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

This guide covers section 3.1.6, Market failure, of the AQA GCSE Economics (8136) specification for first teaching from September 2017. It teaches 3.1.6.1 (misallocation of resources) and 3.1.6.2 (externalities). The specification states no tiers, so all of it is common content, and it sits in Paper 1, How markets work. Every figure below is invented for illustration: the places and firms are made up and none of the numbers are real statistics.

Use it with the revision notes and the practice questions. The wider course is on the AQA GCSE Economics hub, there is a printable checklist, and you can test yourself with the free diagnostics. For the demand and supply that sits underneath this topic, see AQA GCSE Economics: How Markets Work.

What this unit covers

Spec reference	What you must be able to do
3.1.6.1	Explain market failure as the inability of the market system to allocate resources efficiently
3.1.6.1	Explain the costs associated with misallocation of resources
3.1.6.1	Describe methods of government intervention to counter misallocation
3.1.6.2	Define an externality as the difference between social and private costs or benefits
3.1.6.2	Tell positive and negative externalities apart, and identify them in a context
3.1.6.2	Show that both production and consumption can lead to negative externalities

3.1.6.1 Misallocation of resources

Efficient allocation first

Resources are scarce, so every use has an opportunity cost. The market system (the price mechanism) normally steers land, labour, capital and enterprise towards the goods people are willing to pay for. Prices rise where demand is strong, firms respond, and resources move.

An allocation is efficient when resources go to the uses society values most, and nothing can be moved to make people better off overall. In a well-working market this happens without anyone planning it, because buyers and sellers face the true price of what they choose.

What market failure is

Market failure is the inability of the market system to allocate resources efficiently. The result is misallocation: an excess of some goods and a shortage of others, set against what is best for society. The market has not stopped working. It has produced an outcome that is wrong for society, because the prices that buyers and sellers respond to leave something out.

The clearest cause in this specification is the externality (section 3.1.6.2 below). The cause you will use most in answers is this chain:

1. Some of the cost or benefit of a decision falls on people who are not buying or selling.
2. The price therefore does not show the full cost or benefit.
3. Buyers and sellers choose using the wrong signal.
4. The quantity traded is not the quantity that is best for society.

Costs of misallocation

When resources are misallocated, there is a cost to society, and you should name it in the context given.

• Wasted resources and opportunity cost. Land, labour and capital used to make an over-produced good could have made something worth more. The next best use is lost.
• Harm to third parties. Pollution, noise or congestion damages people’s health, property and enjoyment, and nobody in the market pays for it.
• Under-provision of beneficial goods. If too little of something useful is made, such as training or health care, society loses benefits it could have had.
• Lower living standards and a cost to the public purse. Health costs, clean-up bills and repairs often fall on taxpayers, so the money cannot be spent elsewhere.

Methods of government intervention

The specification asks for methods the government can use to counter misallocation. A short, usable list:

Method	How it works	Aims to
Indirect tax on a good	Raises the firm’s cost per unit, so supply falls and price rises	Reduce output and consumption where there is a negative externality
Subsidy	Lowers the firm’s cost per unit, so supply rises and price falls	Increase output and consumption where there is a positive externality
Laws and regulation	Bans, limits or standards backed by fines	Stop or cap harmful activity
Information and education	Campaigns that change how people choose	Shift demand away from harmful goods, or towards beneficial ones
Direct provision	The government supplies the good itself, paid for by taxation	Make sure enough is available

A tax or subsidy works through price, so it keeps the market in place and nudges it. A law works by command, so it is more certain but less flexible.

Evaluating intervention

Intervention is not free and it is not always right. When a question asks for judgement, weigh points such as these:

• Measuring the problem. The government needs a value for the external cost or benefit. If it is set too high or too low, the new outcome is still misallocated.
• Cost. Subsidies and direct provision use taxpayers’ money, which has an opportunity cost.
• Who bears a tax. Firms can pass on part of a tax, so consumers may pay more, and low-income households can be hit hardest.
• Evasion and side effects. Banned activity can move elsewhere or underground, and firms may cut jobs or relocate.
• Time. Campaigns and new rules take time to change behaviour.

A good conclusion picks a method and says why it suits the case: a tax where the harm varies with output, a ban where the harm is severe, a subsidy where society gains from more use.

3.1.6.2 Externalities

Definition

An externality is a cost borne, or a benefit received, by a third party, someone outside the deal, neither buying nor selling. The specification frames it as the difference between social and private costs or benefits:

• Private cost: the cost to the producer or consumer making the decision.
• External cost: the cost to third parties.
• Social cost = private cost + external cost.
• Private benefit: the benefit to the person buying or using.
• External benefit: the benefit to third parties.
• Social benefit = private benefit + external benefit.

So an externality is the gap: external cost = social cost − private cost, and external benefit = social benefit − private benefit.

Negative and positive

	Negative externality	Positive externality
Third parties	Bear a cost	Receive a benefit
Social compared with private	Social cost is above private cost	Social benefit is above private benefit
Market outcome	Too much is produced or consumed	Too little is produced or consumed
Typical response	Tax, regulation, information	Subsidy, provision, information

Production and consumption

The specification states that both production and consumption can lead to negative externalities. Identify which side causes it:

	Negative	Positive
Production	A chemical works releases fumes that harm nearby homes	A firm pays for apprentices, and some later take jobs with rival local firms
Consumption	Drivers add congestion and exhaust fumes for everyone else	Vaccinated people lower the chance of passing on disease

Ask: who is hurt or helped, and are they in the transaction? If the answer is “no, an outsider”, it is an externality.

Identifying externalities in a context

Use three questions:

1. Who makes the decision, and what do they pay or gain?
2. Who else is affected?
3. Is that effect a cost or a benefit, and is it paid for through the price?

If third parties are affected and the price does not cover it, name the externality and say whether it is positive or negative.

Worked examples

Example 1: finding the social cost (Town X, invented)

A small factory makes 4,000 units a month. Its private cost is £12 per unit. The smoke it produces costs nearby residents £3 per unit in cleaning and health care.

• Social cost per unit = 12 + 3 = £15.
• External cost per month = 3 × 4,000 = £12,000.
• Share of social cost falling on third parties = 3 ÷ 15 = 20%.

The factory sets its price from £12 per unit, so the price understates the true cost by one fifth.

Example 2: a negative externality and a tax (Country A, invented)

The market for a fuel in Country A has these schedule points. External cost is £6 per unit.

Output (units)	Value to buyers of the last unit (£)	Private cost of the last unit (£)	Social cost of the last unit (£)
10,000	30	30	36
8,500	33	27	33

• Free market: buyers’ value equals private cost at 10,000 units and a price of £30. Output is 10,000.
• At 10,000 the last unit is worth £30 to buyers but costs society £36. It should not be made.
• Social optimum: value equals social cost at 8,500 units, where both are £33.
• Over-production = 10,000 − 8,500 = 1,500 units.

A tax of £6 per unit adds the external cost to the firm’s cost, so supply moves up by £6.

• New output = 8,500 units, and buyers pay £33 (up £3).
• Producers keep 33 − 6 = £27 (down £3), so buyers and producers each bear half the tax.
• Tax revenue = 6 × 8,500 = £51,000.

In words on a diagram: the supply curve shifts upward by the width of the tax, and the new equilibrium sits where it crosses the unchanged demand curve, at a higher price and lower quantity. This matches the social optimum only because £6 is the correct size. A tax of £2 would still leave over-production.

Evaluation: the government would need to estimate the £6 reliably, and the tax is easier to avoid if buyers can buy from a cheaper source.

Example 3: a positive externality and a subsidy (Town Y, invented)

A clinic offers a vaccination in Town Y. Each dose gives the patient a private benefit, and an external benefit of £10 to everyone who is now less likely to catch the disease.

Doses	Private benefit of last dose (£)	Social benefit (£)	Cost of last dose (£)
2,500	35	45	35
3,000	30	40	40

• Free market: private benefit equals cost at 2,500 doses, price £35.
• Social optimum: social benefit equals cost at 3,000 doses, where both are £40.
• Under-provision = 3,000 − 2,500 = 500 doses.

A subsidy of £10 per dose lowers the clinic’s cost, so supply rises.

• Patients now pay 40 − 10 = £30, a fall of £5.
• Quantity rises to 3,000.
• Cost to the government = 10 × 3,000 = £30,000.

Evaluation: the £30,000 could have funded something else, and there is no guarantee it is set at the right level.

Common errors

• Writing that the market has “failed” because a price is high. Market failure means resources are misallocated.
• Calling a cost to the producer an externality. External means a third party.
• Saying a negative externality causes under-production. It causes over-production, and a positive externality causes under-production.
• Adding “tax” or “ban” without explaining how it removes the misallocation.
• Stating that a tax removes pollution. It reduces output; it does not make it zero.
• Forgetting a direction. Always say whether output rises or falls.

Official syllabus

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