OCR A Level Economics: The environment and market failure (H460)

This guide follows the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. It covers the topic Environment in Component 1, Microeconomics, within the area of study Market failure and government intervention. The specification labels no content as AS or Extension: it is all A Level. Every figure below is invented and illustrative, and every country, firm and market is fictional.

General externality theory, cost-benefit analysis and government failure sit in neighbouring topics. Use the OCR Economics hub, the printable checklist and the free diagnostics to plan revision. For the wider microeconomics course see the Microeconomics guide.

What this unit covers

Outcome	You must be able to
Functions	Explain the three functions of the environment: provider of resources, provider of amenities, absorber of waste
Production	Explain, with a diagram, how externalities from production’s impact on the environment cause market failure
Consumption	Explain, with a diagram, the same for consumption
Kuznets	Explain, with a diagram, the environmental Kuznets curve
Growth	Evaluate whether growth will cause degradation or depletion and limit sustainable development
Policy	Evaluate policies at local, national, regional and global level: indirect taxes and subsidies, legislation and regulation including environmental standards, tradable pollution permits, information provision, government expenditure, public and private partnerships

1. The three functions of the environment

• Provider of resources: raw materials, energy, water, soil and timber. Some are renewable (forests, fish stocks) and some are non-renewable (fossil fuels, minerals). Renewables are depleted if used faster than they regrow.
• Provider of amenities: landscape, clean air, parks, coastline and wildlife. They give enjoyment, health and recreation, often unpriced.
• Absorber of waste: air, water and land take in emissions and rubbish and break them down, up to a limit. This is the assimilative capacity.

The functions compete. A river used to carry away waste is worse for drinking water and angling, so each use has an opportunity cost in the others.

Worked example (invented). A river in Country A can absorb 100 tonnes of waste a year without harm. Factories discharge 80 tonnes now, rising 5% a year.

• Year 1: 80 × 1.05 = 84. Year 4: 80 × 1.05⁴ = 97.2. Year 5: 80 × 1.05⁵ = 102.1.
• The limit is passed in the fifth year. From then, excess waste damages amenity and water supply.

Markets fail here because the environment is largely unpriced. A firm pays for labour and materials, not for the waste capacity it uses.

2. Externalities from production and consumption

An externality is a cost or benefit that lands on someone outside the transaction and is left out of the price. On the cost side use MPC (marginal private cost), MEC (marginal external cost) and MSC (marginal social cost) = MPC + MEC. On the benefit side use MPB, MEB and MSB = MPB + MEB.

Production externality: negative

The market sets output where MPB = MPC. The firm ignores MEC, so MSC lies above MPC. Society’s best output is where MSB = MSC, which is lower.

Worked example (invented). A dye works in Country A. MPB: P = 120 − 2Q. MPC: P = 20 + 2Q. Each unit puts £20 of pollution cost on a river downstream, so MSC = 40 + 2Q.

	Market	Social optimum
Rule	MPB = MPC	MPB = MSC
Quantity	25	20
Price	£70	£80

• Market: 120 − 2Q = 20 + 2Q gives Q = 25 and P = 70.
• Optimum: 120 − 2Q = 40 + 2Q gives Q = 20 and P = 80.
• At 25 units, MSC = 40 + 50 = £90 and MSB = £70. The units from 20 to 25 cost society more than they are worth.
• Welfare loss = ½ × 20 × (25 − 20) = £50. The triangle lies between MSC and MPB, from the optimum to the market quantity.
• A tax of £20 a unit moves the supply curve to MSC. Consumers pay £80, producers keep £60 and the revenue is 20 × 20 = £400.

In words, the diagram: put price (or cost) up the vertical axis and quantity along the horizontal. MPC and MSC slope upwards, MSC above and parallel. MPB slopes downwards. The market equilibrium sits where MPB meets MPC. The optimum sits where MPB meets MSC, with less output at a higher price.

The result is overproduction and a misallocation of resources: too many go to the dye. A positive environmental externality of production works the other way. A firm that restores wetlands gives free flood protection, so MSC lies below MPC and output is too low.

Consumption externality: negative

Here MSB lies below MPB, because consumers ignore the harm their use causes.

Worked example (invented). Households in Country B burn firewood. MPB: P = 80 − 2Q. MPC: P = 20 + Q. Smoke imposes £12 a unit on neighbours, so MSB = 68 − 2Q.

• Market: 80 − 2Q = 20 + Q gives Q = 20 and P = 40.
• Optimum: 68 − 2Q = 20 + Q gives Q = 16. Consumers’ willingness to pay is 80 − 32 = £48, and supply price is £36. The £12 gap is the external cost.
• Welfare loss = ½ × 12 × (20 − 16) = £24.

In words: the MSB curve lies below the demand curve (MPB). Supply (MPC) crosses MPB at the larger market quantity, so there is overconsumption.

Depletion as an externality

Resource users also impose a cost on future generations, who cannot bid in today’s market. Prices can understate that cost, so non-renewable resources may be used too fast.

3. The environmental Kuznets curve

The environmental Kuznets curve (EKC) is an inverted U. Environmental degradation per head rises as income per head rises, reaches a peak at a turning point, then falls.

Degradation
   |          ***
   |       **      **
   |     *            **
   |   *                 **
   +------------------------- Income per head
              ^ turning point

Worked example (invented). In a model of Country C, degradation D = 5 + 3Y − 0.1Y², where Y is income per head in thousands.

Y	0	5	10	15	20	25	30
D	5	17.5	25	27.5	25	17.5	5

The turning point is at Y = 3 ÷ (2 × 0.1) = 15, where D = 27.5.

Why the curve may turn:

• Early industrialisation expands output (the scale effect) and pollution rises.
• Richer economies shift towards services (a composition effect).
• Newer technology is cleaner (a technique effect).
• Richer households want a cleaner environment, and governments can afford and enforce regulation.

Evaluation:

• The evidence is mixed. Local pollutants such as smoke seem to fall at higher incomes, but global ones such as carbon dioxide often keep rising.
• Rich economies can import goods whose production pollutes other countries, so the fall at home overstates the fall in total harm.
• The turning point may come at an income level that is reached late, after damage that cannot be reversed.
• The curve is a pattern in data, not a law. Policy and technology can bring the turning point earlier.

4. Growth, degradation, depletion and sustainable development

Sustainable development means meeting people’s needs today in a way that leaves future generations able to meet their own.

Worked example 1 (invented): growth and emissions. Real GDP in Country D grows 3% a year.

• Emissions per unit of GDP fall 4%: 1.03 × 0.96 = 0.9888, so emissions fall 1.12%.
• Emissions per unit of GDP fall only 2%: 1.03 × 0.98 = 1.0094, so emissions rise 0.94%.
• Emissions stay constant when intensity falls by 1 − 1 ÷ 1.03 = 2.91%.

Growth harms the environment only if intensity does not fall fast enough: the case for decoupling.

Worked example 2 (invented): depletion. Country D has reserves of 600 million units of a mineral and extracts 20 million a year.

• At a constant rate: 600 ÷ 20 = 30 years.
• If extraction grows 4% a year, cumulative use after 20 years is 20 × (1.04²⁰ − 1) ÷ 0.04 = 595.6 and after 21 years 639.4. The reserve runs out during the 21st year.

Evaluate whether growth will cause degradation, depletion and limit sustainable development.

• For: higher output uses more resources and produces more waste. Growth in the poorest economies often depends on cheap, dirty energy. Non-renewable stocks are finite.
• Against: growth funds clean technology, research and enforcement. Rising prices encourage substitutes and recycling, and new reserves are found.
• Key judgement: the answer depends on the type of growth, the resource (renewable or not), the technology and policy, and the time horizon. Higher income does not guarantee action, so policy matters.

5. Policies to reduce degradation and depletion

Indirect taxes and subsidies. A tax equal to MEC moves the market to the social optimum (section 2). A subsidy lowers the cost of cleaner production, such as renewable energy.

• Strengths: they use the price mechanism, raise revenue and let firms choose how to cut.
• Limits: MEC is hard to measure, taxes hit poorer households harder, and subsidies cost taxpayers and may reward what firms would do anyway.
• Elasticity matters. Suppose demand has PED of −0.4. A 10% price rise cuts quantity by 0.4 × 10 = 4%. A 12% cut needs a 12 ÷ 0.4 = 30% rise, so a tax on a price-inelastic good raises revenue but changes behaviour little.

Legislation and regulation, including environmental standards. Limits on emissions, bans and licence conditions.

• Strengths: certain, fast and suited to dangerous pollutants.
• Limits: monitoring costs, no reward for beating the standard, and no allowance for firms’ different costs.
• Compliance can be weak. A firm facing a compliance cost of £800 and a 10% chance of a £5,000 fine expects to pay 0.1 × 5,000 = £500, so breaking the rule can pay. The fine would need to exceed 800 ÷ 0.1 = £8,000 to deter it.

Tradable pollution permits. A cap sets the total pollution. Permits are issued, and firms trade them.

Worked example (invented). Firms X and Y must cut a total of 100 tonnes. Marginal abatement cost: X = 0.2q, Y = 0.8q, where q is tonnes cut. Total cost is the area under the marginal cost line: 0.1q² for X, 0.4q² for Y.

• Equal cuts of 50 each: X pays 0.1 × 2,500 = £250 and Y pays £1,000. Total £1,250.
• With trading, the firms equalise marginal costs: 0.2qX = 0.8qY and qX + qY = 100, so qX = 80, qY = 20 and the permit price is £16.
• Total cost = 0.1 × 6,400 + 0.4 × 400 = 640 + 160 = £800, a saving of £450.
• Y cuts 30 tonnes fewer than its 50 and buys 30 permits at £16 (£480). Net cost X = 640 − 480 = £160. Net cost Y = 160 + 480 = £640. Both firms are better off.

Limits: a cap set too high gives a low permit price, local pollution can concentrate where permits are bought, monitoring is needed, and free or auctioned allocation affects fairness.

Information provision. Labels, campaigns and reporting rules. Cheap and supportive of other policies, but behaviour changes slowly and effects are hard to measure.

Government expenditure. Spending on clean-up, conservation, public transport, research and enforcement. It can act where markets will not, but has an opportunity cost and may be badly targeted.

Public and private partnerships. The government and a firm share the finance, risk and running of a project, such as a waste-treatment plant. Private expertise and capital can raise efficiency, but long contracts and poor value for the public are risks.

Level of action.

Level	Example	Strength	Limit
Local	A low-emission zone in a city	Fits local needs	Pollution moves across the boundary
National	A carbon-style tax or standards	Full legal power	Firms may relocate
Regional	A permit scheme across neighbouring countries	Covers cross-border pollution	Needs agreement and shared enforcement
Global	A climate treaty	Matches a global problem	Free riding, uneven costs and weak enforcement

Test each policy against effectiveness, cost, fairness, enforceability, time lag and side effects, then judge which fits the pollutant and level.

Common errors

• Placing MSC beneath MPC when the externality is a cost.
• Saying a tax removes all pollution. It moves output to the social optimum.
• Treating the EKC as proof that growth will fix the environment.
• Listing policies with no judgement on which works best.
• Forgetting that permits cap the total, while a tax fixes the price.

Use the revision notes to recall the content and the practice set to test yourself.

Official syllabus

OCR, A Level in Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021, Component 1 content, area of study Market failure and government intervention, topic Environment.