Key Idea: Topic 2.8 explains why markets fail when there are external costs or benefits that are not reflected in the price. It covers negative externalities, positive externalities, and common pool resources.
✅ Core definitions
- Externality
- A cost or benefit that affects a third party not involved in the transaction.
- Negative externality
- External cost — market overproduces (Qm > Qopt). MSC > MPC.
- Positive externality
- External benefit — market underproduces (Qm < Qopt). MSB > MPB.
- Common pool resource
- Rivalrous but non-excludable — leads to overuse (fisheries, forests, groundwater).
📉 Negative externalities
- Production — factory pollution, carbon emissions (MSC above MPC)
- Consumption — smoking (passive smoking), alcohol (drink driving)
- Market overproduces → welfare loss triangle between MSC and MSB
- Solutions: Pigouvian taxes, carbon taxes, tradable permits, regulation
📈 Positive externalities
- Consumption — vaccination (herd immunity), education (informed citizens)
- Production — R&D (knowledge spillovers)
- Market underproduces → welfare loss triangle between MSB and MPB
- Solutions: subsidies, government provision, legislation (compulsory schooling)
🌊 Common pool resources
- Tragedy of the commons — individuals overuse because they get full private benefit but share the depletion cost
- Example: Atlantic cod collapse — each fisher catches as much as possible → stock crashes
- Solutions: quotas, property rights, tradable permits, community management (Ostrom), international agreements
Know the diagram labels: MPC, MSC, MPB, MSB. The gap between private and social curves = the externality. The welfare loss is ALWAYS a triangle.