Market failure and externalities
Key terms
Define each term.
Multiple choice
Circle the correct answer.
Why does a free market under-provide public goods?
Worked problems
Show your working.
Deciding on a bypass using social costs and benefits. A government is considering a bypass. Construction and running costs are $30m. Noise and loss of habitat for local residents are valued at $6m. Toll revenue would be $20m. Time saved by drivers and fewer accidents in the town are valued at $25m. Calculate social cost and social benefit, and decide whether the bypass should be built.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How an indirect tax corrects a negative externality
- A An indirect tax raises the firm's marginal private cost by the amount of the tax.
- B If the tax is set equal to the marginal external cost, output falls to where MSB = MSC.
- C The deadweight welfare loss is eliminated and allocative efficiency is restored.
- D The supply curve shifts left, since supply reflects marginal cost.
- E A demerit good generates external costs, so marginal social cost exceeds marginal private cost.
- F The free market equilibrates where MPB = MPC, at an output above the social optimum.
- G Equilibrium price rises and equilibrium quantity falls.
Why tradable permits can beat a uniform tax
- A Abatement therefore concentrates where it is cheapest, so a given environmental target is met at lower total cost.
- B Each firm abates until its marginal abatement cost equals the tax, so total abatement is determined by the tax rate rather than chosen directly.
- C Firms differ in their marginal cost of abatement, since some have newer technology than others.
- D Under a permit scheme the regulator fixes the total quantity of emissions instead.
- E The regulator also achieves certainty over the environmental outcome, which a tax cannot deliver.
- F A uniform tax charges every firm the same rate per unit of pollution.
- G Low-cost abaters cut emissions and sell their surplus permits; high-cost abaters buy permits rather than abate.
Diagrams
Draw a market with a negative production externality. Show MPC, MSC, the free market equilibrium, the social optimum, and shade the welfare loss.
Draw a market with a positive consumption externality: MSB above MPB, and a single MPC = MSC curve. Mark the free market output where MPB = MPC, the socially optimal output where MSB = MSC, and shade the welfare loss. Then draw a negative consumption externality with MSB below MPB and shade its welfare loss.
Extended answer
Plan your answer: list the points you would make in each paragraph.
Assess whether indirect taxation is the most effective method of correcting the market failure caused by negative externalities. (13 marks)
Answers
Market failure: A situation where the market mechanism allocates resources inefficiently, producing too much or too little of a good.
B. If people cannot be excluded from a good once it exists, they have no reason to pay for it. No firm can profitably supply it, so provision falls to the government.
Step 1. Social cost. Social cost = private cost + external cost = $30m + $6m = $36m.
Step 2. Social benefit. Social benefit = private benefit + external benefit = $20m + $25m = $45m.
Step 3. The decision on social grounds. Net social benefit = $45m - $36m = $9m. Social benefit exceeds social cost, so the bypass should be built.
Step 4. The private decision. A private firm would compare only the $20m of toll revenue with the $30m of cost and would not build it, since it loses $10m. The external benefits are what make the project worthwhile, which is why such projects are often provided or funded by the state.
Step 5. Question the numbers. If time saved were valued at $14m instead of $25m, social benefit would fall to $34m, below the $36m of social cost, and the decision would reverse. The conclusion depends on a valuation that nobody can observe directly.
Step 5 is the evaluation mark in any cost-benefit question: show how sensitive the decision is to the hardest number to measure.
E, F, A, D, G, B, C
- A demerit good generates external costs, so marginal social cost exceeds marginal private cost.
- The free market equilibrates where MPB = MPC, at an output above the social optimum.
- An indirect tax raises the firm's marginal private cost by the amount of the tax.
- The supply curve shifts left, since supply reflects marginal cost.
- Equilibrium price rises and equilibrium quantity falls.
- If the tax is set equal to the marginal external cost, output falls to where MSB = MSC.
- The deadweight welfare loss is eliminated and allocative efficiency is restored.
AO2 analysis carries 40% of the marks. Each arrow in a chain like this is a linked step, and examiners credit the linking, not the assertion. Never jump from 'tax imposed' to 'externality solved'.
C, F, B, D, G, A, E
- Firms differ in their marginal cost of abatement, since some have newer technology than others.
- A uniform tax charges every firm the same rate per unit of pollution.
- Each firm abates until its marginal abatement cost equals the tax, so total abatement is determined by the tax rate rather than chosen directly.
- Under a permit scheme the regulator fixes the total quantity of emissions instead.
- Low-cost abaters cut emissions and sell their surplus permits; high-cost abaters buy permits rather than abate.
- Abatement therefore concentrates where it is cheapest, so a given environmental target is met at lower total cost.
- The regulator also achieves certainty over the environmental outcome, which a tax cannot deliver.
The trade-off is the mirror image: a tax gives certainty over cost but not over emissions, permits give certainty over emissions but not over cost. Naming that trade-off explicitly is what lifts an answer into the evaluation band.
MSC lies above MPC by the value of the marginal external cost. The welfare loss triangle sits between the two cost curves, bounded by the free market output and the socially optimal output.
For a positive externality the market underproduces, and the welfare loss triangle lies to the right of the free market output; for a negative one it overproduces, and the triangle lies to the left of it. The triangle always points towards the social optimum.
Define and frame: Define negative externality and market failure. State that effectiveness will be judged against correcting the misallocation, and flag that the answer depends on elasticity and on the measurability of the external cost.
Analysis: the case for: Run the full chain from external cost through to restored allocative efficiency, supported by an MPC/MSC diagram with the welfare loss shaded. Add that the tax raises revenue which can be hypothecated to remedial spending.
Analysis: the alternatives: Take two alternatives seriously rather than dismissing them. Tradable permits give certainty over the environmental outcome; regulation is immediate and does not require valuing the externality in money terms.
Evaluation: Weigh rather than list. Inelastic demand means a tax changes quantity little while hitting consumers hard. The external cost is very difficult to value, so the tax rate is likely to be wrong. Regressive incidence raises equity objections. Government failure is possible.
Judgement: Reach a supported conclusion that depends on stated conditions: taxation is most effective where demand is price elastic and the external cost is measurable; permits are preferable where the environmental target matters more than the cost; regulation suits cases where the harm is severe enough that any positive quantity is unacceptable. An answer ending 'it depends' without specifying on what will not reach the top level.