MARKET FAILURE

 There are a number of things that prevent markets from being perfect and, therefore,
from allocating resources in an optimal manner.
 If this is the case, then community surplus is not maximized and we say that this is a
market failure.
 When markets fail, governments are often expected to intervene in order to attempt to
eliminate the market failure and move towards the optimal allocation of resources.
 Examples of market failure include:
 When a production process causes pollution, such as in the air or water
 When people consume goods that are harmful for them and the rest of society,
such as cigarettes and illegal drugs
 When the current generation exploits or depletes resources so that they won't
be available to future generations
 When markets fail, governments are expected to intervene to try to correct that failure.

Concept

Economic well-being
Intervention

Market failure is a problem that affects our economic well-being in many different ways and in
many different aspects of our lives. There can be both negative and positive consequences from
market failure: we want some markets to reduce in size because of their ill-effects on
others, and some markets to grow due to their good effects.

When people buy goods, how much time do you think people spend considering how it was
made or what will happen to it once they have finished using it?

What do you think are some of the best ways to promote positive choices by consumers and
producers?

Types of market failure

 When a market is in equilibrium, with no external disturbances, it is said to be in a state
of allocative efficiency.
 This means that the resources are allocated in the most efficient way, from that
society's point of view.
 When the price of a good adjusts to make the quantity demanded equal to the quantity
supplied, the equilibrium quantity reflects the optimal (best) allocation of resources to
the production of that good, maximising the social/community surplus.
 In other words, when the marginal social benefit (MSB) equals the marginal social cost
(MSC), this is the socially optimal output.
 This is the level of output at which there are no net positive or negative consequences
for society when an additional unit of the good or service is produced or consumed.

1
  In reality, the free market fails to achieve this desirable situation for a variety of reasons.
 For example, it might be that sometimes the private costs of production of a good do
not represent the social costs of production.
 It might also happen sometimes that the private benefit from consuming a good causes
some external effects, negative or positive, which prevent the society from achieving
optimal welfare.
 The market equilibrium shown in Figure 1, where D=MSB=S=MSC shows a situation
where the market has achieved the optimal social welfare.
 This allocative efficiency will not be achieved when either D≠MSB or D≠MSC, which is
considered a market failure .

Figure 1. Consumer surplus and producer surplus.

Important

Remember:

 The marginal private cost (MPC) refers to the cost for firms to produce one more unit
of a good.
 The marginal social cost (MSC) refers to the total cost to society when one more unit
of a good is produced. It includes the MPC.
 The marginal private benefit (MPB) refers to the benefit to consumers of consuming
one more unit of a good.
 The marginal social benefit (MSB) refers to the total benefit to society when one
more unit of a good is consumed. It includes the MPB .

1. Existence of externalities
2
  An externality occurs when the production or consumption of a good or service has an
effect upon a third party.
 If the effect is harmful, then we talk about a negative externality.
 There is an external cost that must be added to the private costs of the producer or
consumer to reflect the full cost to society.
 If the effect is beneficial, then we talk about a positive externality.
 Externalities can result either from the consumption or production of goods and
services, and they create a gap or difference between the MPC and the MSC, or
between the MPB and the MSB.
 In other words, an externality occurs when the free market leads to an outcome where
MPB is equal to MPC, (MPB=MPC), but MSB is not equal to MSC, (MSB≠MSC), and the
outcome for the society is allocative inefficiency.
 For example, the consumption of chewing gum’s MSB is made up of consumers’ MPB
gained from consuming the gum (the enjoyment, fresh breath, etc.) and the cost to
society of cleaning up the chewing gum from the ground.
 The market produces while only taking into account the marginal private benefit and the
marginal social costs, not the marginal social benefits.

Types of externalities:

 Negative externalities of production

 Positive externalities of production
 Negative externalities of consumption
 Positive externalities of consumption

Important

 All negative externalities (of production and consumption) create external costs.
When there is an external cost, MSC > MSB at the equilibrium point of the market.
 All positive externalities (of production and consumption) create external benefits.
When there are external benefits, MSB > MSC at the equilibrium point of the market.
 All production externalities (positive and negative) create a divergence between
private and social costs (MPC ≠ MSC).
 All consumption externalities (positive and negative) create a divergence between
private and social benefits (MPB ≠ MSB).

2. Under-supply of merit goods

 Merit goods are private goods that will be under-produced by the market as consumers
do not appreciate the benefits to themselves and society of their consumption.

3
  As a result, they are under-provided by the market, because firms are profit driven and
will only produce goods and services for consumers who can pay for them.
 As these goods will be under-consumed, they will be under-provided with respect to the
socially optimal output, and so this creates a market failure.
 Merit goods are goods that are considered beneficial to both the individual and society
as a whole, as in the cases of education and healthcare. As governments think that these
goods should be consumed to a greater degree, they will tend to provide them directly
or subsidise private firms to do so, increasing the supply and making them more
affordable.

3. Over-supply of demerit goods

 Demerit goods are private goods that will be over-consumed and therefore over-
provided by the market for the same reason that merit goods will be under-provided:
consumers do not appreciate the costs to themselves and society of their consumption.
Firms are profit driven, so the market will produce and consume based on the forces of
demand and supply.
 As these goods will be over-consumed, they will be over-supplied with respect to the
socially optimal output, so they also create a market failure.
 Demerit goods are considered to be harmful for both the individual and society as a
whole, as in the cases of cigarettes and alcohol. As governments think that they should
be consumed to a lesser degree, or not consumed at all, they will tend to reduce or
attempt to eliminate supply and/or demand.

a) Negative externalities of production

 When the production process of a good or service generates a negative effect on a third
party or on society as a whole, we say that there is a negative externality of production.
 This usually happens when there is a negative impact on the environment caused by a
good being produced eg air or water pollution as a result of the production process,
loud noises generated while producing or any other negative side-effects of production
activities that spill over onto society and are not accounted for in the private costs for
the firm.
 When this happens, the marginal social cost of production (MSC) is greater than the
private cost of production (MPC), as firms do not take these extra costs into
consideration when deciding how much to supply at each price level.
 This results in a greater amount of the good being produced than the socially optimal
output, and therefore an over-allocation of resources to the production of such goods
from the society's point of view.
 Through the forces of demand and supply, only taking into consideration the firm's
private costs of production (MPC) and the private benefit of consumption (MPB), the
market will end up producing at the point where the quantity supplied is equal to the
quantity demanded of steel, Q1.

4
 Figure 2. Production of steel while polluting the air.

This type of externality involves only the production side of the market (the supply curve).

The demand curve represents both the marginal private benefit (MPB) and marginal social
benefit (MSB) of consuming the good, so here MPB = MSB.

 As seen in Figure 2, the total cost of production for society (MSC) is greater than the
private cost (MPC), for every level of output. The vertical difference between MSC and
MPC represents the externality.
 The optimum amount of steel produced, from the society's point of view, should be at
the point where the MSC curve crosses the demand curve (the MSB curve), at Q1.
 As the cost of producing steel is greater for society than for the private firm, the market
outcome results in a greater amount of steel produced than what should be produced if
the total social costs of production were taken into consideration – in other words, if the
pollution caused by the firm is not internalized.

Important

When there is a negative externality of production, the amount produced is greater than what
it should be, from the society's point of view. Therefore, more resources are allocated to the
production of this good than what is optimal for society. The market over-allocates resources to
the production of the good.

5
Possible government responses

 Imposing a carbon tax on polluting firms

 Legislation
 Tradable emission permits

1. Imposing a carbon tax on polluting firms

 The government could impose a tax on the firm per unit of output produced, or a tax
per unit of pollutants emitted, to increase the private costs of production.
 The tax results in an upward shift of the supply curve from MPC to MPC + tax, nearer to
the point of social efficiency.
 If the tax is equal to the external cost of production, then the externality would be
internalised. If not, although the welfare loss for society would be reduced, it would not
be eliminated completely.
 There is still a welfare loss, but it will be less than with no government intervention at
all.

Benefits of this solution:

 Carbon taxes on polluting firms are much easier to apply than other measures, such as
tradable emission permits.
 Tax revenues from carbon tax will be collected, and can be invested in promoting
innovation and new technologies, such as renewable sources of producing energy.

Problems with this solution:

 It is often difficult to measure the pollution created and put a value on it to establish the
amount of the tax.
 It is also difficult to identify which firms are polluting and to what extent each firm is
responsible for the pollution.
 Taxes make firms pay for the pollution they create but do not actually stop the pollution
from taking place.

Theory of Knowledge

Consider the problems explored above when imposing carbon taxes. For a carbon tax to be
successful, it must be the correct size to offset the social costs associated with pollution.

Guyana, in South America, is considering imposing a carbon tax on crude oil that is currently
extracted by ExxonMobil. The tax has the potential to earn the government of Guyana billions
each year. How does Guyana decide how large the tax should be? How canGuyana calculate the
social costs associated with offshore drilling to ensure the tax can offset them?

6
The government of Guyana argues that in a six-month period Exxon flared over nine billion
cubic feet of natural gas. A forest the size of 4642 hectares of forest would be required to soak
up the carbon in the air from the flares.

How can we calculate what the forest is worth? How can we place a price on a forest? How can
we fully measure all of its benefits? Its lumber, its biodiversity, the oxygen it creates, not just
for our generation, but for all future generations as well.

According to the government of Guyana, such a forest is worth USD 25 million. They used that
figure as a measure for the carbon tax on Exxon.

Do you think the government of Guyana can accurately measure the value of a forest?

Knowledge question: To what extent can we use economic models accurately and with
precision to solve practical problems?

2. Legislation
 The government could pass laws relating to environmental standards that firms must
comply with in the production process, such as using specific types of machinery, air
filters, water processes and disposal methods.
 To meet these standards, a firm's cost of production would increase, shifting the supply
curve upwards.
 An extreme intervention could also be to ban polluting firms altogether.

Problems with this solution:

 The ban or restriction may lead to unemployment in the corresponding industry, as jobs
would be lost if firms are closed or the market reduced.
 Banning a firm would create non-consumption of the good that was being produced,
which might be a good necessary or desirable to consumers.
 The cost of setting and then enforcing the policy standards may be very difficult to
implement, and/or have a greater cost than the pollution itself.

[Link] emission permits

 This type of solution was agreed upon in the Kyoto Protocol, made under the United
Nations Framework Convention on Climate Change, which came into force in February
2005.
 The objective was to reduce the global emission of greenhouse gases. In this particular
example, the agreement was between countries, but a similar procedure could be
applied to individual market cases.
 Look at Figure 4 to see which countries currently employ emissions trading schemes.

7
 Source: "World Bank" is licensed under CC BY 3.0 IGO

Figure 4. A map showing the carbon taxes and emissions trading schemes employed in various
countries.
 The government sets the level of 'admitted pollution' per year and splits the 'permission
to pollute' into a number of tradable emission permits.
 These are allocated to individual firms, which now have a quota of emissions that they
are allowed to produce.
 Firms that pollute less can sell their remaining quota to other firms who need to pollute
more. This is why they are called 'tradable'.

Benefits of this solution:

 It encourages firms to seek lower-cost methods of reducing emissions, such as better

energy efficiency, which will lower their overall production costs.
 It helps achieve the environmental objective of reduced emissions at lower costs.
 The price of permits is determined by the free market, which allows greater flexibility to
firms, because in a period of recession the price will fall due to falling output and in
periods of economic boom the price will rise. This flexibility will allow firms to benefit
from reducing emissions.
 It provides a way for international cooperation to tackle the global challenge of
emissions.

Problems with this solution:

 To start with, it is difficult to set an acceptable level of pollution.

8
  It is also difficult to measure a firm's pollution production in order to establish the
amount of permits per firm.
 Firms pay for the pollution they create but it does not lead to a reduction in pollution
once the allowed limit has been set.

b) Positive externalities of production

 When the production process of a good or service generates a positive effect on a third
party or on society as a whole, it is called a positive externality of production.
 Examples include private companies investing in research and development of a new
technology that spreads throughout the economy, training provided by private firms to
their employees, private involvement in bee-keeping or the building of a flood defence.
 The individual bee-keeper will benefit from the production and sale of honey and other
by-products.
 Society will also benefit from bee-keeping, as bees are famous pollinators and they will
pollinate agricultural plants that will later result in a more abundant harvest for farmers
and more vegetables and fruits for consumers at farmers’ markets.
 Those additional benefits of bee-keeping on third parties are considered a positive
externality of production.
 When this happens, the marginal social cost of production (MSC) is smaller than the
marginal private cost of production (MPC), as the bee-keepers are the ones who pay
for the costs of honey production, rather than the society as a whole.


Figure 2. Positive externality of production: employees taking professional development

courses.

9
  In Figure 2, as the cost of honey production is paid for by the private bee-keeper, the
total cost of production for society (MSC) is smaller than the private cost (MPC) for
every level of output.
 The vertical difference between MSC and MPC represents the externality. This is
because bee-keeping will bring additional benefits to society in the process of honey
production.
 For example, the UNDP Aral Sea Programme helped communities in Uzbekistan address
their needs by keeping bees when the Aral Sea started drying up.
 It not only helped families to find alternative sources of income for their needs, but also
brought additional benefits to others engaged in agriculture.
 Planting a garden of wild flowers, instead of hybrid and pollen-free plants, helps save
the increasingly diminishing numbers of wild bee species, which are also crucial for
agriculture.

Important

When there is a positive externality of production, the amount produced is smaller than what it
should be, from the society's point of view.

Therefore fewer resources are allocated to the production of this good than what is optimum
for society. The market under-allocates resources to the production of the good.

Possible government responses

This can be done in three different ways:

 Subsidising firms
 Direct government provision
 Vocational training

1. Subsidise firms
 The government could grant subsidies to the firms that provide training or research and
development.
 Firms involved in provision of professional training or research and development will be
willing to provide more opportunities to other businesses at more affordable prices as
now their costs of production will be partially covered by the subsidy.
 The government could grant subsidies to producers involved in bee-keeping. An
example of such subsidies is the EU: around half of the EU budget for 2017–2019 was
allocated to each country in accordance with the number of beehives in each country.
 As seen in Figure 3, the subsidy results in a downward shift of the supply curve from
MPC to MPC + subsidy, nearer to the point of social efficiency, A.

10
  As firms' costs of production are reduced, they are willing and able to produce more at
every price level, and the society gains from the positive external benefits this
production generates.
 In turn, this reduces the unrealised potential welfare gain. In other words, the social
welfare gained from this production process has increased.

Problems with this solution:

 It is very difficult for the government to estimate the level of subsidy deserved by every
firm.
 Each subsidy uses government funds and therefore they have an opportunity cost; the
government would have to cut back on other expenditures that might be important,
such as health care.

2. Direct government provision

 Governments often fund research and development into many areas, including new
technologies, medicine and pharmaceuticals, bee-keeping and agriculture.
 The government can also directly provide those goods and services that present positive
externalities of production, for example flood defences.
 The effect on the market outcome would be similar to the effect of subsidies: the MPC
would shift outwards towards the MSC, reducing the externality, as the government
would pay for such investment, reducing firms' costs of production.

Problems with this solution:

 The cost for the government might be high and create an opportunity cost, as in the
case of subsidies.
 The government might lack the expertise found in firms, which are specialised in their
area of knowledge.
 Private firms might be dissuaded from investing in these areas themselves because of
this government policy.

c) Negative externalities of consumption

 Occurs where the external effect on third parties is caused by the consumption of a
good or service.
 Negative externalities of consumption occur when an individual's consumption of a
good generates a negative effect on third parties who were not factored into the
decision to consume that good.
 For example, when people consume goods like cigarettes around other people, the non-
smokers will be affected by the second-hand smoke; people also drive cars that pollute
the air for everyone, and when someone listens to very loud music, it can cause
discomfort to others around them.

11
  When this happens, the marginal social benefit (MSB) is smaller than the marginal
private benefit (MPB), as the benefit of the private use is diminished by the negative
impact suffered by the third party.
 This results in a greater amount consumed of the good than the socially optimal output,
and therefore an over-consumption of such goods, from the society's point of view.
 By the forces of demand and supply, only taking into consideration the individual's
private benefit of using cars (MPB) and the cost of producing cars (MPC), the market will
end up consuming at the point where the quantity supplied of cars is equal to the
quantity demanded, Q1.

Figure 2. Negative externality of consumption: market of petrol-run cars.

Be aware

When the externality is on the demand side of the market, and not generated by the
production process, the social and private costs of production are equal: MPC = MSC.

 As seen in Figure 2, if the air pollution generated while consuming cars is considered,
the total benefit for society (MSB) is lower than the private benefit (MPB) for every level
of output.
 The vertical difference between MSB and MPB represents the externality.
 The optimal amount of cars consumed and produced from the society's point of view
should be at the point where the MSC curve crosses the MSB curve, at Q1.
 As the benefit to society is smaller than the benefit to the individual, the market
outcome results in a greater amount of polluting cars being consumed than should
be consumed if the total social costs of consumption were taken into consideration.

12
Important

 When there is a negative externality of consumption, the amount of the good

consumed is greater than what it should be, from the society's point of view.
 Therefore, more resources are allocated to the consumption of this good than what is
optimum for society. The market over-allocates resources to the consumption of the
good.
 In the example of cars, society is consuming an amount Q1 which less than Q2 and
purchasing them at a lower price, P1 which is greater than P2.
 Therefore, there is an inefficient allocation of resources from the society's point of view
and the welfare loss is shown by the yellow shaded triangle.
 All of the units consumed from Q2 to Q1 have a higher cost for society than the benefit
they bring to it (MSC > MSB). This is why it is a market failure.

NB
When the externality is produced on the demand side of the market, then:

MSB ≠ MPB.

When the externality is produced on the supply side of the market, then:

MSC ≠ MPC.

Possible government responses

 The solutions aim to make people aware of the risks associated with their consumption,
or to demotivate people from consuming the good by increasing the cost of the good
itself.
 This can be done through different methods:
 Banning or regulating the good
 Imposing an indirect tax on the good
 Negative advertising

13
 Figure 3. Possible solutions to negative externalities of consumption.

1. Ban or regulate the good

 The government could directly stop the consumption of goods by making them illegal.
 This would make the externality disappear completely, as the good would no longer
exist on the market, unless a black market arose (depending on the nature of the good).
 The government could also regulate the consumption of the product by introducing
legislation.
 For example, in the case of cigarettes, many governments have restricted where people
can smoke, have introduced uniform packaging or have tightened up on who can buy
cigarettes in an attempt to reduce demand and shift the MPB closer to the MSB.
 In France, Paris has in recent years limited the number of vehicles that are allowed to
drive in the city during weekdays.
 Measures taken include having car-free Sundays and restricting the passage of vehicles
of a particular age. This would reduce the demand for cars locally. Another example of
regulation of the car industry is in the Netherlands, where they have reduced the
maximum speed limit to 100 km/h (previously it was 130 km/h) on highways in order to
reduce emissions from vehicles.

Problems with this solution:

14
  This would have a large effect on the corresponding industry in terms of shareholders
and employment.
 It might have a big effect on the government's revenue as it would receive fewer or no
taxes from this market.
 Banning the good might cause a negative reaction from consumers if they perceive
the banning of the good as restrictions on their liberties and rights. This could have a
negative effect on the government's future election prospects, as consumers are also
voters, which makes it unlikely that governments will choose this option.
 Regulations will need to be enforced and this may impose an additional cost on the
government.

2. Impose an indirect (Pigouvian) tax on the good

 The government could impose an indirect tax on the good itself to increase the private
costs of consumption by increasing the price of the good.
 When indirect taxes are used in this way, to resolve negative externalities, they are
called Pigouvian taxes.
 The tax results in an upward shift of the supply curve, from MSC to MSC + tax, which
reduces the quantity demanded nearer to Q*, as the price in the market increases from
P1 to P2. (Figure 3 above)
 Because consuming the good has become more expensive, people will tend to consume
less of it, due to the law of demand.
 The government will gain some revenue from the tax, which can be used to correct or
mitigate some of the negative effects caused by the consumption of the good.

NB

 Many cities have introduced charges for drivers entering the city. Students often
interpret this as a tax.
 If you choose to discuss congestion charges in an exam or your IA, you need to be clear
about who is paying the charge and what the market is (through your axis labels).
 If the market is for car sales, then congestion charges do not reduce supply, but they will
reduce demand.
 If the market you are showing is for delivery services, then yes, these charges would act
like an indirect tax.

Problems with this solution:

 When the good is addictive, such as cigarettes, its demand tends to be price inelastic
and an increase in price will not reduce the quantity consumed very much.
 If taxes are raised too much, consumers might look for other illegal sources of supply,
causing black markets to appear.
 Taxes make people pay for the external cost they create but do not stop the negative
effect from taking place, as there will still be people using or consuming the good.

15
3. Negative advertising
 The government could create awareness about the risks and dangers that consuming
these harmful goods creates for others, or for the consumer themselves.
 The government could fund negative advertising in order to reduce demand, as shown
in Figure 3.
 This would shift the demand curve inwards, closer to the MSB curve, thereby reducing
the externality and the welfare loss for society because less of the good would be
consumed.

Activity

Watch the following video showing an advertisement discouraging drink driving.

[Link]

As a class, consider the following discussion points:

 Do you think this video is effective in discouraging drink driving? Why/why not?
 Does it do enough to convince you that drink driving is not worth the risk? If not, how
could it be improved?

In groups, come up with your own ideas for a drink driving advert.

Problems with this solution:

 The costs of these solutions might be high and generate an opportunity cost for the
government. However, if these goods were taxed as well, then the revenue generated
could be used to fund these measures.
 There is always a level of doubt about how effective advertising is at reducing demand,
especially in cases such as cigarette consumption within certain age groups.

c) Positive externalities of consumption

 Occurs the consumption of a good or service generates a positive effect on a third party
or on society as a whole.
 This is the case for merit goods and any other good or service that has a positive side-
effect on third parties when being consumed.
 Education and health care are the most common examples that come to mind.
 When an individual gets a vaccine, for example, he or she is not the only one who
benefits from its consumption.
 Vaccines prevent the individual consumer from getting sick, but this has the secondary
effect of preventing others from getting sick because vaccinations reduce the spread of
illness.

16
  When this happens, the marginal social benefit of consumption (MSB) is greater than
the marginal private benefit (MPB), as the demand for the good or service does not
take into consideration the positive external effects it has on the society as a whole, but
only the benefits to the private individual that consumes it.
 This results in a smaller amount consumed of the good than the socially optimal output,
and therefore an under-allocation of resources to the production of the good, from the
society's point of view.

Figure 2 shows the example of the market of health care services.

 The market will produce and consume where the demand is equal to the supply, only
taking the private costs and benefits into consideration.
 This will result in a quantity Q1 smaller than the social optimum Q*. The MSB is greater
than the MPB at every output level and therefore a potential welfare gain is created, as
shown by the yellow shaded triangle.
 The socially optimal price P* should be lower than the market price P1.

Figure 2. Positive externality of consumption: health care services.

Important

 When there is a positive externality of consumption, the amount consumed

is smaller than what it should be, from the society's point of view.
 Therefore, fewer resources are allocated to the production of this good than what is
optimal for society. The market under-allocates resources to the production of the
good.

Possible government responses

17
  'to solve the externality' means to gain the extra potential welfare for society by
increasing the quantity consumed of the good until Q1 reaches Q*.
 This can be done using different methods:
 Subsidising firms
 Direct government provision
 Positive advertisement
 Legislation to make consumption compulsory

Figure 3. Possible solutions to positive externalities of consumption.

1. Subsidise firms
 The subsidy results in a downward shift of the supply curve, from MSC to MSC + subsidy,
nearer to the point of social efficiency at A.
 As firms' costs of production would be reduced, they would be willing and able to
produce the good or service at a lower price, so that more people can afford it.
 The society would benefit from the positive external benefits generated by consumption
of the good, therefore reducing the unrealised potential welfare gain by gaining extra
social welfare.

Problems with this solution:

 The main problem with this solution is the cost for the government. Each subsidy uses
government funds and therefore has an opportunity cost because the government
would have to cut back on alternative expenditures that might be important.
 Another problem is that subsidies can generate production inefficiencies in private firms
because part of their revenue is guaranteed by the government.

18
2. Direct government provision
 Governments often provide goods and services that have positive externalities of
consumption.
 These goods are usually free of charge to all consumers, as is the case with state schools
and public hospitals in most countries in the world.

Activity

Read the following articles and answer the questions that follow.

Debate: Private schools shouldn’t be abolished, The Oxford Student, 15 October 2019

Private schools criticise plans to get more poor students into university, The Guardian, 29
January 2020

1. Outline the arguments that the articles make for and against private schools in the UK.

2. Discuss the measures that governments can take to reduce the problem of positive
externalities of consumption.

 The effect this has on the market is similar to the effect from subsidies: the supply curve
MSC (MPC = MSC) will increase, shifting downwards, therefore decreasing the price and
increasing the quantity consumed nearer to the socially optimal point Q*.

Problems with this solution:

 The cost to the government might be very high and create an opportunity cost, as in the
case of subsidies.
 The government might be less efficient than private firms at providing these services,
and the quality of the good or service might not be as good.
 Private firms might be dissuaded from investing in these areas because the government
will provide these goods or services anyway.

3. Positive advertisement
 The government could educate people and create awareness through advertising
campaigns about the benefits to the consumer and others of consuming such goods, in
order to increase demand towards the MSB curve.

Problems with this solution:

 The costs might be high and generate an opportunity cost for the government, as with
any other government expenditure.

4. Legislation

19
  The government could pass laws to make the consumption of these goods compulsory.
 This is the case for education up to a certain age in many countries, and certain
vaccinations in some countries.
 This solution increases the demand for the good or service (for example, vaccines),
shifting the demand curve outwards towards the MSB curve, as in the case of positive
advertising.
 Ideally, it will shift until it reaches the MSB curve, where Q* is produced and consumed,
eliminating the externality as society gains the maximum potential welfare.

Problems with this solution:

 This solution is less likely to be successful unless the government provides the goods
and services free of charge.
 Some people might resent laws of this type if they see them as an infringement of their
civil liberties.
 There is the additional cost of enforcing the law.

Calculating welfare loss (HL)

Figure 1. A market with positive externalities of consumption.

 Figure 1 shows a market with positive externalities of consumption.

 In this diagram, the socially optimal level of output is 25 million vaccines, and the
welfare loss (unrealised potential additional welfare gain) is shown by the yellow
triangle.

20
Making connections

 You need to be able to draw on your maths skills in economics, which does require some
flexible thinking.
 After all, maths is a way of communicating that can be applied to many different disciplines.
For this subtopic, though, you only need to draw on some maths lessons from several years
ago.

To calculate a welfare loss (or unrealised potential welfare gain), we need to use the
formula for a triangle:

Area of a triangle =1/2 base × height

Potential welfare gain =1/2 (6−4) ×5 million
=1/2 ×2×5 million
=1/2×10 million
= EUR 5 million
NB
 When performing calculations, it is important to show every step of your calculations and
write the answer out in full. This is true in maths and science too.
 It is easy to rush during the exam, and think these things aren’t important, but being careful
will result in you gaining the highest number of marks possible.

Common pool resources/ common access resources/ common property

resources.
 The concept of common pool resources is studied in relation to environmental
problems as they are usually natural resources.
 Some examples are: fish found in open seas, clean air, lakes, rivers, wildlife,
hunting grounds, forests, fertile soil from common land, open grazing land, the
ozone layer, the stable global climate and many others.
 A good is considered rivalrous if, once it has been consumed, it cannot be
consumed by another person.
 If we destroy the stability of the global climate or use up fossil fuel reserves, they
will not be available for future generations to use.
 When we catch a fish, there are fewer fish left for others to catch. As a
result, overfishing is a problem in most seas and oceans.
 A good is non-excludable if it is not possible to exclude anyone from using it.
Most goods are excludable because they have a price.
 Common access resources are different because they have no price and anyone
can use them without payment. It is usually very difficult and/or very expensive to
exclude people from using them.
 Historically, English villages had a common plot of land that villagers could use to
graze their cattle and other livestock.
 Many still do have their commons, but you won’t see any cows on them anymore.

21
  While it was in the interest of all those using the common land for grazing that not
too many animals were there, and that the plot wasn’t overgrazed, it was also in
the interest of each individual user to use as much of the available land for their
animals as possible.
 It is likely that users will act in their own self-interest instead of preserving the
common land.
 This problem captures the heart of the issue with common pool resources, which is
referred to as the ‘tragedy of the commons’.

Important

 Common access resources are a case of market failure because the individual benefits of
consuming or using the resource are much greater than the private cost of doing so, and this
gives the individual an incentive to keep consuming it.
 Therefore, there is an over-consumption with respect to what is optimal for society.
 The nature of this type of resource and the inability to charge for them results in
their overuse or over-consumption, which eventually might lead to serious
environmental degradation and depletion.
 This issue is tied to the concept of sustainability, as these resources could
eventually run out or degrade in such a way that they will not be available to
future generations.
 When we focus on economic goals without regard to the environment, it can result
in the environment's irreversible destruction.
 Conversely, if we focus on environmental goals and disregard the economy, we
might not be able to satisfy human needs and wants.
 The solution to this problem is found in the concept of sustainable development.

Making connections

 Sustainability is a topic that is covered across disciplines, including geography,

environmental systems and societies, and biology.
 In economics, we consider the unintended consequences of markets, but our impact on our
environment can be analysed from many angles.

Government responses to threats to sustainability

 Solutions to the problems associated with the overuse or degradation of common
access resources relate mainly to those who use the resources.
 If the use of resources can be isolated to the geographical limits of one country,
the solutions should be implemented at a national level.
 But when the problems extend to several countries, as in the case of global
warming, then negotiations must take place to find international agreements about
solutions.

22
  Government responses to threats to sustainability are limited by the global nature
of the problems and the lack of ownership of common access resources, and
therefore effective responses require international cooperation.
 Methods used include:
 Cap and trade systems and carbon taxes
 Clean technologies
 Collective self-governance

[Link] and trade systems and carbon taxes

 This may be done where governments set national targets for emission reductions and
encourage firms to meet the targets by creating an economic incentive to reduce
emissions.
 Since emissions are not confined to borders, however, an internationally coordinated
approach is necessary to reduce the activities which generate emissions effectively.
 One such approach to reduce the level of emissions is the Kyoto Protocol, an agreement
made under the United Nations Framework Convention on Climate Change (UNFCCC) .
 Its objective is to cut global emissions of six major greenhouse gases. The treaty was
negotiated in Kyoto, Japan in 1 997 and came into force in February 2005.
 In November 2009, 1 87 countries had ratified the agreement, committing themselves to
the reductions.
 A carbon tax can be used to regulate pollution. Regarding consumption, governments
can tax petrol (gasoline) to encourage consumers to use less of it (for example, by using
substitute transportation such as electric cars).
 Regarding production, governments can tax coal to encourage producers to use substitute
energy sources, such as wind, solar or nuclear sources. Of course, these examples aren’t
without problems.
 Promoting the use of electric cars raises the question of how the electricity was produced.
Producing energy using nuclear power generates nuclear waste that takes a very long
time to decompose and which remains radioactive.
 Another possible solution, specifically in the case of production, is to set up a cap and
trade system by issuing tradable emission permits
 This is where the government sets emission reduction targets and encourages firms to
meet them by creating economic incentives.

23
 Figure 3. The market for pollution permits.

 Figure 3 shows how the government can use tradable permits to limit and, over time,
reduce pollution.
 The government issues a fixed number of permits, which is represented by the vertical
supply curve S1.
 This intersects the demand curve for tradable permits such that a price is set at P1. The
government can reduce the number of permits, which will reduce the amount of pollution
that can be produced.
 This causes the supply curve to shift inwards from S1 to S2 and the price per permit to
increase from P1 to P2.
[Link]

2. Clean technologies
 Renewable sources of energy include solar power, wind power, hydropower and
biofuels. These are called clean technologies.
 Governments tend to intervene in the market and promote the development and use of
these technologies by subsidising them or giving tax credits to those who invest in them.
 According to the OECD, there has been a strong and steady increase in investment in
clean technology by governments.
 Figure 4 below shows that total investment across different types of
renewables increased approximately nine times between 2000 and 2014.

24
Figure 4. Trends in investment flows in renewable-power sources in OECD and G20 countries.

 When a government subsidy is granted to a firm generating power from wind farms, the
supply curve increases from S1 to S1 + subsidy as it lowers the firm's costs of production.
 This will result in a lower price of electricity to consumers (P2 < P1) and increase the
amount of electricity demanded (Q2 > Q1).
 The cost of this policy to the government is shown by the orange rectangle on Figure 6,
while the cost to consumers is represented by the yellow rectangle.
 Subsidising clean technologies creates an opportunity cost for the government, as these
funds cannot be used for alternative government objectives.
 However, if the government is strongly committed to reducing carbon emissions, then it
is worthwhile to subsidise clean energy, as an increase in the use of cleaner forms of
energy can only be possible if the prices to consumers are affordable.

25
 Figure 6. Production of electricity using wind turbines.

Worked example 1

Explain, using negative externalities diagrams, why economic activity requiring the use of fossil fuels such
as petrol (gasoline) to satisfy demand poses a threat to sustainability.

26
3. Collective self-governance
 Collective self-governance is defined as those who contribute to the environmental issue
being involved in all the processes, such as working with local communities and
governments, that lead to the improved use of that resource or location.
 An interesting example of an industry that poses a threat to sustainability of common
access resources is the cruise industry.
 Due to the transient nature of cruises, it is difficult to manage the activities of ships when
they have negative impacts on their surroundings.
 Tourists today are increasingly concerned about environmental issues, and cruise
companies can market themselves for their sustainability policies.
 Local marine communities concerned with the impact of cruises on the environment can
legislate to work with companies that promise to operate within certain boundaries.
 For example, the Svalbard Environmental Protection Act allows companies to visit
the Svalbard archipelago of islands (islands belonging to Norway) as long as they
promise to look after the area.
 The Association of Arctic Expedition Cruise Operators (AECO) exists to balance the
needs of the environment and local culture with the needs of the tourist industry in the
area.
 In this example, all interested parties work together to promote sustainability in a self-
governing way.

The importance of international cooperation

 In many cases of positive and negative externalities, solutions require countries to work
together and come to an international agreement to secure a sustainable future.

27
International Mindedness

 A lot of what will be discussed on this page covers the need for countries to work
together to achieve common goals.
 This doesn’t happen easily, and requires politicians to put those common goals ahead of
any political interests they may have.
 Consumers also need to consider their impacts on the environment globally and be
willing to make changes.

The global nature of sustainability issues

 International cooperation is required in order to find sustainable solutions to global
issues; for example, the widespread use of vaccinations.
 A sufficient percentage of people must be vaccinated globally for viral diseases to be
eradicated.
 After Edward Jenner developed the smallpox vaccine in 1796, vaccination programmes
were steadily employed from the mid- to late-1800s in European and North American
countries.
 A major international push led by the World Health Organization, starting in
1967, resulted in the last case of smallpox occuring in 1977.
 For a country to benefit from herd immunity, the WHO advises that 90 per cent of the
population must be inoculated.
 Vaccines are an example of positive externalities of consumption.
 The external benefits of people consuming vaccinations are not just limited to people in
the local area, but in the entire country and in other countries too.
 Therefore, a global effort is required in order to roll out a sustainable vaccine programme
successfully.

Case study

The climate crisis in Tuvalu

Tuvalu is an island nation in the Pacific Ocean. Its land mass occupies 26 km2 and its population
is 11 000. Its gross domestic product is USD 39 million.

28
 Figure 1. Funafuti, the main island of Tuvalu.
Credit: Getty Images Ashley Cooper
 The climate crisis will affect this country in one of the most extreme ways: by making it
disappear entirely.
 Already, the sea water level is rising so that it floods much of the country’s arable land
regularly.
 Nothing can grow when the ground is saturated with salt. Tuvalu’s highest point is only
4.6 metres above sea level. Some scientists estimate that Tuvalu will disappear within the
next 50 years.
 None of this is Tuvalu’s fault, however. It produces no significant carbon emissions and
barely contributes anything to the climate emergency.

Consider the following questions:

 What do you think Tuvalu’s government can do in the coming years to mitigate some
of the effects of climate change?
 What role should Tuvalu play in climate negotiations?

 Countries have also had to cooperate in order to try and agree to a set of policies that will
halt and reverse the effects of climate change.
 The first of such meetings was the 1992 Earth Summit held in Rio de Janeiro, Brazil.
 Countries subsequently adopted the Kyoto Protocol in 1997, which was largely seen as
unsuccessful due to China and the United States not participating.
 Current promises as agreed by the Paris Agreement (Conference of the Parties 21, or
COP21) will limit the temperature increase to 2°C compared to pre-industrial levels.
 To limit warming further, much more commitment is needed.

29
  Carbon emissions cause air pollution, which is a negative externality of production with
the marginal social costs being experienced by the whole planet.
 Island nations in the Pacific Ocean are suffering from rising sea level that they are not
responsible for in any way.

Challenges faced in international cooperation

1. Lack of shared responsibility

 Not all countries are responsible for the carbon emissions that have caused climate
change.
 Some countries will experience the consequences of climate change much more than
others, particularly those with low-lying coastal regions, like the Netherlands,
Bangladesh and the Pacific Islands.
 This makes coming to an agreement on how to approach the problem very difficult. The
countries most affected will want the biggest international response, and the countries
most to blame will likely drag their feet.

2. Inequality of resources
 The inequality of resources between countries is to blame for the slow policy response
since the 1990s.
 At the time, China did not have to adhere to the Kyoto Protocol because it was
considered a developing country, despite being a major polluter.
 Developing countries were exempt from the agreement, and only developed countries
were bound to restrict emissions.
 Developing countries were not considered to have the resources to dedicate to the effort.
In total, there were 41 countries and the European Union who participated in the
agreement.
 Countries with significant poverty challenges often argue that it is difficult to choose
between climate change prevention measures and development policies such as increased
electricity provision.
 For example, approximately 304 million people in India live without electricity
(Washington Post).
 It would be difficult to transition away from existing coal or other polluting energy
industries without significant investment.

3. Political disagreements
 Disagreements in what methods should be employed and which will be most effective is
a challenge.
 Governments always have different views as to whether taxes should be used or whether
the government should legislate.
 Some governments are more committed than others to reducing environmental damage
with appropriate taxation policies.

30
4. Monitoring and enforcement
 It is difficult to get all countries to work together. Supranational organisations, such as
the Intergovernmental Panel on Climate Change (IPCC) and the United Nations, can play
a vital role.
 The IPCC was formed in 1988 in order to provide all governments with ‘scientific
information that they can use to develop climate policies’.
 The reports that they produce usually serve as the basis for discussions during
international policy negotiations, such as the Paris Climate Agreement.
 Most countries are members of this organisation.
 In 2007, the IPCC was awarded the Nobel Peace Prize for their work on publishing and
sharing information about climate change, as well as helping to facilitate the measures
that need to be taken to prevent climate change.
 While the IPCC has done a lot to improve the transparency of information surrounding
the climate debate, there are still some criticisms of the organisation:
 Some argue that the estimate put together by the IPCC are conservative.
 The IPCC does not carry out its own research.
 There have been some incidents of misrepresentation of data.

Case study

The European Union's emissions trading scheme

Figure 4. The current president of the European Commission, Ursula von der Leyen. The EU
promises to be carbon neutral by 2050.
Source: "EPP Summit, Brussels, 12 December 2019 (49208409236)" by European People's Party is licensed under CC BY 2.0

31
The European Union has implemented an emissions trading scheme since 2005. Countries agree
to national caps of emissions, which are approved by the EU. Each country is responsible for
monitoring the emissions by industries in their respective countries. Firms are allowed to trade
permits privately, using a broker or on a climate exchange. The EU must be informed when
permits are sold.

Consider these questions:

 Do you think this is an effective system? Why/why not?

 Can you suggest any improvements?
 What does its effectiveness depend on?

What you should know

By the end of this subtopic 2.8 Market failure – externalities and common pool resources,
you should be able to:

 Be familiar with the following terms: market failure, allocative efficiency, merit
goods, externality, demerit goods, negative externalities of production, positive
externalities of production, positive externalities of consumption, negative
externalities of consumption, emissions trading or cap and trade schemes,
sustainability, sustainable development, common pool (or access) resources, carbon
tax, pigouvian taxes, collective self-governance, tradable emissions permits, welfare
loss.

The meaning of market failure and externalities

 Analyse the concept of market failure as a failure of the market to achieve allocative
efficiency, resulting in an over-allocation of resources (over-provision of a good) or an
under-allocation of resources (under-provision of a good).
 Describe the concepts of marginal private benefits (MPB), marginal social benefits
(MSB), marginal private costs (MPC) and marginal social costs (MSC).
 Describe the meaning of externalities as the failure of the market to achieve a socially
optimal output where MSB = MSC.

Negative externalities of production and consumption

 Explain, using diagrams and examples, the concepts of negative externalities of

production and consumption, and the welfare loss associated with the production or
consumption of a good or service.
 Explain that demerit goods are goods whose consumption creates external costs.
 Evaluate, using diagrams, the use of policy responses, including market-based policies
(taxation and tradable permits) and government regulations, to the problem of
negative externalities of production and consumption.
32
Positive externalities of production and consumption

 Explain, using diagrams and examples, the concepts of positive externalities of

production and consumption, and the welfare gain associated with the production or
consumption of a good or service.
 Explain that merit goods are goods whose consumption creates external benefits.
 Evaluate, using diagrams, the use of government responses, including subsidies,
legislation, advertising to influence behaviour and create awareness, and the direct
provision of goods and services.
 Calculate the welfare gain from a diagram (HL).

Common access resources and the threat to sustainability

 Describe, using examples, common access resources.

 Describe sustainability.
 Explain that the lack of a pricing mechanism for common access resources means that
these goods may be overused/depleted/degraded as a result of activities of producers
and consumers who do not pay for the resources that they use, and that this poses a
threat to sustainability.
 Explain, using negative externalities diagrams, that economic activity requiring the
use of resources such as fossil fuels to satisfy demand poses a threat to sustainability.
 Explain that the existence of poverty in economically less-developed countries creates
negative externalities through over-exploitation of land for agriculture, and that this
poses a threat to sustainability.
 Evaluate, using diagrams, possible government responses to threats to sustainability,
including legislation, carbon taxes, cap and trade schemes, and funding for clean
technologies.
 Explain, using examples, that government responses to threats to sustainability are
limited by the global nature of the problems and the lack of ownership of common
access resources, and that effective responses require international cooperation,
monitoring and enforcement.

33