Edexcel IAL Economics: Externalities and public goods as sources of market failure (YEC11) – Revision Notes

These revision notes are aligned to the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018, section 1.3.5 Market failure, items 1 to 3. They sit in Unit 1: Markets in action, which the specification labels as International AS (IAS) content, also part of the full IAL. For full explanations, read the study guide. Then test yourself with the practice set.

All data are invented. Useful links: the Edexcel economics hub, the printable checklist, the Unit 1 revision notes and the free 10-minute diagnostics.

Item 1: sources of market failure

• Market failure: the market gives too much or too little of a good compared with the socially optimal output.
• Socially optimal output: where marginal social benefit (MSB) equals marginal social cost (MSC).
• Sources named by the specification: externalities; the free-rider problem and non-provision of public goods; imperfect market information; moral hazard; speculation and market bubbles.
• On this page you need the first two in depth. The other three are overview only.

Item 2: key definitions

Term	Definition
Private benefit	Gain to the consumer or producer directly involved
External benefit	Gain to a third party who does not pay
Social benefit	Private benefit + external benefit
Private cost	Cost to the consumer or producer directly involved
External cost	Cost to a third party who is not compensated
Social cost	Private cost + external cost
Externality	A cost or benefit to third parties that is not reflected in the market price

Formulas: MSB = MPB + MEB. MSC = MPC + MEC.

The four types

Type	Test	Typical example
External cost of production	Harm arises when the good is made	Smoke from a brickworks
External cost of consumption	Harm arises when the good is used	Exhaust fumes from driving
External benefit of production	Gain arises when the good is made	A hillside orchard that supports local wildlife
External benefit of consumption	Gain arises when the good is used	Training that makes a worker safer for colleagues

Diagram recipes

Negative production externality (output too high).

1. Demand = MPB = MSB, downward sloping.
2. Supply = MPC, upward sloping.
3. MSC above MPC. Vertical gap = MEC.
4. Qm: MPB meets MPC. Qs: MSB meets MSC. Qs is less than Qm.
5. Welfare loss: the triangle between MSC and MSB from Qs to Qm.

Positive consumption externality (output too low).

1. Supply = MC = MSC, upward sloping.
2. MPB (demand) downward sloping. MSB above MPB. Vertical gap = MEB.
3. Qm: MPB meets MC. Qs: MSB meets MC. Qs is more than Qm.
4. Welfare gain from correcting: the triangle between MSB and MC from Qm to Qs.

Label each axis (quantity; price or cost and benefit), each curve, both quantities and the shaded area. A sketch that omits one of these loses clarity.

Worked reminder: congestion (illustrative)

A busy road in Country D. Let n be the number of trips per hour. Demand: MPB = 50 - 0.1n. Average private cost per trip = 20 + 0.1n. Each extra driver slows others, so MSC = 20 + 0.2n.

Step	Working	Result
Market trips	50 - 0.1n = 20 + 0.1n, so 0.2n = 30	n = 150
Private cost at 150	20 + 15	35
External cost per trip at 150	0.1 x 150	15
Social optimum	50 - 0.1n = 20 + 0.2n, so 0.3n = 30	n = 100
MSC and MSB at 100	20 + 20 and 50 - 10	both 40
At 150: MSC and MSB	20 + 30 and 50 - 15	50 and 35
Welfare loss	0.5 x 50 x (50 - 35)	375

The reasoning chain: each driver weighs only own cost, so trips rise to 150; the extra 50 trips each cost society more than they are worth; resources are misallocated; the loss is 375.

Worked reminder: positive consumption externality (illustrative)

Country E offers first-aid courses. Per course: MPB = 80 - 4Q, MC = 20 + 2Q, and safer workplaces add MEB = 12.

Step	Working	Result
Market	80 - 4Q = 20 + 2Q, so 6Q = 60	Q = 10, price 40
MSB	80 + 12 - 4Q	92 - 4Q
Social optimum	92 - 4Q = 20 + 2Q, so 6Q = 72	Q = 12, MC = 44
At Q = 10: MSB and MC	92 - 40 and 20 + 20	52 and 40
Welfare gain	0.5 x (12 - 10) x (52 - 40)	12

Chain: buyers count only their own gain, so they buy 10 courses; courses 11 and 12 would add more to society than they cost; the market underprovides; correcting this would add 12 to welfare.

Evaluation points for externality answers

• Size: a small external cost or benefit means a small welfare area, so the case for action is weaker.
• Measurement: external costs such as damage to health or the climate are hard to value, so MEC and MEB are estimates.
• Who is affected: the same activity may help some third parties and harm others.
• Time: some external costs, such as environmental damage, appear years later.
• Responses: the market may correct some problems itself, for example if neighbours bargain, but this is harder when many people are involved.

Contexts at a glance

Context	Effect	Direction of market error
Transport	Congestion, emissions, noise (negative consumption)	Too many journeys
Health	Fewer infections when others are treated (positive consumption)	Too little uptake
Education	Wider gains in skills and civic life (positive consumption)	Too little bought
Environment	Pollution, habitat loss (negative production)	Too much output
Financial	Bank failure spreads loss of confidence (negative)	Too much risk taken

Item 3: public goods and the free rider

Property	Private good	Public good
Rivalry	Rival	Non-rival
Excludability	Excludable	Non-excludable
Example	A restaurant meal	A flood-warning siren

• Non-rival: one more user does not reduce others’ use.
• Non-excludable: non-payers cannot be kept out.
• Free rider: someone who benefits without paying.
• Chain: non-excludable, so people will not volunteer to pay; revenue cannot cover cost; private firms do not provide; non-provision of a good that may have positive net social benefit.

Method for classifying a good:

1. Ask: does my use reduce yours? If no, it is non-rival.
2. Ask: can non-payers be stopped? If no, it is non-excludable.
3. Both no: public good. Both yes (rival and excludable): private good. Otherwise say it is a mixed case and explain.

Must-know distinctions

• External cost versus total cost: external cost is only the part borne by third parties.
• Welfare loss versus total external cost: the loss is the triangle, not the whole cost of the externality.
• Production versus consumption externality: who creates the effect, and when.
• Public good versus a good provided by the state: provision does not decide the category.
• Non-rival versus non-excludable: two separate tests.

Quick self-test

1. Define an external cost.
2. A good has MPC = 5 + Q and MEC = 3 per unit. Find MSC when Q = 6.
3. At 10 units, MPB = 42 and MSB = 50. State the external benefit per unit, and the total if it is constant over 10 units.
4. A welfare loss triangle has a base of 4 units and a height of 6 currency units. Find its area.
5. Five households have maximum willingness to pay of 12, 9, 7, 6 and 4. A shared security gate costs 30. Is it worth providing? Could any one household fund it?
6. MPB = 60 - 2Q and MEB = 5. Find MSB at Q = 8.
7. State whether a quarry’s dust is a production or consumption externality.
8. Name the two features of a public good.
9. Why does the market fail to provide a flood siren?
10. In which direction does Qm differ from Qs for a positive consumption externality?

Answers

1. A cost imposed on third parties by a transaction, not paid by the buyer or seller and not reflected in the price.
2. MSC = 5 + 6 + 3 = 14.
3. 50 - 42 = 8 per unit; 8 x 10 = 80 in total.
4. 0.5 x 4 x 6 = 12 currency units.
5. Total willingness to pay = 12 + 9 + 7 + 6 + 4 = 38, which exceeds 30, so net benefit = 8. The highest single willingness to pay is 12, below 30, so no single household would fund it.
6. MSB = 60 - 16 + 5 = 49.
7. A production externality (an external cost), because it arises while the good is made.
8. Non-rival and non-excludable.
9. It is non-excludable, so households have an incentive to free ride, and a firm cannot collect enough revenue to cover the cost.
10. Qm is less than Qs; the market produces or consumes too little.

Where marks are usually lost

• Not saying who the third party is. Name them.
• Leaving out one of the labels on a diagram: curves, Qm, Qs or the shaded area.
• Placing Qs on the wrong side of Qm.
• Treating the welfare area as a rectangle or as the whole external cost.
• Using the words “negative externality” without stating whether it affects cost or benefit.
• Describing a public good as “free” or “provided by the government” instead of using rivalry and excludability.
• Describing the free-rider problem without the link to non-provision.
• Giving a list of contexts with no chain of reasoning.
• Making a one-sided evaluation that never weighs how hard external costs and benefits are to measure.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics, Specification, Issue 2, June 2018 (first teaching September 2018), Pearson Education Limited. Section 1.3.5 Market failure, items 1 to 3.