Market Failure

We have already learned from the previous lessons that individuals are always trying to maximise their satisfaction of wants. Individual Economics, therefore, is about managing resources available to him/her to satisfy as much wants as possible.
When we look into a higher level, a country also tries to maximise the best use of its resources to deliver the best outcome, that is the satisfaction of wants of its people in general. And that is how the types of economic systems have come into place.
We have also seen the types of economic systems and one of them is market economy. In a market economy, resources are allocated by the forces of demand and supply. When something is demanded by the consumers, suppliers try to produce that good. Therefore, in theory, it should deliver the maximum satisfaction of wants.
However, there are reasons why market forces may not always allocate resources efficiently. In this situation we say there is market failure.

Market failure could result in productive inefficiency which means the firms are not producing the best output from the resources they have.

Market failure could also result in allocative inefficiency. This means that businesses are not producing those goods which are most wanted and needed by the consumers. In this case satisfaction of wants of the people will not be as good as it ought to be.

Reasons for market failure

  1. Negative externalities – When production is done, there are two categories of costs that are incurred. They are, private costs and social costs. Private costs are those incurred by the business or individual who does the production. When production is done, the society as a whole also bears some costs. For example, air pollution. These are known as social costs or external costs. Negative externalities occur when the social costs exceed private costs.
  2. Positive externalities – Production gives benefits to the business or individual who does the production. This is known as private benefits. production also gives benefit to the society as a whole.
    This is known as social benefits. Social benefits = private benefits + external benefits. Positive externalities occur when the external benefits is greater than the private benefit. In this case the individual or the business may be discouraged to do the production, leading to fall in output.
  3. Public goods – Market forces may not be able to provide public goods. Goods like street lights, light houses, drainage system on the roads, cannot be provided by the private sector. For example, once a lighthouse is provided, the ships at sea cannot be prevented from benefiting from it, and there is no way to charge a price from the ships that benefit from the lighthouse. Therefore, public goods have to be provided by the government as the private sector has no incentive to produce/provide them.
  4. Imperfect information – For markets to work, there needs to be perfect and symmetric information ie consumers and producers must have the same level of knowledge about the products, and they must know everything there is to know about them. In many cases, however, information may be asymmetric (producers know more than consumers) or incomplete/imperfect. In these situations, we have market failure. In the private healthcare market, doctors know more than patients about healthcare and treatments (asymmetric information). There is an incentive, therefore, for doctors to prescribe more expensive treatment than that is necessary in order to increase their profits. This is an inefficient use of resources. Many consumers in the healthcare market take out insurance to help pay for treatment; this, however, leads to a problem of moral hazard, where they take more risks and therefore require more treatment because they are insured. Again, this is a consequence of asymmetric information in the market where consumers know more than insurers about their intended future actions.
    In many markets, such as the tobacco, alcohol or pensions markets, providers of these goods and services often withhold information deliberately from consumers. For example, many tobacco companies knew of the link between tobacco and lung cancer before consumers were aware of it, and they continued to advertise tobacco as being ‘healthy’ and ‘sociable’, leading to over-consumption of tobacco, and therefore market failure.
  5. Monopolies – A monopoly is a situation where there is only one seller in the market, and everyone else is a buyer. Free markets sometimes result in monopolies, which can charge high prices from consumers and there is under-production of the particular goods that the monopoly provides.
  6. Factor immobility – Factors of production, such as labour may not be able to move from one place to another for many reasons. If they cannot move to the place where production is done, then there will be unemployment.
  7. Unfair income distribution – When the production is done for those who can pay for the goods and services, this could leads to the rich becoming richer and the poor becoming poorer.
  8. Uncertainty – the price of certain goods are subject to fluctuations in the market, which leads to uncertainty for those who produce those goods.

Benefits and disadvantages of specialisation at regional and national levels

In O Level Unit 3, we have already looked into division of labour and specialisation at individual level. For individuals, specialisation means each individual takes up a special task of production and he becomes special to that task. Read the tutorial about specialisation at individual level for more details.

Regional Level

Certain regions have specialised in certain industrial production e.g. coal mining in Yorkshire, pottery in Stoke. In Maldives, R.Alifushi is specialised in local boats construction and carpentry.

Advantages of Specialisation at Regional Level

  • efficient use of resources – A region could specialise in a particular industry due to availability of resources. Therefore it will be easier to use that resource efficiently
  • Creates jobs to residents – When an industry develops in a particular region, it helps the residents of that area since they can find work nearby their homes
  • Infrastructure development – When a region is specialised in a particular industry, infrastructure will be built to support that industry, therefore, it develops the region.

Disadvantages of Specialisation at Regional Level

  • Risk of low demand – Even though specialisation increases output, its benefits will not be achieved if there is no matching demand.
  • Rising costs – Costs will increase if labour and raw materials have to be transported from other regions

National Level

Certain countries have advantages in producing certain goods. They may have natural resources or they may be able to produce goods more cheaply.
e.g. Sri Lanka Tea, Japan electronics. They then trade these goods for those produced in other countries.

Advantages of specialisation at national level

  • Economies of scale and efficiency – Just like specialisation by individuals, countries can specialise in what they do best, and this leads to efficiency and economies of scale. It can therefore increase output of the country. When more and more countries specialise, it increases world output.
  • Job creation – Specialisation leads to increased output and therefore it could lead to more investment and thus jobs are created as the output increases. Moreover, it requires skilled labour and thus earnings are higher.
  • National level specialisation allows more international trade to take place and therefore more goods that other countries produce can be imported as well. Therefore it increases choice for the people of the country
  • Revenue to the government – As income increases, and as more trade takes place, it gives the possibility for the government to increase the revenue.
  • Improves standard of living – increased choice for the consumers, increased income, increased output, increased infrastructure means a better quality of life for the people, therefore standard of living will improve

Disadvantages of specialisation at national levels

  • Danger of unemployment – Even though national level specialisation usually creates more jobs, there is a risk of certain types of structural unemployment to occur. As the country moves towards specialisation, the workers in the declining industries may not find suitable work for them
  • Over-exploitation of resources – output maybe increased by over-exploiting resources. In this case todays output is increased at the cost of the future generations.
  • Negative externalities/ social cost – There could be external costs like damage to the environment which is a matter of concern

Upload of Tutorials Under O Level Unit 7 is complete!

HDI components
Cambridge O Level Unit 7 – Developed and Developing Economies: trends in
production, population and living standards

Topics covered in this unit

  1. Why some countries are classified as developed and others are not
  2. Absolute and relative poverty
  3. Policies to alleviate poverty>
  4. Factors affecting population growth
  5. The effects of changing size and structure of population on an economy
  6. Comparing developed and developing countries and regions within a country

The effects of changing size and structure of population on an economy

World Population
As labour is one of the factors of production, any changes to the population will affect the economy accordingly. Therefore it is important to look at the effects of the changing the size and structure of population on an economy. In this tutorial we will look at different aspects of changes to the population.

Increase in population

Population in a country can increase either due to increase in birth rate and reduction in death and infant mortality rate and/or due to immigration.

Advantages of increase in population

  • It increases labour force and therefore supply of labour.
  • It increases mobility of labour as a higher workforce tries to look for employment.
  • It increases demand for goods and services; demand for goods and services is a signal for producers to increase production.
  • If increases in demand for goods and services results in higher output from producers, it will lead to more investment and creation of employment opportunities.
  • In many cases, an adequate population is necessary for certain services to be feasible. This is the case for many Maldivian islands which does not have certain services and such services actually could not be started due to the population being too small.

Disadvantages of increase in population

  • If increase in population is not managed properly, it could lead to social problems like crowding and congestion.
  • It requires production of more consumer goods at the expense of capital goods.
  • Increase in population often leads to increases in poverty if not properly managed.
  • It could put strain on the scarce resources and it requires a higher government expenditure on infrastructure and basic facilities.

Structural Changes to population

Economic effects of an increase in the percentage of population in working age group

  • It results in a lower dependency ratio.
  • A higher working age group increases the national output.
  • It encourages production of more capital goods.
  • It increases economic growth and improves standard of living.
  • If properly managed, it reduces poverty.
  • However, government has to carefully manage this resource and must make sure that employment opportunities are provided to them. They must also be provided with education and training so that their efficiency and skill is improved.

Economic effects of an increase in the percentage of population in dependent age group

  • It increases burden on the working age group to produce goods and services for everyone.
  • It requires increased government spending on healthcare and education.
  • It requires production of more consumer goods.
  • It could lead to poverty and lower rate of economic growth.

Economic effects of an ageing population

  • More resources have to be spent for the production of consumer goods and services for the aged.
  • Higher government expenditure on healthcare and retirement pensions.
  • Low rate of economic growth.

Undesirable geographical distribution of population

  • Population spread into small groups – like in small Maldivian islands
  • The small size of population in such groups make it difficult to provide social and economic facilities
  • Unnecessary duplication of works and resources

Consequences of population changes at different stages of development

Stages in the development process

Stage 1: Traditional Society

This stage is characterized by a subsistent, agricultural based economy, with intensive labour and low levels of trading, and a population that does not have a scientific perspective on the world and technology.

Population in this stage

At this stage, both birth rate and death rate is high. children are an economic benefit to families, reinforcing high birth rates. Children contribute to the household economy by carrying water and firewood, caring for younger siblings, cleaning, cooking, or working in fields and household chores. With few educational opportunities, raising children costs little more than feeding them. As they became adults, children become major contributors to the family income and also become the primary form of insurance for adults in old age.

Stage 2: Preconditions to Take-off

Here, a society begins to develop manufacturing. As the name suggests, the preconditions of development start to appear at this stage. Examples of such preconditions are:
– external demand for raw materials initiates economic change
– development of more productive, commercial agriculture & cash crops not consumed by producers and/or largely exported
– widespread and enhanced investment in changes to the physical environment to expand production (i.e. irrigation, canals, ports)
– increasing spread of technology & advances in existing technologies
– changing social structure, with previous social equilibrium now in flux
– individual social mobility begins
– development of national identity and shared economic interests

Population changes at this stage

As death rates fall, birth rates remain high, resulting in a population explosion. Population growth is not due to increasing fertility, but to decreasing deaths: Many people continue to be born, but now, more of them live longer. Falling death rates also change the age structure of the population. In stage one, mortality is especially high among children between five and 10 years old. The decline in death rates in stage two improves the odds of survival for children. Hence, the age structure of the population becomes increasingly youthful.

Stage 3: Take-off

This stage as a short period of intensive growth, in which industrialization begins to occur, and workers and institutions become concentrated around a new industry.

Population changes at this stage

At this stage the death rate begins to fall while falling birth rates coincide with many other social and economic changes, including better access to contraception, higher wages, urbanization, commercialization of agriculture, a reduction in the value of children’s work, and greater parental investment in the education of children.

Stage 4: Drive to Maturity

This stage takes place over a long period of time, as standards of living rise, use of technology increases, and the national economy grows and diversifies.

Population changes at this stage

The conditions seen at the previous level continues. As birth rates fall, the age structure of the population changes again. Families have fewer children to support, decreasing the youth dependency ratio. But as people live longer, the population as a whole grows older, creating a higher rate of old age dependency. During the period between the decline in youth dependency and rise in old age dependency, there is a demographic window of opportunity called the demographic dividend: The population has fewer dependents (young and old) and a higher proportion of working-age adults, yielding increased economic growth. This phenomenon can further the correlation between demographic transition and economic development.

Stage 5: Age of High Mass Consumption

Here, a country’s economy flourishes in a capitalist system, characterized by mass production and consumerism.

Population changes at this stage

population growth stabilizes as birth rates fall into line with death rates. In some cases, birth rates may even drop below replacement level(2.1 children per woman), resulting in a shrinking population. Death rates in developed countries may remain consistently low or increase slightly due to lifestyle diseases related to low exercise levels and high obesity and an aging population. As population growth slows, the large generations born during the previous stages put a growing economic burden on the smaller, younger working population. Thus, some countries in this stage may have difficulty funding pensions or other social security measures for retirees.

Next topic: The effects of changing size and structure of population on an economy

Factors affecting population growth

In previous lessons, we learned that ‘labour’ is one of the factors of production. Labour means efforts of human beings that is input into the production. Therefore, population is an important factor of development.

Factors affecting population growth

  • Birth Rate

  • It is the average number of the children born in a country compared to the rest of the population. In other words, it is the number of births for every 1000 people in the country. Increase in population is directly related to birth rate of the country.
    Factors affecting birth rate of a country
    a) Existing age-sex structure – More young people starting married life.
    b) Availability and awareness among people about family planning.
    c) Religious beliefs – there are many aspects to it. Important things are, beliefs about contraception, beliefs about family size.
    d) Female employment – We can see that more and more women are opting to work for some time before getting married and even after getting married, their career commitments may reduce the number of children they may want to have.
    e) Economic prosperity – Even though richer families can afford to have more children, their style of life may actually reduce the number of children they want to have.
    f) Poverty Levels – Even though bringing up children could cost more, a poor family may opt to have more children as they it could give more working hands for the family later.
    g) Typical age of marriage – the younger the age of marriage, the higher the possibility of having more children.
    h)infant mortality rate – if IMR is high, birth rate will be high as some children are expected to die young.


  • Death Rate

  • Death rate is the number of people who die every year compared to 1000 people in the population.
    Factors affecting death rate of a country
    a) Medical facilities and health care – better medical facilities and health care reduces death rate.
    b) Nutrition levels
    c) Living standard
    d) Access to clean drinking water
    e) Hygiene levels
    f) Levels of infectious diseases
    g) Social factors such as conflicts and levels of violent crime


  • Fertility Rate

  • Fertility rate of a population is the average number of children born to a woman in her life time. If fertility is high, population will increase.


  • Net Migration

  • Migration is the movement of people in to and out of the country. Net migration is the difference between the immigration(people moving in to the country) and emigration(people moving out of the country). A positive net immigration will increase the population, while the opposite decreases the population.

Why do some countries have higher population growth than others?

Given above are the main factors that affect population growth. However, there are specific factors that we can discuss.

Most of the countries restrict immigration and emigration
Immigration is restricted by countries for many reasons. The most important reason is that countries want to encourage skilled workers rather than unskilled workers. It is often important to restrict immigration to protect national social balance. Countries may also want to restrict emigration to prevent brain-drain(a situation of skilled workers leaving the country).

Some countries discourage child birth
The most noticeable example of this is the one-child policy in China. Even though this could help reduce population, it also created many undesirable results.

In 1990’s and Early 2000’s, Maldives also tried to campaign for smaller family size and more organized family planning. Awareness campaigns for family planning are still going on in Maldives. However, the campaign to reduce the number of children per family is stopped due to many negative outcomes that could arise because of that.

Next topic: Consequences of population changes at different stages of development

Policies to alleviate poverty

One of the most important areas of discussion in development Economics is poverty reduction. Poverty often deepens and reduces due to the policies of the government. Poverty is affected positively and negatively due to the policies which are implemented to achieve other economic objectives.

Policies to reduce poverty

  • Policies to promote economic growth
  • Policies to reduce unemployment
  • Progressive taxes
  • Increasing benefits to the poor
  • Pension reforms
  • Education and training

Economic growth

Sustainable economic growth will generate wealth which can be used to re-distribute within the society. Economic growth is sustainable when more supply-side economic growth policies are used.
If we look at the countries today, those whith higher economic growth tend to reduce poverty in absolute terms.

Reducing Unemployment

Unemployment is always a problem for each and every economy, and poverty will increase if there is high unemployment. Therefore governments can use both demand-side and supply-side policies to reduce unemployment.

Progressive taxes

The purpose of progressive taxes is to take more taxes from those on high income levels. This will re-distribute income and will reduce relative poverty. It also enables the government to reduce indirect taxes and to increase benefits to the poor.

Problems of Using Taxes to Redistribute Income
1. Disincentives of Higher Tax

Critics argue higher income taxes create a disincentive to work., leading to less output. This is because higher tax makes work less attractive and reduces the opportunity cost of leisure. Therefore people work less and enjoy more leisure. This is known as the Substitution Effect.

2. Higher corporation tax may discourage investments

However this is disputed by other economists. Higher Tax reduce incomes and this may encourage people to work more, to maintain their income. (This is known as the income effect)

Evidence suggests that higher income tax has little effect on the supply of labour, suggesting Labour supply is relatively inelastic. However, it also depends at what level income tax is set. There is certainly a level where higher income tax will reduce incentives to work.

2. Tax Evasion

High levels of tax will encourage more people to use off shore accounts to avoid paying income tax at home country.

3. Firms may adjust wages to compensate

E.g firms may increase wages to those who are taxed and pay lower wages to those who pay less tax.

4. There are administrative costs of collecting taxes.
If costs of collecting taxes is high, it is one of the ways in which government fails in its policies to correct market failure.

5. Distortion effect of putting taxes on goods

Indirect taxes are levied to overcome market failure for demerit goods such as cigarettes, therefore cutting such taxes may encourage consumption of demerit goods.

Increasing benefits to the poor

About giving benefits to the poor, the best way is to give means-tested benefits. Means-tested benefits are benefits that are available only to individuals whose income is below a certain level. For example, in the U.S. food stamps are a means-tested benefit. They are available only to low-income families.

Advantages of means-tested benefits
1. They allow money to be targeted to those who need it most. e.g family tax credit or pension credit.

2. It is cheaper than universal benefits and reduces the burden on the tax payer· However, means-tested benefits are often unpopular because people are stigmatized as being poor.

3. Also it may create a disincentive to earn a higher wage, because if you do get a higher paid job you will lose at least some of your benefits and pay more tax. This is known as “the benefit trap” or the “poverty trap”

4· Some relatively poor may fall just outside the qualifying limit.

5· Also not everyone entitled to means-tested benefit will collect them because of ignorance or difficulties in applying.

Governments used to prefer universal benefits because it avoided the above problem, and people feel if they contribute towards taxes they deserve their benefits regardless of their wealth.

However in recent years, the welfare state has faced increased demands due to demographic factors leading to more calls for means-tested benefits.

Pension Reforms

– Linking State pensions to earnings and not inflation.
This would increase pensioners income and reduce inequality as poor pensioners would have more income

However this would be very costly because of the demographic changes and if the country is experiencing ageing population.

– Means Tested Pensions.
This enables more money to be targeted to those who need it . However it may discourage people from putting money into private pension schemes.

– Compulsory Company pensions schemes

Education and training

Some people are not able to come out of poverty because they are not able to get employment due to the lack of necessary skills. Improving education and giving training will make them employable. Education also helps to make the workforce more skilled and productive which in turn will help economic growth of the country.

Next topic: Factors affecting population growth