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The answers print on a separate page at the end. Higher levels include the lower-level questions.

ExamPass · AS Level worksheet

Market failure and externalities

NameClassDate

Key terms

Define each term.

1
Market failure

Multiple choice

Circle the correct answer.

2

Why does a free market under-provide public goods?

  1. They are too expensive to produce
  2. Non-excludability means consumers can free-ride, so firms cannot charge
  3. Demand for them is inelastic
  4. Governments prohibit private firms from supplying them

Chains of reasoning

The steps are in the wrong order. Write the letters in the order that makes a linked chain.

3

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.

Diagrams

4

Draw a market with a negative production externality. Show MPC, MSC, the free market equilibrium, the social optimum, and shade the welfare loss.

Answers

1

Market failure: A situation where the market mechanism allocates resources inefficiently, producing too much or too little of a good.

2

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.

3

E, F, A, D, G, B, C

  1. A demerit good generates external costs, so marginal social cost exceeds marginal private cost.
  2. The free market equilibrates where MPB = MPC, at an output above the social optimum.
  3. An indirect tax raises the firm's marginal private cost by the amount of the tax.
  4. The supply curve shifts left, since supply reflects marginal cost.
  5. Equilibrium price rises and equilibrium quantity falls.
  6. If the tax is set equal to the marginal external cost, output falls to where MSB = MSC.
  7. 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'.

4

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.