ECONOMICS SL
Market Failure
Name___________________
April 23, 2012
1. Explain why negative externalities are an example of market failure. (10
marks) (November 2010)
INSTRUCTIONS: This question is taken from a past paper, which means that
you should write it in essay form. Remember: define relevant economic terms,
include correctly labelled diagrams, explain and refer to your diagrams in the
text and, if appropriate, include examples. BUT, first of all: read the question
carefully!!
Market failure refers to the failure of the market to allocate resources efficiently. It results in
allocative inefficiency, where either too much or too little of the good is produced and
consumed in relation to what is socially desirable.
A negative externality occurs when the actions of consumers or producers have a negative
side effect on third parties, who are not part of these actions. For example, a cement factory
creates a negative externality on society derived from the production of cement because it
pollutes the air. The consumption of cigarettes creates a negative externality of consumption
because of the costs that smoking has on third parties, such as the effects of passive smoking
and the extra health costs generated by smoking related diseases.
The diagram below illustrates a negative production externality, caused, for instance, by a
cement factory. The supply curve represents the marginal private costs (MPC) incurred by
the factory. In the absence of externalities, these are equal to the marginal social costs
(MSC). However, as the cement factory produces external costs in the form of pollution, the
MSC are larger than the MPC by the amount of the externality, ie, MSC = MPC + externality.
The externality is equal to the vertical distance between both curves.
The quantity of cement considered to be optimal from a social point of view, Qopt, is
determined by the intersection of the MSB and MSC curves. This level of output and its
corresponding price Popt takes into account the external costs produced by the cement
factory. In the absence of externalities (when MPC=MSC and MPB=MSB), the quantity
determined by the free market (by the intersection of the MPC and MPB curves) is equal to
the social optimum, Qopt, and allocative efficiency is achieved. However, in the presence of
externalities they differ. In our case, the quantity determined by the free market is larger
than the social optimum (Qm>Qopt) and there is overallocation of resources to the production
of cement. At Qm, the MSC of producing one more unit of the good is larger than the MSB, so
society would be better off by producing less. That is, the free market produces too much
cement in relation to what is socially optimal. Therefore, in the presence of negative
externalities from production, the free market fails to achieve allocative efficiency and for
this reason it constitutes an example of market failure.
Market for cement
P
MSC
externality
S=MPC
C
Popt
Pm
D=MPB=MSB
Qopt
Qm
Q
2. Define the following terms and give one example of each (2 marks each):
Demerit good
Public good
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