AQA GCSE Economics: Market failure, externalities and intervention (8136) – Revision Notes

These notes condense sections 3.1.6.1 and 3.1.6.2 of the AQA GCSE Economics (8136) specification for first teaching from September 2017. The content is common to all candidates, as the specification states no tiers. For explanations and longer worked examples, read the study guide, then try the practice questions. The course home is the AQA GCSE Economics hub, the checklist tracks what you have covered, and the free diagnostics show what to revise first. All figures here are invented for illustration.

Key definitions

Term	Meaning
Efficient allocation	Resources go to the uses society values most, with no change that makes society better off
Market failure	The inability of the market system to allocate resources efficiently
Misallocation	An excess of some goods and a shortage of others, set against the best outcome for society
Externality	A cost borne or benefit received by someone outside the transaction
Private cost / benefit	What the buyer or seller pays or gains
External cost / benefit	What a third party bears or gains
Social cost	Private cost plus external cost
Social benefit	Private benefit plus external benefit
Third party	Someone who is neither buyer nor seller

The core rules

• Social cost = private cost + external cost.
• Social benefit = private benefit + external benefit.
• An externality is the gap between the social and the private figure.
• Negative externality: social cost is above private cost, so the market produces too much.
• Positive externality: social benefit is above private benefit, so the market produces too little.

3.1.6.1 Costs of misallocation

• Scarce resources wasted: the opportunity cost is a better use forgone.
• Harm to third parties, such as pollution, noise, congestion and ill health.
• Beneficial goods under-provided, such as education and health care.
• Public money spent on clean-up and treatment, which cannot be spent elsewhere.

Methods of government intervention

Method	Effect on the market	Best matched to
Indirect tax	Supply shifts up and left, price rises, output falls	Negative externality
Subsidy	Supply shifts down and right, price falls, output rises	Positive externality
Laws and regulation	Limits or bans backed by penalties	Serious harm, or where a limit is needed
Information and education	Changes what people choose to buy	Harmful or beneficial goods
Direct provision	The government supplies, funded by taxes	Goods that would be under-supplied

Evaluation prompts for any method:

• Can the government measure the external cost or benefit correctly?
• Who pays: firms, consumers or taxpayers?
• What is the opportunity cost of the public money used?
• Can people avoid or evade it?
• How long will it take to work?

3.1.6.2 Identifying externalities

	Production	Consumption
Negative	A factory’s fumes harm local homes	Driving adds congestion and fumes for others
Positive	A firm trains workers who later help local firms	Vaccination lowers the chance others catch a disease

Three-question test:

1. Who decides, and what do they pay or gain?
2. Who else is affected?
3. Is that effect covered by the price? If not, it is an externality.

Method boxes

Social cost question

1. Write the private cost per unit.
2. Add the external cost per unit to get social cost per unit.
3. Multiply by output for any total.

Tax or subsidy question

1. State the direction: tax raises cost and cuts output, subsidy lowers cost and raises output.
2. Give the new price and the new quantity.
3. Say whether the outcome is closer to the social optimum.
4. Add one limit of the policy.

Diagram described in words (tax)

• Axes: price up the side, quantity along the bottom.
• The demand curve falls and the supply curve rises; where they meet is the free-market equilibrium.
• A tax shifts supply upward by the size of the tax.
• At the new equilibrium the price is up and the quantity is down.

Small worked reminders (invented figures)

Reminder 1. A coach firm’s private cost is £8 per trip and noise costs nearby residents £5 per trip. Social cost = 8 + 5 = £13. The external share is 5 ÷ 13 = 38.5%.

Reminder 2. Private benefit of a course is £20 per learner. External benefit to employers is £7. Social benefit = £27.

Reminder 3. A tax of £2 per unit on 500 units raises 2 × 500 = £1,000.

Reminder 4. A subsidy of £4 per unit on 2,000 units costs 4 × 2,000 = £8,000.

Chains of reasoning to learn

Negative externality, tax

1. A factory’s smoke harms local people, who are third parties.
2. The factory’s price covers only its private cost, so social cost is above private cost.
3. The price is too low and the market produces too much.
4. Resources are misallocated, because some units cost society more than they are worth to buyers.
5. A tax on each unit raises the firm’s cost, supply falls and price rises.
6. Output falls towards the level that is best for society.
7. Evaluation: the tax only works if the external cost is estimated well, and buyers may pay most of it.

Positive externality, subsidy

1. A service gives benefits to people who do not buy it.
2. Buyers count only their own benefit, so demand is lower than society would want.
3. The market produces too little.
4. A subsidy lowers cost per unit, price falls and output rises.
5. Evaluation: the subsidy is paid by taxpayers and could be spent elsewhere.

Worked reminder with a table (invented)

In a made-up market for a delivery service, external cost is £4 per delivery.

Deliveries	Value to buyers of the last one (£)	Private cost of the last one (£)	Social cost of the last one (£)
9,000	22	22	26
7,200	24	20	24

• Free market: value equals private cost at 9,000 deliveries.
• Social optimum: value equals social cost at 7,200 deliveries.
• Over-production = 9,000 − 7,200 = 1,800, which is 1,800 ÷ 9,000 = 20% of the market output.
• A tax of £4 per delivery raises 4 × 7,200 = £28,800.

Command words and what they ask for

• State or identify: give the point, no development.
• Define: give the meaning, using the exact idea, such as “difference between social and private”.
• Calculate: show the working, give the answer and the unit.
• Explain: make a point, then say why or what follows.
• Analyse: build a chain, each link leading to the next.
• Evaluate or assess: weigh both sides and reach a reasoned judgement.

Examiner insights in the practice questions give advice on how answers gain or lose credit. They do not state mark-scheme rules.

Must-know distinctions

• Private versus external: the buyer or seller versus an outsider.
• Production versus consumption externalities: where the harm or benefit starts.
• Negative versus positive: over-production versus under-production.
• Tax versus subsidy: raises cost and cuts output versus lowers cost and raises output.
• Market failure versus a high price: failure means misallocation, not an unwelcome price.

Quick self-test

1. State what is meant by market failure.
2. Social cost per unit is £15 and private cost is £11. What is the external cost per unit?
3. Is a positive externality associated with over-production or under-production?
4. Name one externality from production and one from consumption.
5. A tax raises a firm’s costs. Does output rise or fall?
6. Private benefit of a service is £30 and external benefit is £12. State the social benefit.
7. A subsidy of £3 per unit goes to 1,200 units. What is the total cost?
8. State one drawback of using a subsidy.
9. Who is a third party?
10. Explain one cost of misallocation.

Answers

1. The inability of the market system to allocate resources efficiently.
2. 15 − 11 = £4.
3. Under-production.
4. Any pair, such as factory smoke (production) and traffic congestion (consumption).
5. Falls, because supply shifts up and price rises.
6. 30 + 12 = £42.
7. 3 × 1,200 = £3,600.
8. Any one: it costs taxpayers, the benefit may be mis-measured, or firms may keep the subsidy as profit.
9. Someone outside the deal, neither buying nor selling, who is still affected.
10. For example, resources used to over-produce a harmful good could have made something more valuable, so the opportunity cost is a better use forgone.

Where marks are usually lost

• Saying “externality” without saying who the third party is.
• Mixing up which type leads to over-production and which to under-production.
• Describing a diagram’s shift without naming the new price and quantity.
• Writing about a tax without saying whether supply or demand moves.
• Listing methods of intervention without linking each to the problem.
• Treating market failure as the same as unfair prices.
• Giving an evaluation point with no consequence, such as “it costs money” with no mention of opportunity cost.
• Leaving out the direction (rise or fall) in a calculation answer.

Official syllabus

AQA, GCSE Economics (8136) specification, for first teaching from September 2017, sections 3.1.6.1 and 3.1.6.2.