however, no guarantee that these gains will be achieved.
• Governments may seek to alter the provision of certain goods and services based on a normative judgment that consumers will consume too much or too little of the goods. Goods for which such judgments are made are called merit or demerit goods.
• Governments redistribute income through transfer payments. Such redistribution often goes from people with higher incomes to people with lower incomes, but other transfer payments go to people who are relatively better off.

Here is a list of actual and proposed government programs. Each is a response to one of the justifications for government activity described in the text: correction of market failure (due to public goods, external costs, external benefits, or imperfect competition), encouragement or discouragement of the consumption of merit or demerit goods, and redistribution of income. In each case, identify the source of demand for the activity described.

• The Justice Department sought to prevent Microsoft Corporation from releasing Windows ’98, arguing that the system’s built-in internet browser represented an attempt by Microsoft to monopolize the market for browsers.
• In 2004, Congress considered a measure that would extend taxation of cigarettes to vendors that sell cigarettes over the Internet.
• The federal government engages in research to locate asteroids that might hit the earth, and studies how impacts from asteroids could be prevented.
• The federal government increases spending for food stamps for people whose incomes fall below a certain level.
• The federal government increases benefits for recipients of Social Security.
• The Environmental Protection Agency sets new standards for limiting the emission of pollutants into the air.
• A state utilities commission regulates the prices charged by utilities that provide natural gas to homes and businesses.

Case in Point: “Fixing” the Gasoline Market

Figure 15.5

Emily – gas prices in san diego – CC BY-NC-ND 2.0.

Moderating the price of gasoline is not an obvious mission for the government in a market economy. But, in an economy in which angry voters wield considerable influence, trying to fix rising gasoline prices can turn into a task from which a wise politician does not shrink.

By the summer of 2008, crude oil was selling for more than $140 per barrel. Gasoline prices in the United States were flirting with the $4 mark. There were perfectly good market reasons for the run-up in prices. World oil demand has been rising each year, with China and India two of the primary sources of increased demand. The world’s ability to produce oil is limited and tensions in the Middle East were also adding doubts about getting those supplies to market. Ability to produce gasoline is limited as well. The United States has not built a new oil refinery in more than 30 years.

But, when oil prices rise, economic explanations seldom carry much political clout. Predictably, the public demands a response from its political leaders—and gets it.

Largely Democratic Congressional proposals in 2008 included such ideas as: a bill to classify the Organization of Petroleum Exporting Countries (OPEC) as an illegal monopoly in violation of U.S. antitrust laws, taxing “excessive” profits of oil companies, investigating possible price gouging, and banning speculative trading in oil futures. With an overwhelming majority on both sides of the aisle, Congress passed a bill to suspend adding oil to the Strategic Petroleum Reserve—a 727 million gallon underground reserve designed for use in national emergencies. President Bush in 2008 was against this move, though in 2006, when gas prices were approaching $3 a gallon, he supported a similar move. Whether or not to offer a “tax holiday” on the 18.4 cents per gallon federal gas tax stymied some politicians during the 2008 presidential campaign because Hillary Clinton, a Democrat, and John McCain, a Republican, supported it, while Barack Obama, a Democrat, was against it. Mostly Republican proposals to allow offshore drilling and exploration in the Arctic National Wildlife Refuge also received attention.

These measures were unlikely to have much affect on gas prices, especially in the short-term. For example, the federal government would normally in a two-month period deposit 10 million gallons of gasoline in the strategic reserve; consumption in the United States is about 20 million gallons of gasoline per day. World gasoline consumption is about 87 million gallons per day. Putting an additional 10 million gallons into a global market which will consume about 5 billion gallons in a 60-day period is not likely to have any measurable impact.

The higher oil prices were very good for oil companies. Exxon Mobil, the largest publicly traded oil company in the United States, reported profits of nearly $11 billion for the first quarter of 2008. Whenever oil prices rise sharply, there are always cries of “price gouging.” But, repeated federal investigations of the industry have failed to produce any evidence that such gouging has occurred.

Meanwhile, market forces responding to the higher gasoline prices are already at work. Gasoline producers are looking at cellulosic ethanol, which can be produced from materials such as wood chips, corn stalks, and rice straw. Automobile producers are examining “plug-in” hybrids—cars whose batteries could be charged not just by driving but by plugging the car in a garage. The goal is to have a car that could go some distance on its battery before starting to use any gasoline. Consumers are doing their part. Gasoline consumption in the United States fell more than 4% by the summer of 2008 from its level one year earlier.

These potential market responses are the sort of thing one would expect from rising fuel prices. Ultimately, it is difficult to see why gasoline prices should be a matter for public sector intervention. But, the public sector consists of people, and when those people become angry, the urge for intervention can become unstoppable.

Sources: Paul Davidson and Chris Woodyard, “Proposals To Cut Gas Prices Scrutinized,” USA Today , May 11, 2006, p. 5B; Joseph Curl, “Bush Orders Suspension Of Gas Rules; Federal Probe To Look At Price-Gouging Charges,” The Washington Times , April 26, 2007, p. A1; David M. Herszenhorn, “As Gasoline Prices Soar, Politicians Fall Back on Familiar Solutions,” The New York Times , May 3, 2008, p. A16; Richard Simon, “The Nation; Mixing Oil and Politics; Congress Votes To Stop Shipments to the Nation’s Reserve. The Move Could Save Motorists Some Money,” Los Angeles Times , May 14, 2008, p. A18.

Answers to Try It! Problems

• This is an attempt to deal with monopoly, so it is a response to imperfect competition.
• Cigarettes are treated as a demerit good.
• Protecting the earth from such a calamity is an example of a public good.
• Food Stamps are a means-tested program to redistribute income.
• Social Security is an example of a non-means-tested income redistribution program.
• This is a response to external costs.
• This is a response to monopoly, so it falls under the imperfect competition heading.

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