Market failure and externalities: key terms
15 terms. Say the definition out loud, tap to check, then say whether you knew it. Back to the topic
These cards were written by the site from the specification, mark schemes and examiners' reports and are being checked by our Economics tutor; tell us if you spot an error.
Market failure
A situation in which the free market allocates resources inefficiently, so that social welfare is not maximised.
Examiners say The types the specification names are externalities, under-provision of public goods and information gaps; a strong answer says which one applies before analysing.
Externality
A cost or benefit from production or consumption that falls on a third party who is not part of the transaction and is not reflected in the market price.
Examiners say Say 'third party' and 'not in the price': both ideas are needed for a complete definition.
External cost (negative externality)
A cost imposed on third parties by an economic activity, such as pollution from a factory or congestion from car use, so that social cost exceeds private cost.
Examiners say Reports credit 'negative externality' as a synonym for external cost, but a definition that only gives an example scores nothing.
External benefit (positive externality)
A benefit received by third parties from an economic activity, such as the wider gains from education or vaccination, so that social benefit exceeds private benefit.
Examiners say The one-mark 'define external benefits' question was answered well; the marks were lost later, when students confused it with a merit good's private benefit.
Private cost
The cost of an activity to the producer or consumer who carries it out, such as a firm's wages and raw materials or a driver's fuel.
Examiners say On the diagram this is the MPC curve: the supply curve of the free market.
Social cost
Private cost plus external cost: the full cost of an activity to society.
Examiners say MSC lies above MPC by the size of the external cost. The gap should be labelled as the externality, not left as two unexplained lines.
Private benefit
The benefit of an activity to the person who consumes or produces it, shown by the demand curve as the maximum they would pay.
Examiners say MPB is the demand curve. Examiners note students sometimes shift the wrong curve for a consumption externality.
Social benefit
Private benefit plus external benefit: the full benefit of an activity to society.
Examiners say For a positive consumption externality MSB lies above MPB; the free market under-consumes.
Social optimum
The level of output or consumption where marginal social cost equals marginal social benefit, which maximises welfare.
Examiners say The annotation question asked for the new social optimum after intervention: the mark was for marking the quantity where MSC crosses MSB, not just drawing a shift.
Welfare loss (deadweight loss)
The loss of total welfare that arises when output is above or below the social optimum, shown as the triangle between the MSC and MSB curves over the gap in quantity.
Examiners say Shade the triangle and say what its base and apex are. Reports describe a 'welfare loss triangle' drawn in the wrong place as the most frequent diagram error on this topic.
Over-production and over-consumption
The outcome of a negative externality in a free market: the market quantity exceeds the social optimum because producers or consumers ignore the external cost.
Examiners say Linking 'ignores external cost' to 'price too low, quantity too high' is the chain that earns the analysis marks.
Under-consumption
The outcome of a positive externality in a free market: the market quantity is below the social optimum because consumers do not take account of the external benefit.
Examiners say The Singapore education question was marked up for answers that tied the external benefits of education to under-consumption and therefore to a case for state provision.
Merit good
A good that is under-consumed in a free market because consumers under-value its private benefits or ignore its external benefits, such as education or healthcare.
Examiners say Merit goods are not on the Edexcel specification by name but appear in extracts; define them through information gaps or externalities, which are.
Demerit good
A good that is over-consumed in a free market because consumers under-estimate its harm or ignore its external costs, such as tobacco or alcohol.
Examiners say As with merit goods, route the analysis through the externality or the information gap.
Internalising an externality
Making the party that creates an externality bear its cost or receive its benefit, for example through a tax equal to the external cost or a subsidy equal to the external benefit.
Examiners say The phrase that lifts a tax or subsidy answer: it explains why the policy moves the market towards the social optimum.
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