1. a) Explain how health-care & education might represent cases of market failure in the economy [10 marks ]



– define market failure

Market failure is the inability of market forces of demand and supply to achieve allocative inefficiency, ie welfare not maximized (DWL exists) and there is requirement of government intervention. Welfare is maximized or market is efficient only if MSB=MSC at socially optimal output. Healthcare and education are cases of failure arising from positive externality/merit goods. These items are underallocated in the economy.


– define positive externality

Benefits incurred to third parties who are not directly involved in production and consumption of goods and services. It positively influences third bystander who is not involved in transaction of the good. WIthout government regulation, the price mechanism does not internalize the external benefit generated (for example, if a person has a good education and brings about better labor productivity and economic growth for an economy, he is not not given a subsidy for it through lower education pricings)


Positive externality diagram

Positive externality diagram

E.g.) Improving social efficiency by Healthcare and Education

When MSB > MPB  (because MSB=MPB+MEB), for example, in the consumption of education, society enjoy greater benefits than private benefits due to existence of external benefits. This is usually in the form of a more productive or healthier workforce, as a result, MSB>MPB, where MPB is the private benefit in the form of better job prospects or higher income.


From diagram, social welfare is maximized when MSC=MSB, at Qopt. This is where DD=SS and social surplus is maximum. But in the absence of government regulation, external benefits are not internalized by price mechanism (private individuals will not be willing to pay for external benefits); the price is too high and society consumes at MPB=MPC, or output Qm


This results in under-consumption and welfare loss (or dwl) to society, which it is the shaded region in the diagram. The welfare loss to society would be in the form of lost economic revenue, productivity and unemployment if they had a healthier and more educated workforce