IB DP Economics: Externalities and common pool resources

This guide follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. It covers sub-topic 2.8, Market failure: externalities and common pool or common access resources, in Unit 2 Microeconomics. The whole sub-topic is SL and HL, except one calculation (welfare loss from a diagram), which is HL only. Every place, firm and figure below is invented.

Revise from the revision notes, then test yourself with the practice questions. The IB DP Economics hub and the printable checklist show where this fits in the course, and the free diagnostics help you find weak spots. Earlier ideas on prices and markets are in demand, supply and equilibrium.

What the sub-topic asks of you

Strand	You must be able to	Level
Socially optimum output	Explain MSB = MSC as allocative efficiency, with community surplus at its largest	SL and HL
Externalities	Explain negative and positive externalities of production and consumption; draw all four diagrams	SL and HL
Merit and demerit goods	Link them to under- and over-consumption	SL and HL
Common pool resources	Explain rivalry without excludability, the tragedy of the commons, unsustainable production	SL and HL
Welfare loss	Calculate it from a diagram	HL only
Policy	Explain and draw responses to externalities; judge their strengths and limits	SL and HL
International cooperation	Explain why it is needed, what makes it hard, and the role of monitoring and enforcement	SL and HL

Socially optimum output

A market left alone reflects only the private costs and benefits of the people trading. Economists add the effect on everyone else to get social values:

• MSC (marginal social cost) is the producer’s own marginal cost, MPC, plus the extra cost borne by others.
• MSB (marginal social benefit) is the buyer’s own marginal benefit, MPB, plus the extra benefit enjoyed by others.

The socially optimum output is where MSB = MSC, the point on a diagram where the two curves cross. This is allocative efficiency: every unit that is worth more to society than it costs is made, and no other unit is. At that output community surplus (consumer surplus plus producer surplus, adjusted for external effects) is as large as it can be.

An externality is a side effect of buying or selling that lands on an outsider to the deal, who is neither paid for a benefit nor compensated for a cost. With no externality, MPB = MSB and MPC = MSC, so the free market reaches the social optimum. With an externality the market output differs from the optimum. That gap is a market failure.

Negative externalities and welfare loss

A negative externality of production arises when making a good harms others. Take the fictional country Veltria, where a dye works in a river valley (output in thousand litres a week, prices in Veltrian crowns, VC, per litre).

• Demand (MPB = MSB): P = 90 − 3Q
• Supply (MPC): P = 10 + 2Q
• Marginal external cost of river pollution: 15 VC per litre, so MSC = 25 + 2Q

Market equilibrium: 90 − 3Q = 10 + 2Q, so 5Q = 80, Q = 16 and P = 42 VC.

Social optimum: 90 − 3Q = 25 + 2Q, so 5Q = 65, Q = 13 and P = 51 VC.

The market overproduces by 3 thousand litres.

Key points to plot (quantity, price in VC):

Quantity	Demand (MSB)	MPC	MSC
0	90	10	25
13	51	36	51
16	42	42	57

Demand slopes down; MPC and MSC slope up, with MSC a constant 15 above MPC. MSC cuts demand at Q = 13 (price 51), and MPC cuts demand at Q = 16 (price 42).

Label the axes (price or cost, quantity), the MPC and MSC curves (MSC above MPC), the demand curve, the market output where MPC meets demand, the social optimum where MSC meets demand, and the welfare loss triangle between the two outputs. The triangle exists because units between Q = 13 and Q = 16 cost society more than they are worth.

HL only: welfare loss. The triangle has base 16 − 13 = 3 (thousand litres). Its height is the gap between MSC and MSB at the market output: MSC = 25 + 2 × 16 = 57 and MSB = 90 − 3 × 16 = 42, a gap of 15, which is the marginal external cost. Area = ½ × 3 × 15 = 22.5 thousand VC.

A negative externality of consumption arises when using a good harms others. In the fictional city of Calder, car journeys cause congestion and fumes (thousand journeys a day):

• MPB: P = 48 − 2Q
• MPC: P = 6 + Q
• Marginal external cost: 9 VC, so MSB = MPB − 9 = 39 − 2Q (the social benefit is lower than the private benefit)

Market: 48 − 2Q = 6 + Q gives Q = 14, P = 20 VC. Optimum: 39 − 2Q = 6 + Q gives Q = 11, P = 17 VC. On the diagram, MSB lies below MPB, and the welfare loss triangle sits between 11 and 14. HL only: at Q = 14, MPC = 20 and MSB = 39 − 28 = 11, a gap of 9, so the loss is ½ × 3 × 9 = 13.5 thousand VC.

Demerit goods are goods that people consume too much of, because they underestimate the harm to themselves or because others are harmed too. Tobacco is the usual example. A demerit good often involves a negative externality of consumption, so its diagram looks like the Calder one.

Positive externalities and welfare loss

A positive externality of consumption gives benefits to others. In the fictional country Norland, adult evening literacy courses (thousand places a term, prices in Norland marks, NM):

• MPB (demand): P = 80 − 2Q
• MPC (supply): P = 20 + Q
• Marginal external benefit: 12 NM, so MSB = 92 − 2Q

Market: 80 − 2Q = 20 + Q gives Q = 20, P = 40 NM. Optimum: 92 − 2Q = 20 + Q gives Q = 24, P = 44 NM. The market underproduces by 4 thousand places. On the diagram MSB lies above MPB. HL only: at Q = 20, MSB = 92 − 40 = 52 and MPC = 40, a gap of 12. Welfare loss = ½ × 4 × 12 = 24 thousand NM.

A positive externality of production benefits others as a by-product of supply. A hillside orchard in Norland feeds a neighbour’s bees. Suppose demand is P = 70 − 2Q, MPC = 10 + 2Q and the marginal external benefit is 8 NM, so MSC = 2 + 2Q (the social cost is lower than the private cost). Market: Q = 15, P = 40 NM. Optimum: 70 − 2Q = 2 + 2Q, so Q = 17, P = 36 NM. On the diagram MSC lies below MPC. HL only: at Q = 15, MSB = 40 and MSC = 32, a gap of 8, so the loss is ½ × 2 × 8 = 8 thousand NM.

Merit goods are goods that people consume too little of, because they undervalue the benefit to themselves or because others benefit too. Education and vaccination are standard examples. A merit good often has a positive externality of consumption, so it is drawn like the literacy case.

Type	Curve that moves	Market output	Welfare loss
Negative, production	MSC above MPC	Too high	Triangle between outputs
Negative, consumption	MSB below MPB	Too high	Triangle between outputs
Positive, production	MSC below MPC	Too low	Triangle between outputs
Positive, consumption	MSB above MPB	Too low	Triangle between outputs

Common pool resources

A common pool (common access) resource is rivalrous but non-excludable. One person’s use leaves less for others, yet nobody can easily be kept out. Open fisheries, shared grazing land and groundwater are examples.

Each user gains the full benefit of an extra unit taken but shares the cost of depletion with everyone. So users take too much. This is the tragedy of the commons: individually rational use destroys the resource that all depend on. The overuse is a negative externality, and unsustainable production follows when the stock is harvested faster than it renews.

Fictional example: Lake Orrin in Veltria. Each boat costs 11 thousand VC a season, and each tonne of fish sells for 1 thousand VC.

Boats	Total catch (tonnes)	Average catch	Extra catch from last boat	Net gain (thousand VC)
1	20	20	20	9
3	54	18	16	21
5	80	16	12	25
6	90	15	10	24
8	104	13	6	16
10	110	11	2	0

Boats keep entering while the average catch exceeds the cost of 11, so open access settles at 10 boats with net gain of zero. Society gains most where the extra catch still covers the cost: the fifth boat adds 12 (above 11), the sixth only 10 (below 11). The best fleet is 5 boats, with a net gain of 25 thousand VC. The lake is overfished by 5 boats.

Government responses

• Indirect (Pigouvian) taxes equal to the marginal external cost shift MPC up to MSC. In Veltria a tax of 15 VC a litre moves output to 13. Consumers pay 51 VC (9 more than before). Producers keep 51 − 15 = 36 VC (6 less). Revenue is 15 × 13 = 195 thousand VC.
• Carbon taxes are a Pigouvian tax on the carbon content of a fuel or a product. Draw the market of the particular polluting industry (such as steel or cement) with MPC shifting up by the tax.
• Subsidies work for positive externalities. In Norland, a subsidy of 12 NM per place shifts supply down to 8 + Q. Then 80 − 2Q = 8 + Q gives Q = 24. Students pay 80 − 48 = 32 NM and providers receive 44 NM. The cost to government is 12 × 24 = 288 thousand NM.
• Legislation and regulation set limits, bans or standards. On the diagram a legal cap is a vertical line at the permitted quantity, such as 13 in Veltria, which output cannot pass.
• Education and awareness campaigns change preferences, shifting demand for demerit goods left or demand for merit goods right.
• Tradable permits cap total pollution and let firms trade the right to emit. Two firms each emit 60 units and the cap is 80. Firm A cuts a unit for 3 VC, firm B for 8 VC. Without trading each cuts 20, costing 20 × 3 + 20 × 8 = 220 VC. With trading A cuts 40 and sells 20 permits to B, costing 40 × 3 = 120 VC. The same cap is met for 100 VC less, because the cheapest cuts happen first.
• International agreements bind several countries to common targets.
• Collective self-governance lets a community agree and police its own rules, such as catch quotas on Lake Orrin.
• Government provision supplies the good directly, such as free vaccination.

Strengths and limitations

Judge each policy using three lenses from the guide.

1. Measurement. Nobody observes the external cost directly. Estimating the right tax or subsidy needs a money value for harm such as illness or lost habitat, so a tax may be too high or too low.
2. Effectiveness. A tax cuts output by less when demand is price inelastic, so it may need to be high to change behaviour. Permits fix the quantity but not the price. Regulation is simple but gives firms no reason to cut below the limit.
3. Stakeholders. Consumers pay higher prices, workers may lose jobs, producers’ profits fall and governments gain revenue or bear costs. Poorer households may be hit hardest by taxes on necessities.

International cooperation

Sustainability issues such as climate change cross borders, so one country acting alone cannot solve them. Cooperation is hard because countries differ in income, in their share of the harm and in what they gain or lose from acting. Each is tempted to let others bear the cost. Agreements need monitoring (measuring emissions or catches honestly) and enforcement (penalties for those who break the terms), and sovereign states can be hard to penalise.

Common errors

• Drawing the MSC curve through the market equilibrium. It must sit above or below MPC by the external amount.
• Shading the whole area under the curves instead of only the triangle between the two outputs.
• Treating a subsidy as shifting demand when it is paid to suppliers. Say which curve moves and label the new curve.
• Calling every shared resource a public good. A common pool resource is rivalrous; a public good is not.
• (HL) Using the price, or the whole quantity gap, as the triangle height. The height is the MSC to MSB gap at the market output.

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).