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

This guide teaches section 2.10 (Market failure) of the 2026 examination syllabus for Cambridge O Level Economics (2281). It follows the three statements 2.10.1 (definition and key terms), 2.10.2 (causes) and 2.10.3 (consequences). The syllabus is not tiered. It notes that demand and supply diagrams relating to market failure are not required, so every idea here is shown with words and small tables. Practise on the practice questions, recall with the revision notes, and tick off topics on the checklist. Course home is the subject hub. All names and figures below are invented for illustration, and money is in dollars.

What this section covers

Syllabus	What you must be able to do
2.10.1	Define and use the vocabulary of market failure: three kinds of good, and benefits and costs at private, external and social level
2.10.2	Explain why markets fail in five areas (public goods, merit and demerit goods, externalities, monopoly abuse and immobile factors), with examples from those areas only
2.10.3	Explain how resources end up misallocated when some goods are consumed too much and others too little

Government responses (taxes, subsidies, regulation and so on) belong to section 2.11. This guide only diagnoses the problem. For the whole of Topic 2 see the Allocation of Resources guide, and for all your weak spots try the free diagnostics.

2.10.1 Key terms

Market failure means the price mechanism fails to allocate resources efficiently, so the output the market produces is not the output that gives most benefit to society. Learn these pairs.

Term	Meaning
Private benefits	Gains to the buyer or user of a good
External benefits	Gains to third parties who did not buy it
Social benefits	Private benefits plus external benefits
Private costs	Costs paid by the producer or consumer
External costs	Costs imposed on third parties who are not paid
Social costs	Private costs plus external costs

Social benefit = private benefit + external benefit. Social cost = private cost + external cost. Markets work on private figures only. Market failure appears when social and private figures differ.

Three good types need exact definitions.

• Public good: a good with two features. It is non-excludable: once it exists, those who refuse to pay cannot be kept out. It is non-rival: your enjoyment leaves as much for everyone else. Private firms struggle to charge for it.
• Merit good: a good that is under-consumed because people undervalue its benefits. It usually also brings external benefits. Education and healthcare are standard examples.
• Demerit good: a good that is over-consumed because people underestimate its harm to themselves and others. Tobacco and alcohol are standard examples.

2.10.2 Causes of market failure

Public goods and the free rider

Take Harbour H, where 60 boat owners share a rocky approach with no navigation beacon. A beacon costs 21,000, and each owner values it at 600.

Total benefit = 60 x 600 = 36,000
Equal cost share = 21,000 / 60 = 350 each
Net benefit to the harbour = 36,000 - 21,000 = 15,000

The project is worth building. Yet no boat can be kept from seeing the light, and one boat’s use does not dim it for another. So each owner hopes the others pay: the free rider problem. Suppose only 12 owners offer 350.

Money raised = 12 x 350 = 4,200
Share of cost = 4,200 / 21,000 = 20%
Shortfall = 21,000 - 4,200 = 16,800

A private firm cannot earn enough revenue, so it does not supply the beacon. Resources that could create 15,000 of net benefit are not used. Other examples: national defence, flood defences, street lighting on public roads.

Public, private and merit goods compared

Feature	Public good	Merit good	Ordinary private good
Can non-payers be excluded?	No	Yes	Yes
Does one person’s use reduce another’s?	No	Usually yes	Yes
Main market problem	Free riders, so no supply	Under-consumption	None of these
Example	Navigation beacons, national defence	Education, healthcare	A bakery loaf

A merit good can be sold privately, so the market does supply it, just not enough. A public good is often not supplied at all.

Merit goods

An annual vaccination costs 18. A person perceives its benefit as only 12, but the true private benefit is 24, and fewer infections bring an external benefit of 14 to other people and the health service.

Perceived net = 12 - 18 = -6  (does not buy)
True private net = 24 - 18 = +6
Social benefit = 24 + 14 = 38
Social net = 38 - 18 = +20

The person decides on the perceived 12, so the vaccination is under-consumed. Two things cause it: poor information and undervaluing the future, and external benefits that the buyer ignores.

Demerit goods

A fizzy drink sells for 2.00 and the buyer values it at 3.00. But heavy use brings later harm to the drinker worth 1.50 and costs the health service 0.50.

Social cost = 2.00 + 1.50 + 0.50 = 4.00
Social benefit = 3.00
Net = 3.00 - 4.00 = -1.00

The buyer sees a surplus of 1.00 (3.00 - 2.00) and buys, ignoring the harm. Consumption is too high.

External costs

Charcoal kilns in Country A sell bags at 8 each, equal to the private cost. Smoke imposes 3 of external cost per bag (health costs and cleaning), so social cost is 8 + 3 = 11. The table gives the value buyers place on each extra batch of 1,000 bags.

Batch	Value to buyers per bag (dollars)	Bought at 8?	Value minus social cost (11)
1	16	Yes	+5
2	14	Yes	+3
3	12	Yes	+1
4	10	Yes	-1
5	9	Yes	-2
6	6	No	-5

The market stops at 5 batches (5,000 bags), where value just exceeds private cost. Society gains only from the first 3 batches. Batches 4 and 5 lose (-1 - 2) x 1,000 = 3,000 in total. Total external cost at the market output is 3 x 5,000 = 15,000, which is 3/11 = 27.3% of the social cost per bag. Kiln owners, not the smoke victims, decide the output.

External benefits

A landowner’s hillside plot of trees costs 60 a year to plant and tend and gives 50 of timber. Farms downstream gain 30 from reduced flooding.

Private net = 50 - 60 = -10  (no plot planted)
Social benefit = 50 + 30 = 80
Social net = 80 - 60 = +20 per plot

At 20 plots the lost social gain is 20 x 20 = 400. The landowner receives no payment from the farms, so too few plots are planted.

Abuse of monopoly power

A sole supplier can restrict output and raise price. In Town T, tank-water deliveries cost 15 each. Compare the market with several suppliers with the market after one supplier takes over.

	Several suppliers	Sole supplier
Price (dollars)	20	26
Deliveries per month	1,000	800
Revenue (dollars)	20,000	20,800
Profit (dollars)	5,000	8,800

The price rises (26 - 20)/20 = 30% and quantity falls 20%. Profit rises by 3,800. The 200 lost deliveries were each worth at least 20 to buyers and cost 15 to supply, so at least 200 x 5 = 1,000 of gain disappears. That is the market failure: higher prices, less output, resources moved elsewhere though buyers want them.

Factor immobility

Land, labour and capital are not always able to shift into the uses where they would be worth most. Occupational immobility is lack of the skills for a new job. Geographical immobility is difficulty moving, because of housing costs, family ties or distance.

In Town M a mill closes and 400 workers lose jobs. The town’s labour force is 5,000, and unemployment was 250.

Rate before = 250 / 5,000 = 5%
Unemployed after = 250 + 400 = 650
Rate after = 650 / 5,000 = 13%

The town has 90 vacancies in construction, which need new skills, and 260 vacancies in a city far away. Even if 90 workers retrain, unemployed = 650 - 90 = 560, a rate of 11.2%. Labour sits idle while jobs go unfilled: a misallocation.

2.10.3 Consequences: misallocation

Markets respond to private costs and benefits. So:

Situation	Market output compared with best	Result
Demerit good	Too high	Over-consumption
Good with external costs	Too high	Over-consumption (kilns above)
Merit good	Too low	Under-consumption
Good with external benefits	Too low	Under-consumption (tree plots above)

Misallocation means resources go to the wrong uses: too many into harmful goods, too few into beneficial ones. Link each answer in a chain: private view differs from social view, so quantity is wrong, so resources are misallocated, so society’s welfare is lower than it could be. Evaluation points include how large the gap is and how accurately it can be measured.

How to write the chain in an answer

A clear chain of reasoning makes an answer stronger, so build it in four links. For a demerit good: buyers ignore the harm, so they buy more than is best for society, so resources flow into the good, so other uses lose out. For a merit good: buyers undervalue the benefit, so they buy too little, so resources are under-used on something that would raise welfare. Always name the good and one specific harm or benefit. A sentence such as “kiln smoke raises hospital costs for nearby families” is more convincing than “it is bad for the environment”.

Where a question gives numbers, use them. State the private figure, add the external figure, and compare the total with the price. When a question says “evaluate”, add a judgement: how large is the gap, who gains and who loses, and how hard is the harm or benefit to measure?

Common errors

• Calling a good a public good because the government provides it. Test non-excludable and non-rival.
• Mixing up a demerit good (harm the consumer underestimates) with a good that has external costs (harm to others).
• Adding external cost to price instead of to private cost.
• Writing that under-consumption means “nobody buys it”. It means too little compared with the social best.
• Forgetting percentages need the original value as denominator.

Practice and next steps

Work through the practice questions, then use the revision notes close to the exam. Past papers for this course are listed on the 2281 past papers page.

Official syllabus

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