Cambridge O Level Economics: Market failure: public, merit and demerit goods and externalities (2281) – Revision Notes

These notes squeeze section 2.10 (Market failure) of the 2026 examination syllabus for Cambridge O Level Economics (2281) into recall form: 2.10.1 terms, 2.10.2 causes, 2.10.3 consequences. The syllabus is not tiered and says demand and supply diagrams relating to market failure are not required. When you need reasons and longer working, return to the study guide. Test yourself on the practice questions, tick topics off on the checklist, and open the subject hub for the rest of the course. To see where you stand first, take a free diagnostic. All names and numbers are invented for illustration, and money is in dollars.

Definitions to learn word for word

Term or description	Matching term or description
Market failure	The price mechanism allocates resources in a way that is not best for society
Costs paid by the producer or consumer	Private costs
Costs dumped on an uncompensated outsider	External costs
Private costs plus external costs	Social costs
Gains enjoyed by the buyer or user	Private benefits
Gains that spill to someone who did not pay	External benefits
Private benefits plus external benefits	Social benefits
Public good	Non-excludable and non-rival, so private firms cannot easily charge
Merit good	Under-consumed because benefits are undervalued; usually has external benefits
Demerit good	Over-consumed because harm is underestimated; harms the user and often others

Causes at a glance (2.10.2)

Cause	What goes wrong	Typical result	Example
Public good	Free riders: people use it without paying	Not supplied privately	Defence, navigation beacons
Merit good	Benefits undervalued, external benefits ignored	Under-consumption	Education, healthcare
Demerit good	Harm underestimated	Over-consumption	Tobacco, alcohol
External cost	Third parties bear costs	Over-production and over-consumption	Factory smoke, noisy traffic
External benefit	Third parties gain for free	Under-production and under-consumption	A neighbour’s well-kept garden raising local house values
Abuse of monopoly power	Sole seller restricts output, raises price	Higher price, lower output	A sole local water supplier
Factor immobility	Workers or capital cannot move to better uses	Idle resources, unfilled vacancies	A mill closes, workers lack other skills

Syllabus limit: give examples of these areas only.

Consequences (2.10.3)

Situation	Market output vs best output	Word to use
Demerit good	Too high	Over-consumption
External cost	Too high	Over-consumption
Merit good	Too low	Under-consumption
External benefit	Too low	Under-consumption

Misallocation means resources are in the wrong uses. Too much goes into harmful goods, and too little into beneficial ones.

Formulae and quick checks

Idea	Rule
Social benefit	add the external gain to the buyer’s own gain
Social cost	add the outsider’s loss to the producer’s own cost
External cost share	external cost / social cost x 100
Percentage change	change / original x 100
Equal cost share	total cost / number of households
Unemployment rate	unemployed / labour force x 100
Net social gain	social benefit - social cost

Method in steps

Spotting the type of failure

1. Ask whether non-payers can be stopped from using it. If not, think public good.
2. Ask whether the buyer misjudges the benefit or harm to themselves. If yes, merit or demerit.
3. Ask whether a third party gains or loses without payment. If yes, external benefit or cost.
4. Ask whether there is one seller. If yes, monopoly power.
5. Ask whether workers or capital are stuck. If yes, factor immobility.

Writing a four-link chain

1. Private decision differs from the social best.
2. So output or consumption is too high or too low.
3. So resources are misallocated.
4. So society is worse off. Name who loses.

Worked reminders

External cost. A cement works in Country B has a private cost of 40 per tonne and causes dust damage to nearby homes of 12 per tonne. It makes 300 tonnes.

Social cost per tonne = 40 + 12 = 52
Total external cost = 12 x 300 = 3,600
Total social cost = 52 x 300 = 15,600

The seller counts only 40 per tonne, so the dust damage is ignored.

External benefit. A training course gives the trainee a private benefit of 60 and an employer an extra 25.

Social benefit = 60 + 25 = 85
If the course costs 70: social net gain = 85 - 70 = 15

If the trainee will not pay 70 for a private benefit of 60, the course is not bought. Society loses a net gain of 15.

Unemployment from immobility. A town with a labour force of 8,000 has 480 unemployed (6%). A plant closure adds 160 unemployed.

New total = 480 + 160 = 640
New rate = 640 / 8,000 = 8%

Monopoly abuse. A sole bus operator in Town S raises the fare from 50 to 56 and weekly trips fall from 900 to 720. Each trip costs 40.

Fare change = (56 - 50) / 50 = 12%
Trips change = (720 - 900) / 900 = -20%
Profit before = (50 - 40) x 900 = 9,000
Profit after = (56 - 40) x 720 = 11,520

The seller gains while riders lose trips they valued above cost. That is the failure.

Examples sorted by area

Area	Safe examples to quote
Public good	Defence, navigation beacons, lighthouses
Merit good	Education, healthcare, immunisation
Demerit good	Tobacco, alcohol, harmful drugs
External cost	Factory smoke, river dumping, traffic noise
External benefit	Workers trained by one firm who later help another, woodland that reduces downstream flooding
Monopoly abuse	One firm controlling local water or rail supply
Factor immobility	Retired miners without new skills, families tied to a home region

Use an example from the area the question asks about. Do not stretch to topics outside section 2.10.

Must-know distinctions

• Public good or merit good. Public goods cannot be restricted to payers. Merit goods can be sold, but are bought too little.
• Demerit good or external cost. A demerit good is over-consumed mainly because the user misjudges harm. An external cost harms others. Tobacco can be both.
• External benefit or private benefit. Only gains to people who did not buy count as external.
• Over-consumption or over-production. Say which side you mean, though both are too much.
• Occupational or geographical immobility. Skills against location.

Sentence frames for explanations

• “Because the good is non-excludable, people can use it without paying, so firms cannot earn revenue and do not supply it.”
• “The buyer considers only the private benefit, so the quantity bought is below the quantity that gives the greatest social benefit.”
• “The producer ignores the external cost, so the price is below the social cost and too much is produced and consumed.”
• “Workers lack the skills for the vacancies, so labour is unemployed while jobs go unfilled, which wastes a factor of production.”

Add the name of the good, one named person or group who gains or loses, and one number if the question gives data.

Quick self-test

1. State what makes a good non-excludable.
2. A firm has a private cost of 34 per unit and an external cost of 9. Find the social cost per unit.
3. In question 2, what percentage of social cost is external, to 1 decimal place?
4. A vaccine gives a private benefit of 26 and an external benefit of 14. What is the social benefit?
5. A flood barrier costs 18,000 and 120 households each value it equally. What is the equal cost share?
6. In question 5, only 24 households pay the equal share. What percentage of the cost is raised?
7. Is tobacco a merit good or a demerit good? Give one reason.
8. A sole supplier raises its price from 40 to 46. What is the percentage rise?
9. Name the type of immobility when a retired miner cannot be hired as a software tester.
10. Does a good with an external benefit tend to be over-consumed or under-consumed?
11. A merit good has a price of 70, a social benefit of 85. By how much does social benefit exceed price?
12. Give one example of an external cost caused by a factory.

Answers

1. Non-payers cannot be stopped from using it.
2. 34 + 9 = 43.
3. 9 / 43 x 100 = 20.9%.
4. 26 + 14 = 40.
5. 18,000 / 120 = 150 each.
6. 24 x 150 = 3,600, and 3,600 / 18,000 = 20%.
7. A demerit good: users underestimate the harm to their health and it also harms others.
8. (46 - 40) / 40 x 100 = 15%.
9. Occupational immobility (lack of skills).
10. Under-consumed.
11. 85 - 70 = 15.
12. For example smoke or noise that harms neighbours, or river pollution that harms downstream fishers.

Where marks are usually lost

• Describing a public good only by who pays for it, with no mention of non-excludable or non-rival.
• Saying “pollution” without naming who bears the cost.
• Treating external costs as part of the price the producer pays.
• Giving a government policy answer to a question that asks only for causes or consequences.
• Using a percentage change with the new value as the base.
• Confusing under-consumption with zero consumption.
• Using a famous example of the wrong area, when the syllabus asks for examples of listed areas only.
• Stating a consequence with no chain: say why the quantity is wrong and what happens to resources.
• Missing the units or the word “per” in a cost-per-unit answer.

Official syllabus

Source: Cambridge International, Cambridge O Level Economics (2281), examination year 2026, version 2, section 2.10 headed Market failure.