IB DP Economics: Externalities and common pool resources – Revision Notes

These notes follow the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. They cover sub-topic 2.8, Market failure: externalities and common pool or common access resources, for SL and HL. The welfare loss calculation is HL only. Full explanations are in the study guide, and you can check yourself with the practice questions. Use the course hub, the printable checklist and the free diagnostics to plan your revision. Examples are invented.

Core definitions

Term	Meaning
Externality	A side effect of a transaction that reaches an outsider who neither pays nor is paid
MSC	Private marginal cost, MPC, with the extra cost to others added
MSB	Private marginal benefit, MPB, with the extra benefit to others added
Socially optimum output	Where MSB = MSC
Allocative efficiency	Producing where MSB = MSC, so community surplus is maximised
Welfare loss	Loss of community surplus when output is not at the social optimum
Merit good	Under-consumed, often because of a positive externality or undervalued benefit
Demerit good	Over-consumed, often because of a negative externality or undervalued harm
Common pool resource	Rivalrous but non-excludable
Tragedy of the commons	Each user’s rational overuse destroys the shared resource

The four diagrams in one table

Axes: price or cost (vertical), quantity (horizontal). Always draw the private curves, the social curve, both outputs and the triangle.

Case	What differs from the private curves	Market versus optimum	Example
Negative externality of production	MSC above MPC	Overproduction	Factory pollution
Negative externality of consumption	MSB below MPB	Overconsumption	Traffic in a city
Positive externality of production	MSC below MPC	Underproduction	Orchard feeding neighbouring bees
Positive externality of consumption	MSB above MPB	Underconsumption	Education

Method in steps for any diagram:

1. Draw demand (MPB) and supply (MPC) and label the market output.
2. Add the single social curve that differs (MSC or MSB).
3. Mark the social optimum where MSB = MSC and label it.
4. Shade the welfare loss triangle between the two outputs.
5. Add the policy curve if the question asks for one.

Worked reminder: negative externality and a tax

Fictional market in the country Veltria: MPB P = 40 − Q, MPC P = 4 + Q, marginal external cost 6 crowns (VC).

• Market: 40 − Q = 4 + Q, so Q = 18, P = 22 VC.
• MSC = 10 + Q. Optimum: 40 − Q = 10 + Q, so Q = 15, P = 25 VC.
• Pigouvian tax = 6 VC per unit, which shifts MPC up to MSC.
• Consumers pay 25 VC; producers keep 25 − 6 = 19 VC; revenue = 6 × 15 = 90 VC.
• HL only: at Q = 18, MSC = 28 and MSB = 22. Gap 6, base 3. Welfare loss = ½ × 3 × 6 = 9 VC.

The tax equals the marginal external cost. The tax revenue is a rectangle: tax per unit times the optimum output.

Common pool resources

• Characteristics: rivalrous and non-excludable.
• Why overuse happens: each user gets the whole gain from an extra unit, and the damage to the stock is shared.
• Outcome: the tragedy of the commons, and unsustainable production, a negative externality.
• Rule of thumb for fisheries and grazing: open access adds users while the average return covers the cost; the social optimum stops when the extra return falls below cost.

Fictional check: a pasture where the extra milk from the fourth cow is 18 and from the fifth is 14, with a cost of 16 per cow. The best herd stops at four cows, since the fifth adds 14, less than 16.

Management approach	How it works	Main weakness
Tax or fee	Charges users for the damage	Hard to set at the right level
Regulation or quota	Caps catch or use	Needs monitoring and enforcement
Tradable permits	Cap plus trading of rights	Initial allocation can be unfair
Collective self-governance	Community writes and polices rules	May fail in large groups
International agreement	States share targets	Free riding, weak enforcement

Policy table

Policy	Targets	Effect on the diagram	Key limitation
Indirect (Pigouvian) tax	Negative externality	MPC shifts up towards MSC	Hard to measure the external cost
Carbon tax	Emissions of a polluting industry	MPC shifts up by the tax	Industry may relocate; price rises hit households
Subsidy	Positive externality	MPC shifts down towards MSC	Costs the government; can be wasted
Legislation and regulation	Pollution, unsafe practice	Vertical line at the permitted quantity; limits or bans the activity	Enforcement cost; no incentive to do better
Education and awareness	Demerit and merit goods	Demand shifts left (demerit) or right (merit)	Slow and uncertain effect
Tradable permits	Total pollution	Fixes the total; price set by trading	Cap set wrongly; hard to monitor
International agreements	Global issues	Shared targets across states	Monitoring, enforcement and free riding
Government provision	Merit goods	State supplies directly	Opportunity cost; may be inefficient

Permits: worked reminder

Two firms each emit 60 units and the cap is 80, so total cuts of 40 are needed. Firm A cuts a unit for 3 and firm B for 8 (fictional crowns).

• No trading: each cuts 20. Cost = 20 × 3 + 20 × 8 = 220.
• With trading: A cuts 40 for 120 and sells 20 permits to B. Cost = 120.
• Saving = 100, because the low-cost firm does the cutting.
• The permit price settles between 3 and 8.

Evaluating policies

Use three headings, as the guide does.

• Measurement: the external cost or benefit has to be estimated, so the tax or subsidy may be wrong.
• Effectiveness: depends on elasticity, enforcement, substitutes and time.
• Stakeholders: consumers, producers, workers, taxpayers, governments and the affected third parties each gain or lose differently.

For international cooperation add: sustainability problems are global; countries have different interests; monitoring and enforcement are hard.

Must-know distinctions

• Merit good versus positive externality: a merit good is defined by under-consumption through undervaluing the benefit. A positive externality is a benefit to others. A good can be both.
• Common pool resource versus public good: a common pool resource is rivalrous. A public good is non-rivalrous. Both are non-excludable. Public goods are covered in a separate sub-topic.
• Tax versus permits: a tax fixes the price per unit of pollution; permits fix the quantity.
• MPC versus MSC: MPC is what the producer pays; MSC includes the cost to others.

Command terms to practise

The guide defines the command terms and groups them by assessment objective. For this sub-topic the useful ones are these.

Command term	What it asks for here
Define	The precise meaning of a term such as externality
Distinguish	Clear differences, for example a merit good and a demerit good
Draw	A labelled, accurate diagram, using a pencil and a ruler for straight lines
Calculate	A numerical answer with the working shown
Explain	Reasons or causes, not only a description
Evaluate	Strengths and limitations weighed against each other
Discuss	A balanced review of several arguments, ending with a clear view

Paper 1 does not allow a calculator, so practise the linear equations above by hand. Paper 2 allows calculators, though a four-function model is enough for the questions that need one.

Quick self-test

Use this fictional market for questions 7 to 10: MPB P = 40 − Q, MPC P = 4 + Q, marginal external cost 6.

1. Define a negative externality of consumption.
2. State the condition for allocative efficiency.
3. Which curve lies below MPB when consumption causes harm to others?
4. Name the two characteristics of a common pool resource.
5. Give one reason a carbon tax may be hard to set at the right level.
6. State one advantage of tradable permits over regulation.
7. Find the market output.
8. Find the socially optimum output.
9. State the tax per unit that achieves the optimum.
10. HL only: calculate the welfare loss.

Answers

1. A cost imposed on third parties by the consumption of a good, for which they are not compensated.
2. MSB = MSC.
3. The MSB curve.
4. Rivalrous and non-excludable.
5. The cost of the damage from carbon is uncertain and hard to value in money.
6. The total is capped, and the cheapest cuts are made first, so the cap is met at lower total cost.
7. 40 − Q = 4 + Q, so Q = 18 (price 22).
8. MSC = 10 + Q; 40 − Q = 10 + Q gives Q = 15 (price 25).
9. 6 per unit, equal to the marginal external cost.
10. Gap at Q = 18 is 28 − 22 = 6; base is 3; ½ × 3 × 6 = 9.

Where marks are usually lost

• Leaving the social curve unlabelled or drawing it through the market equilibrium.
• Not naming both outputs on the quantity axis.
• Shading too much: the welfare loss is only the triangle between the two outputs.
• Moving the wrong curve for a subsidy or tax. Taxes and subsidies on suppliers shift supply.
• Describing the tragedy of the commons without saying why individual users overuse.
• Giving a policy without saying what it does to a curve or to the price.
• Evaluation that lists strengths and limits but never weighs them for the situation given.
• Skipping the working in a calculation. Show every step.
• Mixing up common pool resources and public goods.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published February 2020, International Baccalaureate Organization. This page covers sub-topic 2.8 (Unit 2: Microeconomics).