OxfordAQA International AS and A-level Economics: Market failure, public goods and externalities (9640)

This page is aligned to OxfordAQA’s International AS and A-level Economics course (9640), specification version 1.2, and covers 3.1.5.1 (the meaning of market failure), 3.1.5.2 (private, public and quasi-public goods) and 3.1.5.3 (positive and negative externalities in consumption and production). Section 3.1 belongs to the International AS, and the A-level extends it. Quantitative skills from section 3.5 may turn up in any unit, so the calculations below use QS2 (percentages), QS4 (graphs) and QS9 (interpreting information). All figures are invented and illustrative.

Merit and demerit goods, market imperfections, inequity and the policies that correct failure are covered in other pages. The revision notes condense this page, and the practice questions let you check what you have learned. Course pages: OxfordAQA A-level Economics hub and checklist. If you are unsure what to revise first, try a free 10-minute diagnostic. For equilibrium price, see price determination.

Coverage and skills

Ref	Content	Skill to show
3.1.5.1	Market failure is a misallocation of resources	Define both terms and give an example of each cause
3.1.5.2	Pure public goods are non-rival and non-excludable	Explain why each feature matters
3.1.5.2	Quasi-public goods; technological change	Show when a public good gains private-good features
3.1.5.2	Free-rider problem; tragedy of the commons	Explain both, and criticise the commons theory
3.1.5.3	Divergence between private and social costs and benefits	Draw and explain externalities in consumption and production
3.1.5.3	Absence of property rights	Link missing ownership to externalities

1. The meaning of market failure

Resources are scarce, so how they are used involves opportunity cost. A misallocation of resources means resources are used in a way that does not give society the greatest possible benefit. Too much of a good is made, too little, or none at all, compared with what would best serve society.

Market failure is any case where a market’s own outcome misallocates resources. A market can still trade, still clear and still show a profit while failing. The test is the use of resources, not whether the market works.

The specification lists the causes: public goods, positive and negative externalities, merit and demerit goods, monopoly and other market imperfections, and inequalities in the distribution of income and wealth. This page covers the first three. A quick example of each cause helps: a street light (public good), a noisy factory (negative externality), a cycle-safety course (positive externality).

Complete and partial failure. For a pure public good the market fails completely: private firms would supply none. With an externality the market still operates, but the quantity is wrong. Keep that distinction for evaluation.

2. Private, public and quasi-public goods

A private good is rival and excludable. If you eat a loaf, nobody else can, and the baker can refuse to sell it to you unless you pay.

A pure public good has two features:

• Non-rival: an extra user leaves the amount available to everyone else unchanged.
• Non-excludable: nobody can be prevented from using it, even if they have not paid.

The significance is the second feature. If people cannot be excluded, they can enjoy the good without paying, so a firm cannot charge and cannot earn revenue. Private firms do not supply it. Typical cases include street lighting, flood defences and national defence.

The free-rider problem

A free rider gains from a good without paying for it. When enough people think this way, no one pays and the good is not provided, even if it is worth more than it costs.

Worked example (village street light, Country A, illustrative). A village has 8 households. Each values a street light at 6 currency units. Installation costs 30.

• Total benefit = 8 × 6 = 48.
• Net benefit to the village = 48 − 30 = 18, so the light should be provided.
• Equal shares would cost 30 ÷ 8 = 3.75 each, leaving 6 − 3.75 = 2.25 of net benefit per household.
• Yet no single household will pay all 30 for a benefit of 6, and each hopes the others will pay.

A worthwhile project goes unprovided: a misallocation. Government provision, funded by taxation, can remove the problem. Whether it should be run by the state is a separate question for later pages.

Quasi-public goods

A quasi-public good shows only part of the public-good profile. It may be non-rival only up to a point, or partly excludable.

Example: an uncongested road is non-rival, because one more car does not stop another from driving. At rush hour it becomes rival, since each extra vehicle slows the rest. If tolls are added, it also becomes excludable. The same good moves along a spectrum between public and private.

Technological change

Technology can make exclusion possible. A broadcast signal once reached every receiver, so the programme was non-excludable. Encrypted transmission, with a decoder or subscription, makes it excludable. A good that once looked public can then be supplied privately, because firms can charge. Technology can also work the other way, for example by making copying easy and exclusion harder.

The tragedy of the commons

A common resource is open to all, so exclusion is impossible, yet each person’s use leaves less for the rest. The tragedy arises because each user gains the full benefit of extra use while the cost, depletion, is shared among everyone. Overuse follows. It is a source of environmental market failure, for example in fish stocks.

Worked example (shared pasture, illustrative). Total wool output from a pasture with N sheep is T = 20N − N², in value units. Each sheep costs 8 to keep.

Sheep (N)	Total output	Total cost	Net gain
6	84	48	36
10	100	80	20
12	96	96	0

Output per sheep is 20 − N. Each herder keeps adding sheep while that output exceeds the cost of 8, so entry stops at 20 − N = 8, giving N = 12. Net gain is then zero. The best outcome for the community adds a sheep only while the extra output from it, 20 − 2N, covers 8. That gives N = 6 and a net gain of 36. Each extra sheep lowers the output of every other sheep, a cost that the herder ignores.

Criticisms of the theory. Evaluate it with these points:

• It assumes users cannot communicate or agree rules. Many communities do set limits, share work and punish cheats.
• It confuses open access with shared ownership. Where a group owns a resource and can exclude outsiders, the problem is smaller.
• It assumes users act only in self-interest. Social norms and reputation matter.
• Defining private property rights or government regulation may solve it, but enforcement can be costly.
• The result depends on the resource. Slowly regenerating stocks are much more at risk.

3. Externalities

An externality is a spillover cost or benefit borne by someone who is neither buyer nor seller in the deal, and who is not paid or charged for it. Externalities arise where private and social costs or benefits diverge:

• Social cost is private cost with the external cost on top.
• Social benefit is private benefit with the external benefit on top.

The market decides on private costs and benefits only, so it ignores the external element.

	Production	Consumption
Negative	Factory pollutes a river	Loud music disturbs neighbours
Positive	A firm trains staff who later move on	A vaccinated person protects others

The specification asks for demand and supply diagrams, and it says you are not required to use MSC and MSB diagrams. In a production externality the second supply curve shows the full cost to society. In a consumption externality a second demand curve shows the full benefit to society.

Negative externality in production

Worked example (brick kiln, Country A, illustrative). Demand for bricks is Qd = 120 − 6P. Private supply is Qs = 20 + 4P. The brick kiln’s waste costs the downstream town 5 per unit, which the firm does not pay.

1. Market equilibrium: 120 − 6P = 20 + 4P, so P = 10 and Q = 60.
2. Supply showing the full cost to society sits 5 above at every quantity, so Qs = 20 + 4(P − 5) = 4P.
3. Social equilibrium: 120 − 6P = 4P, so P = 12 and Q = 48.
4. Overproduction = 60 − 48 = 12 units, 25% above the social level.
5. At Q = 60 buyers value the last unit at 10, but its cost to society is 15 (10 private plus 5 external).
6. Welfare loss = ½ × 5 × 12 = 30.

Diagram in words: place price up the side and quantity along the bottom. Demand falls from left to right. The private supply curve crosses it at (60, 10). The social supply curve lies above, parallel to it, crossing demand at (48, 12). The triangle between the two supply curves, from 48 to 60 units, is the welfare loss.

Negative externalities cause overproduction, and positive ones cause underproduction.

Positive externality in consumption

Worked example (cycle-safety course, illustrative). Private demand is Qd = 100 − 4P. Supply is Qs = 10 + 2P. Each course taught gives others an external benefit of 6.

1. Market equilibrium: 100 − 4P = 10 + 2P, so P = 15 and Q = 40.
2. Demand showing the full benefit to society sits 6 higher, so Qd = 100 − 4(P − 6) = 124 − 4P.
3. Social equilibrium: 124 − 4P = 10 + 2P, so P = 19 and Q = 48.
4. Underconsumption = 48 − 40 = 8 courses, which is 16.7% of the social level.
5. At Q = 40 the last course costs 15 but is worth 15 + 6 = 21 to society.
6. Welfare gain from reaching 48 = ½ × 6 × 8 = 24.

Other cases

Negative consumption externality: private benefit exceeds social benefit, so the social demand curve lies below private demand and the market overconsumes. Positive production externality: the social supply curve lies below the private one and the market underproduces. The method is the same each time. Find where the private curves meet, shift the curve that carries the externality by the size of the external amount, and compare quantities.

Property rights

Property rights are legal claims that let an owner use a resource and keep others out. Where they are missing or unenforceable, as with a river, the air or the open sea, nobody can charge a polluter or demand payment from a beneficiary. Costs and benefits then spill onto others. Setting up clear ownership can turn an externality into a price, but it is hard when the resource is mobile, when many people are affected, or when harm is hard to trace.

Evaluation points

• The size of the external cost matters. A tiny spillover may not justify action.
• External costs and benefits are hard to measure in money. The figures above are tidy only because they are invented.
• Effects may be delayed, such as damage that takes years to appear.
• Boundaries are blurred. A good can be partly public, and many goods carry several externalities at once.
• Judge both the size of the misallocation and who bears the cost.

Common errors

• Writing that a public good is “provided by government”. That is a solution, not a definition.
• Calling a toll road a pure public good. Tolls make it excludable.
• Saying a market with an externality has no output. Output exists, but the quantity is wrong.
• Drawing the social curve on the wrong side. Negative production externality: social supply above private. Positive consumption externality: social demand above private.
• Forgetting to label both equilibrium points and the area of welfare loss.

Official syllabus

Source: the specification for OxfordAQA’s International AS and A-level Economics course, code 9640, version 1.2. First teaching was September 2020, the first AS exams were May/June 2021 and the first A-level exams were May/June 2022. Covered here: 3.1.5.1, 3.1.5.2 and 3.1.5.3.