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

This study guide is aligned to the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. It covers section 1.3.5 Market failure, items 1 to 3: sources of market failure, positive and negative externalities, and public goods with the free-rider problem. These sit in Unit 1: Markets in action. In the specification, Units 1 and 2 are the International AS (IAS) units and Units 3 and 4 add the extra International A2 (IA2) content. Unit 1 is therefore IAS and also counts towards the full IAL.

The places, firms and numbers in the examples are made up to show the method. They are not real data. Items 4 to 6 of 1.3.5 (imperfect information, moral hazard, speculation and bubbles) are taught on separate pages, so here they appear only as a short overview.

Where to go next: the Edexcel economics hub, the printable checklist, the revision notes, the practice set, the wider Unit 1 guide and our free 10-minute diagnostics.

Scope of this guide

Item	What you must be able to do
1 Sources of market failure	Explain why a market can give too much or too little of a good compared with the socially optimal output; list the sources
2 Externalities	Separate private, external and social benefits and costs; separate production from consumption externalities; draw and read marginal diagrams with welfare loss or gain areas; apply to transport, health, education, environment and financial contexts
3 Public goods	Separate public from private goods using rivalry and excludability; explain non-provision through the free-rider problem

1 Why markets fail

A market is efficient in the sense this topic uses when it produces the socially optimal level of output: the quantity at which the extra benefit to society of one more unit equals the extra cost to society. Market failure occurs when the market produces or consumes too much or too little compared with that level.

Prices and profits steer decisions in a free market, but buyers and sellers look only at their own gains and costs. If other people are affected and nobody charges or pays them, the price signal is wrong and resources are misallocated.

Source of market failure	One-line idea
Externalities	Third parties bear costs or enjoy benefits that the price does not include
Free-rider problem and public goods	People can use a good without paying, so firms will not supply it
Imperfect market information	Buyers or sellers lack the facts needed to choose well
Moral hazard	Protection from risk changes behaviour and raises the risk
Speculation and market bubbles	Prices driven by expected price rises move far from underlying value

The last three are items 4 to 6 and are not developed here. Items 2 and 3 are the focus of this page.

2 Private, external and social benefits and costs

Term	Meaning
Private benefit	Benefit received by the consumer or producer directly involved
External benefit	Benefit received by a third party who is not part of the transaction and who does not pay
Social benefit	Private benefit plus external benefit
Private cost	Cost paid by the consumer or producer directly involved
External cost	Cost imposed on a third party who is not compensated
Social cost	Private cost plus external cost

In marginal terms: marginal social benefit (MSB) = marginal private benefit (MPB) + marginal external benefit (MEB), and marginal social cost (MSC) = marginal private cost (MPC) + marginal external cost (MEC).

A third party is anyone outside the buyer-seller exchange: a neighbour, a rival, a taxpayer, a future generation.

Four types of externality

	Production	Consumption
Negative (external cost)	A chemical works discharges waste into a river that downstream fishers use	A person plays loud music late at night, disturbing neighbours
Positive (external benefit)	A beekeeper’s bees pollinate the crops of nearby farms	A person who is trained as a first-aider can help others in an emergency

The test is who creates the effect. If it arises while a good is being made, it is a production externality. If it arises when the good is used, it is a consumption externality.

3 Diagrams using marginal analysis

Put quantity on the horizontal axis and price or cost and benefit in money units on the vertical axis.

Negative production externality. Draw a downward-sloping demand curve, which is also MPB and, with no consumption externality, equals MSB. Draw an upward-sloping MPC curve (the supply curve). Draw MSC above MPC, with the vertical gap showing MEC. The market equilibrium Qm is where MPB meets MPC. The social optimum Qs is where MSB meets MSC, and it lies to the left of Qm. Between Qs and Qm, MSC is above MSB, so each unit costs society more than it benefits it. The welfare loss is the triangle between MSC and MSB from Qs to Qm.

Positive consumption externality. Draw MPB (the demand curve) sloping down and MSB above it, with the gap showing MEB. Draw MC (supply, equal to MSC with no production externality). The market equilibrium Qm is where MPB meets MC. The social optimum Qs is where MSB meets MC, and it lies to the right of Qm. Between Qm and Qs, MSB is above MC, so society values the extra units more than they cost. The welfare gain from correcting the market is the triangle between MSB and MC from Qm to Qs.

Worked example 1: negative production externality (illustrative)

A tannery in Country A sells leather. All figures are in currency units per tonne. Demand: MPB = MSB = 100 - 2Q. Private cost: MPC = 20 + 2Q. The pollution adds MEC = 12 per tonne.

1. Market output: 100 - 2Q = 20 + 2Q, so 4Q = 80, Q = 20 tonnes. Price = 100 - 40 = 60.
2. MSC = MPC + MEC = 32 + 2Q.
3. Social optimum: 100 - 2Q = 32 + 2Q, so 4Q = 68, Q = 17 tonnes. At this output the price consumers would pay is 100 - 34 = 66.
4. At Q = 20, MSC = 32 + 40 = 72 but MSB = 60, so the tonnes beyond 17 cost society more than they are worth. The gap is 12.
5. Welfare loss = triangle of base (20 - 17) = 3 and height 12, so area = 0.5 x 3 x 12 = 18 currency units.

Overproduction is 3 tonnes, and the market price (60) is lower than the socially correct price (66). The total external cost at the market output is 12 x 20 = 240, but the welfare loss is only the 18 that comes from units society should not have produced. This distinction between the whole external cost and the welfare loss is a frequent source of lost credit.

Worked example 2: positive consumption externality (illustrative)

A government-run scheme in Country B lets adults enrol on literacy classes. Per class: MPB = 90 - 3Q, MC = 18 + Q, and the better-informed households around each learner add MEB = 8.

1. Market: 90 - 3Q = 18 + Q, so 4Q = 72, Q = 18 classes. Price = 36.
2. MSB = 98 - 3Q.
3. Social optimum: 98 - 3Q = 18 + Q, so 4Q = 80, Q = 20 classes. MC at this point = 38.
4. At Q = 18, MSB = 98 - 54 = 44 and MC = 36, so the gap is 8.
5. Welfare gain = 0.5 x (20 - 18) x 8 = 8 currency units.

Underconsumption is 2 classes. Because the figures show the market falling short by only a little, a good answer comments on whether the benefit is large enough to justify action, which depends on how well MEB can be measured.

4 Externalities in context

Context	Typical externality	Type	Chain of reasoning
Transport	Congestion and exhaust fumes from car journeys	Negative, consumption	Each driver counts only own time and fuel, so adds delay and pollution to others; too many journeys
Health	Vaccination or treatment of infectious disease	Positive, consumption	The patient gains, and others face less risk of infection; too few people take it up
Education	Better-trained workers raise others’ productivity and reduce crime	Positive, consumption	The learner values personal pay and ignores wider gains; too little education bought
Environment	Factory emissions, deforestation, waste dumping	Negative, production	Firm ignores damage to air, water and climate; output too high and price too low
Financial	Failure of one bank damaging confidence in others	Negative, production or consumption	Lenders and borrowers do not allow for the effect on the whole system; risk-taking too high

Do not memorise the table as a list. Pick one context, identify who the third party is, say whether the effect is on the cost or benefit side, and say which way output is wrong.

5 Public goods and the free-rider problem

Two features define the categories:

• Rivalry. A good is rival if one person’s use reduces what is left for others. A bread roll is rival. A radio broadcast is non-rival.
• Excludability. A good is excludable if people who do not pay can be kept from using it. A cinema seat is excludable. A navigation light for ships is not.

	Excludable	Non-excludable
Rival	Private good (a loaf of bread, a meal)	Mixed cases, such as a crowded open beach
Non-rival	Mixed cases, such as an uncrowded paid-for bridge	Public good (street lighting, flood-warning sirens)

The specification defines private goods as rival and excludable, and public goods as non-rival and non-excludable. Many real goods fall in between, and you should say so when a question describes one.

The free-rider problem

A free rider enjoys a good without paying because nobody can be stopped from using it. If it is non-excludable, each person gains by letting others pay. If enough people think this way, no firm can recover its costs, so the private sector provides none, or too little.

Worked example 3: street lighting (illustrative)

A lane in Town C has five households. Lighting costs 100 to install. Their maximum willingness to pay is 40, 30, 25, 20 and 15.

1. Total benefit = 40 + 30 + 25 + 20 + 15 = 130.
2. Net social benefit = 130 - 100 = 30, so the lights are worth having.
3. No household values them above 40, so none will buy alone at a price of 100.
4. A firm cannot sell to each household separately, because once the lights are on, everyone benefits.
5. Suppose an equal split of 20 each. The household valuing the lights at 15 would refuse. Contributions fall to 80, short of 100, and the project fails.

The market failure here is non-provision: a good worth having is not produced. This is why the specification phrases it as the “non-provision of public goods”.

Common errors

• Writing “the externality is the whole cost of the factory”. The external cost is only the part borne by third parties.
• Drawing MSC below MPC. External costs add to cost, so MSC is above MPC.
• Shading the area from zero to the market quantity as welfare loss. It is only the triangle between Qs and Qm.
• Calling a public good “anything the state provides”. State provision does not make a good public; non-rivalry and non-excludability do.
• Mixing up “non-rival” and “non-excludable”. Test each separately.

Next steps

Work through the practice set, then use the revision notes to fix the definitions. The existing Unit 1 revision notes and Unit 1 practice cover the unit as a whole.

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.