Cambridge IGCSE Economics: The market economic system and market failure (0455) – Revision Notes

These notes condense sections 2.9 and 2.10 of the Cambridge IGCSE Economics 0455 syllabus for examination in 2026. For full explanations and longer worked examples, read the study guide, then test yourself with the practice questions. Other links: the wider allocation of resources revision notes, the Cambridge IGCSE Economics hub, the printable checklist and the free diagnostics. All figures below are invented.

2.9 The market economic system

Definition (2.9.1). An economic system in which resource allocation is decided by buyers and sellers through the price mechanism, with resources mostly privately owned and little direction from the government.

Advantages (2.9.2)	Disadvantages (2.9.2)
Wide consumer choice	Public goods not provided
Competition lowers costs and prices	External costs ignored
Prices signal what consumers want	Inequality in who can buy
Profit rewards effort and risk	Monopoly power can develop
Quick adjustment without a planner	Under-consumption of merit goods, over-consumption of demerit goods

Countries. No economy is purely market-based. When you give an example, say what the market does there (who decides, how prices work, what the state still provides), then judge the outcome. Do not just name a country.

Evaluation lines. Markets suit goods that people can be charged for and can judge for themselves. They suit goods with large external effects much less. The answer also depends on how competitive the market is and how incomes are shared.

2.10.1 Key terms

Term	Definition
Market failure	The free market allocates resources inefficiently, so the amount produced and consumed is not the amount society would want
Private cost / benefit	Cost to / benefit for the decision maker
External cost / benefit	Cost to / benefit for third parties
Social cost	Private cost + external cost
Social benefit	Private benefit + external benefit
Public good	Non-excludable and non-rival
Merit good	Society judges it beneficial; under-consumed if left to the market
Demerit good	Harmful; over-consumed if left to the market

Must-know distinctions

• Private versus social. A decision maker compares private cost with private benefit. Society should compare social cost with social benefit. Failure arises when these give different answers.
• Public good versus merit good. A public good cannot be sold to individuals in the normal way (free-rider problem). A merit good can be sold but is under-consumed.
• Merit good versus good with external benefits. Many merit goods have external benefits, but the merit good test is society’s judgement about private benefits that people undervalue.
• Demerit good versus good with external costs. A demerit good harms the user first; an external cost lands on others. Some goods are both.

2.10.2 Causes (the areas on the syllabus)

Cause	Key reasoning chain
Public goods	Non-excludable, so free riders; revenue falls short, so firms do not supply; good under-provided or absent
Merit goods	Benefits undervalued or unaffordable, so too little bought
Demerit goods	Harm underestimated, so too much bought
External costs	Third parties pay, so firms and buyers ignore the cost and output is too high
External benefits	Third parties gain, so the buyer’s own benefit is all that counts and output is too low
Abuse of monopoly power	Barriers to entry, so the firm restricts output and raises price; consumers worse off
Factor immobility	Geographical or occupational barriers, so unemployed workers and unfilled vacancies exist together

Examples (these areas only). Public goods: street lighting, flood defences. Merit goods: education, vaccination. Demerit goods: harmful products such as cigarettes. External costs: pollution, noise, congestion. External benefits: a trained workforce, a vaccinated population. Monopoly: a sole supplier of an essential service. Immobility: workers displaced from a closed factory without the skills for other jobs.

Method in steps

Social cost and social benefit (calculation)

1. Identify the private figure and the external figure.
2. Add them: social = private + external.
3. Multiply by the quantity if asked for a total.
4. Compare with the price or private benefit, if the question asks who gains or loses.

Explain-a-cause (written answer)

1. Name the cause and define the key term.
2. Say who takes the decision and what they ignore or undervalue.
3. State whether quantity is too high or too low.
4. Link to misallocation: resources used where social cost exceeds social benefit, or not used where social benefit exceeds social cost.

Worked reminders

External cost. A dye works (invented) has private cost 28 per unit and external cost 9 per unit. Social cost = 28 + 9 = 37. At 2,500 units, external cost = 9 × 2,500 = 22,500.

External benefit. An evening class has private benefit 50 per student and external benefit 10. Social benefit = 50 + 10 = 60.

Free rider. A shared drainage scheme costs 4,000 for 80 households. Equal share = 4,000 ÷ 80 = 50. If 20 households pay, revenue = 20 × 50 = 1,000, so shortfall = 3,000. The scheme is not funded.

Over-consumption. Market quantity 900, socially best 600. Excess = 300, which is 300 ÷ 600 = 50% above the best level.

Under-consumption. Market quantity 300, socially best 500. Shortfall = 200, which is 200 ÷ 500 = 40% below the best level.

2.10.3 Consequences

	Over-consumption	Under-consumption
Goods	Demerit goods; goods with external costs	Merit goods; goods with external benefits
Reason	Costs to the user or others are ignored	Benefits to the user or others are ignored
Misallocation	Too many resources go to the product	Too few resources go to the product

Say what the consequences are in real terms: pollution, ill health, lower skills, wasted resources, higher costs for others. Net gain to society is social benefit minus social cost, so a unit is worth producing only if the first is at least as large as the second.

Evaluation reminders

• Size. A small external cost, or one affecting few people, may not justify a strong response.
• Information. Better information can reduce over-consumption of demerit goods and under-consumption of merit goods without changing prices.
• Time. Harm such as pollution or poor health may appear years later, so the true social cost is hard to measure.
• Judgement. End with a short conclusion that names the most important factor for the case in front of you, with a reason.

Quick self-test

1. Define a market economic system.
2. Private cost is 14 and external cost is 6. Calculate social cost and the percentage of it that is external.
3. A good gives private benefit 35 and external benefit 15. Calculate social benefit.
4. Explain why a private firm is unlikely to provide street lighting.
5. State the difference between a merit good and a demerit good.
6. A shared drainage scheme costs 4,000 and 80 households are meant to share it equally. Calculate each share.
7. Market consumption of a good is 900 units and the socially best level is 600. Calculate the percentage over-consumption.
8. A sole supplier raises price from 12 to 15. Calculate the percentage rise and explain one effect on consumers.
9. A factory closes and 250 workers lose their jobs. New local work takes 60. Calculate the percentage still unemployed and name the type of immobility if the rest lack the skills.
10. Explain why a good with external benefits is under-consumed.

Answers

1. A system where buyers and sellers decide what, how and for whom to produce through the price mechanism, with private ownership of most resources.
2. Social cost = 14 + 6 = 20. External share = 6 ÷ 20 = 30%.
3. 35 + 15 = 50.
4. Lighting is non-excludable and non-rival, so people can free ride; the firm cannot collect enough revenue.
5. A merit good is beneficial and under-consumed if left to the market; a demerit good is harmful and over-consumed.
6. 4,000 ÷ 80 = 50.
7. (900 − 600) ÷ 600 × 100 = 50%.
8. (15 − 12) ÷ 12 × 100 = 25%. Consumers pay more and are likely to buy less, or must pay for an essential product with no alternative.
9. Unemployed = 250 − 60 = 190, so 190 ÷ 250 × 100 = 76%. The type is occupational immobility.
10. The buyer counts only their own benefit and ignores the gain to others, so demand reflects private benefit, which is below social benefit, and too little is bought.

Where marks are usually lost

• Defining a public good with only one of the two features. Give both: non-excludable and non-rival.
• Mixing up external and social costs, or adding when the question asks only for the external part.
• Writing “the government should tax it” in an answer on causes. This unit asks what goes wrong, not the cure (that belongs to section 2.11).
• Saying “over-consumption” for a merit good, or “under-consumption” for a demerit good.
• Giving an example that is not on the syllabus list of causes, or an example with no explanation of why the market fails there.
• Stating that monopolies charge more but not saying why they can (barriers to entry) or what happens to output.
• Leaving out units, or leaving out the working in a percentage calculation.
• Writing a long list of advantages and disadvantages without any judgement at the end.

Official syllabus

Cambridge IGCSE Economics 0455, syllabus for examination in 2026, Version 2, published by Cambridge University Press & Assessment (Cambridge Assessment International Education), sections 2.9 and 2.10.