Key Idea: A factory pollutes a river. The people downstream pay for it, but they were never part of the deal. That is an externality: a cost or a benefit that lands on a third party. When the market ignores it, it makes too much of a harmful good and too little of a helpful one. The gap between what the market does and what is best for everyone is the welfare loss, and closing it is the government's job. Where you meet it:
Paper 1
- Essays.
- Explain [10]: why a firm ignores external costs; why healthcare has positive externalities.
- Evaluate [15]: taxes, regulation or education against a harmful good; how to manage a shared resource.
Paper 2
- Data response.
- Define [2]: market failure, tradable permits, common pool resources.
- Explain [4] with a diagram: fossil fuels, a carbon tax, a subsidy for education. The most common Paper 2 diagram.
The diagram
- Four curves, one triangle.
- MPC, MSC, MPB, MSB. The gap between private and social is the externality. The triangle is the loss.
🏭 Negative externalities: too much gets made
A negative externality is a cost that falls on someone outside the deal. From production: a factory's smoke, a mine's damage. From consumption: a smoker's second-hand smoke, a driver's congestion. Either way the market ignores that cost, so too much is produced or consumed.
| Type | Which curves split | Where the market sits | Cure |
|---|---|---|---|
| Production | MSC above MPC by the external cost; demand = MPB = MSB | MPC = MPB, at Qm, to the right of Qopt | a tax equal to the external cost lifts MPC onto MSC |
| Consumption | MSB below MPB by the external cost; supply = MPC = MSC | MPB = MPC, at Qm, to the right of Qopt | a tax, regulation or education pushes use down towards Qopt |
The welfare loss is the triangle between the two curves, from Qopt to Qm, on the right of the social optimum: value destroyed by units that should not have been made. Label both quantities and all four curves. An externalities diagram with unlabelled curves cannot be read.
🌱 Positive externalities: too little gets made
A positive externality is a benefit that spills over to someone outside the deal. A vaccinated person protects the people around them; a trained worker makes the whole firm better. The buyer does not count that benefit, so too little is produced or consumed.
| Type | Which curves split | Where the market sits | Cure |
|---|---|---|---|
| Consumption | MSB above MPB by the external benefit; supply = MPC = MSC | MPB = MPC, at Qm, to the left of Qopt | a subsidy, direct provision, compulsory rules, information |
| Production | MSC below MPC by the external benefit; demand = MPB = MSB | MPC = MPB, at Qm, to the left of Qopt | a subsidy to the firm, say for research |
Negative: the triangle sits to the right of Qopt. Positive: to the left. If your triangle is on the wrong side, the diagram is upside down. Name the third party. Everyone the vaccinated person would have infected says more than society benefits.
🛠️ Fixing it: the government's tools
Every tool tries to make the market see the cost or benefit it was ignoring. Each one works, and each one has a catch.
| Tool | How it works | The catch |
|---|---|---|
| Tax on the harm | a tax equal to the external cost per unit lifts MPC onto MSC; the firm now pays the full cost | the external cost is hard to measure; regressive if the good is a necessity |
| Tradable permits | cap total pollution and let firms trade the right to emit; cheap cutters sell permits to expensive ones | a cap set too high does nothing; the permit price swings |
| Regulation | ban or limit the activity: emission standards, smoking bans, quotas | costly to enforce; no reward for doing better than the rule |
| Education and information | shift MPB towards MSB by changing what people know | slow; weak against habits and addiction |
| Subsidy for the benefit | a subsidy equal to the external benefit per unit; more is bought at a lower price | taxpayers pay; the money could have gone elsewhere |
| Direct provision | the state supplies the good itself: schooling, vaccines | expensive; can be inefficient |
A tax or a subsidy corrects the failure only if it equals the external cost or benefit per unit. A tax is vaguer than a tax equal to the external cost per unit. Then evaluate with the four questions: effective, efficient, equitable, alternatives.
🌊 Common pool resources: nobody's, so everybody's
A common pool resource is rival (one person's use leaves less for the others) but non-excludable (nobody can be kept out): a fish stock, groundwater, grazing land, clean air. Follow one fisher's reasoning.
The tragedy of the commons
- Full benefit — Every extra fish caught is all mine: the whole gain goes to the person who takes it.
- Shared cost — The cost of a smaller stock next year is spread across every boat, so my share of it is tiny.
- So I take more — Each fisher takes more than is sustainable, because holding back only leaves the fish for someone else.
- The stock collapses — The resource is used up faster than it renews. Newfoundland's cod fishery collapsed in 1992 and has still not recovered.
Full benefit → shared cost → overuse → collapse
| Way to manage it | How | The catch |
|---|---|---|
| Regulation | quotas, closed seasons, protected areas | hard to enforce, especially at sea |
| Property rights | make it excludable again: tradable fishing quotas, private ownership | how do you privatise the atmosphere? |
| Community self-governance | users set their own rules, monitor each other and punish cheats (Ostrom) | works for small, local resources |
| International agreements | countries agree limits together | free riders and weak enforcement |
Important: A public good is non-excludable and non-rival: your using a lighthouse leaves it whole. A common pool resource is non-excludable but rival: your fish is gone for everyone. Say both words in the definition. The diagram is the negative production externality: MSC above MPC, because each user's catch costs the others.
✍️ Worked examples
The four shapes this topic is asked in, with new scenarios. Try each before opening the plan.
A text describes a river polluted by textile factories upstream of a fishing village. Define the term market failure.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Now the Sketch.
A quarry produces gravel, and its dust damages the farms around it. Sketch an externalities diagram for the gravel market and mark the socially optimal level of output.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
Animated graph
Watch the graph build step by step in study mode.
Now the positive case.
A government subsidises adult literacy classes. Using an externalities diagram, explain how the subsidy moves the market towards the social optimum.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
And the Paper 1 shape.
Using real-world examples, evaluate the view that regulation is the best way to reduce carbon emissions from electricity generation.
Model answer plan
See the mark-by-mark plan — for / against / judgement, with marking guidance — in study mode.
✅ Quick self-check
Tap each card to check yourself.
A negative externality of production: which curve sits above which? MSC above MPC. The gap is the external cost per unit. Demand is MPB = MSB, so the market at MPC = MPB makes too much.
Where does the welfare-loss triangle sit for a positive externality? To the left of the market quantity, between Qm and Qopt: the units that should have been made and were not.
How big should a corrective tax be? Equal to the external cost per unit. Then MPC + tax = MSC and the market chooses Qopt on its own.
Define tradable permits. Government-issued rights to pollute up to a capped total, which firms can buy and sell. Cheap cutters sell spare permits to firms that find cutting expensive.
Why does a firm ignore the external cost when it plans output? Because it does not pay it. The firm compares its own cost, MPC, with the price. The river, the neighbours and the climate are not on its bill.
Rival and non-excludable. Which kind of good? A common pool resource: a fish stock, an aquifer. A public good is non-excludable and non-rival.
In one sentence, why does a shared fish stock get overfished? Each fisher takes the full benefit of an extra catch and shares the cost of a smaller stock with everyone, so holding back only leaves the fish for someone else.
Carbon tax or tradable permits: which fixes the quantity, which fixes the price? Permits fix the quantity (the cap) and let the price float. A tax fixes the price per tonne and lets the quantity fall wherever it falls.
Exam tips
- Label all four curves, MPC, MSC, MPB, MSB, and both quantities, Qm and Qopt. Unlabelled, the diagram cannot be read.
- Negative externality: MSC above MPC (production) or MSB below MPB (consumption), triangle to the right of Qopt. Positive: mirror image, triangle to the left.
- Shade the welfare loss and say what it is: value destroyed, not money lost.
- Name the third party every time. Society is weaker than the farms downwind of the quarry.
- A corrective tax or subsidy equals the external cost or benefit per unit. Say so.
- Common pool resource = non-excludable and rival. Both words, or you have defined something else.
- In a 15-marker: draw the failure first, then the tool, then at least one alternative, then a verdict with a real example.