ECO10Market Failure, Externalities and Government Intervention

• Market failure: when the market system fails to allocate resources efficiently.
• Misallocation of resources: resources go into making the wrong amounts of goods and services, so society is worse off than it could be (a welfare loss).
• It shows up in two ways: too much of a harmful good is produced or consumed (e.g. goods that pollute), or too little of a beneficial good (e.g. too little exercise or training).
• Why it happens: buyers and sellers weigh up only their own costs and benefits. Effects on other people are left out of the price.
• Government intervention: action by the government to correct market failure, for example with taxes, subsidies or laws.

Market failure

When the market system fails to allocate resources efficiently.

Misallocation of resources

When resources are used to make the wrong amounts of goods and services, causing a welfare loss to society.

Government intervention

Action by the government to influence a market and correct market failure.

When resources are misallocated, someone pays. Often it is people outside the deal, taxpayers or future generations.

• These costs aren’t in the price, so the good looks cheaper than it really is to society.
• Moral and ethical questions: should people be free to choose, even if others are harmed? How much should today’s consumers think about future generations?

• Third party: anyone affected by a transaction who is not the buyer or the seller.
• Externality: a cost or benefit to a third party, outside the transaction. Nobody pays or is paid for it.
• Private costs: costs paid by the producer or consumer themselves (e.g. a driver’s fuel). Private benefits: the benefit to the consumer of using the good (and the revenue to the seller).
• External costs and external benefits fall on third parties.
• Social cost = private cost + external cost. Social benefit = private benefit + external benefit.
• So an externality is the difference between the social and the private figure: external cost = social cost − private cost.

Social cost and social benefit are the private and external parts added together (invented figures per unit)

Third party

Someone affected by a transaction who is neither the buyer nor the seller.

Externality

A cost or benefit to a third party outside an economic transaction.

Private cost

The cost paid by the producer or consumer of a good.

Private benefit

The benefit to the consumer of using a good.

Social cost

The full cost to society of a good: private cost plus external cost.

Social benefit

The full benefit to society of a good: private benefit plus external benefit.

• Negative externality: a cost to a third party outside the transaction.
• From production: a factory’s smoke, noise from an airport, farm chemicals washing into a river.
• From consumption: second-hand smoke, takeaway litter, exhaust fumes and congestion from driving, a neighbour’s loud music.
• Because the social cost is higher than the private cost, the good is over-produced or over-consumed: the price paid doesn’t cover the harm.

Externalities land on third parties, outside the deal between buyer and seller

Negative externality

A cost to a third party outside an economic transaction.

External cost

The part of the social cost that falls on third parties.

• Positive externality: a benefit to a third party outside the transaction.
• Examples: vaccinations protect people who aren’t vaccinated; education and training give other firms and society more skilled workers; insulation cuts energy use and emissions; a neat front garden pleases the neighbours; a new bus route takes cars off the road.
• Buyers only weigh their private benefit, so the social benefit is higher than what they will pay for. The good is under-consumed, and too little is produced.

Positive externality

A benefit to a third party outside an economic transaction.

External benefit

The part of the social benefit that goes to third parties.

• Three formulas, one idea: social = private + external. Rearrange to find the missing part: external = social − private; private = social − external.
• Give the unit (£, £ million) and round as the question asks.
• Spotting externalities in a source: for each effect, ask “who gains or loses?” If it is the buyer or the seller, it is private. If it is anyone else, it is external.

• Indirect tax: a tax on spending, paid to the government by the seller. It raises firms’ costs, so supply shifts left: the price rises and the quantity falls. The revenue can pay for clean-up. Examples: fuel duty and the Soft Drinks Industry Levy on sugary drinks. The compulsory charge for single-use carrier bags works in a similar way, though the money goes to shops, not the government.
• Regulation, laws and bans: limits on emissions, no smoking in enclosed public places, age limits on buying alcohol. Firms or people who break the rules are fined.
• Tradable permits: the government caps total pollution and issues permits. Firms that cut pollution cheaply can sell spare permits to others.
• Information: health warnings and campaigns, so people understand the harm.
• Subsidising a substitute: e.g. cheaper buses so fewer people drive. Say clearly that it is another product that is subsidised.

An indirect tax shifts supply left: price rises from P to P1, quantity falls from Q to Q1

Indirect tax

A tax on spending, added to the price of a good and paid to the government by the seller.

Regulation

Rules or laws that limit or require certain behaviour, enforced with penalties.

Tradable permits

Permits to pollute, capped in number, that firms can buy and sell.

• Subsidy: a payment from the government to producers (or sometimes consumers) that lowers costs. Supply shifts right: the price falls and the quantity rises. Examples: grants for heat pumps and insulation, support for bus routes and renewable energy.
• Government provision: the government provides the good itself, often free at the point of use. Examples: NHS healthcare, state schools, free vaccinations.
• Information and advertising: campaigns to encourage exercise, healthy eating or vaccination.
• Regulation to encourage use: rules that require consumption, such as compulsory schooling.

A subsidy shifts supply right: price falls from P to P1, quantity rises from Q to Q1

Subsidy

A payment from the government to producers (or consumers) that lowers costs and raises supply.

Government provision

When the government provides a good or service itself, often free at the point of use.

• Price elasticity of demand: if demand is price inelastic (e.g. cigarettes, petrol), a tax raises a lot of revenue but cuts consumption only a little. See the topic on price elasticity.
• Measuring the harm: it is hard to put a money value on an external cost, so the tax or subsidy may be too big or too small.
• Opportunity cost: money spent on a subsidy or free provision can’t be spent on something else.
• Fairness: indirect taxes take a bigger share of a low income (they are regressive).
• Government failure (optional term): when intervention makes things worse, e.g. a ban that creates a black market.

The government’s toolkit for externalities

Regressive tax

A tax that takes a larger share of income from people on lower incomes.

Government failure

When government intervention makes the allocation of resources worse (an optional term).

• Merit good: better for people than they realise, so it is under-consumed. Examples: healthy food, exercise, education.
• Demerit good: worse for people than they realise, so it is over-consumed. Examples: fatty and sugary foods, cigarettes.
• The cause is partly poor information: people don’t weigh the long-term effects on themselves.
• Many merit and demerit goods also have externalities, which is the main idea AQA tests.

Merit good

A good that is better for the consumer than they think, so it is under-consumed.

Demerit good

A good that is worse for the consumer than they think, so it is over-consumed.