Market Failure & Externalities
Allocation of Resources · 5 question types
Exam Frequency Analysis
Past paper frequency (2018 to 2024)
This topic accounts for approximately 11% of your exam marks.
Externalities and market failure corrective policies are increasingly tested; particularly in evaluate questions since 2020.
An externality is a cost or benefit experienced by a third party that is not factored into the price paid by the buyer or received by the seller. Each externality is either positive or negative, and arises either from production or from consumption. That gives four combinations.
Negative externality of production
A cost imposed on third parties as a by-product of making the good. > .
Examples:
- A chemical plant discharges waste into a river; nearby residents and farms suffer.
- A cement factory creates noise and dust pollution for the surrounding neighbourhood.
- An electricity-generation plant burning coal raises CO₂ emissions and contributes to climate damage.
Because the producer ignores the third-party cost, the market over-produces these goods at a socially inefficient level.
Negative externality of consumption
A cost imposed on third parties when consumers use the good. Social cost > private cost at the consumption stage.
Examples:
- Passive smoking from cigarettes.
- Drink-driving from alcohol consumption.
- Litter from fast-food packaging.
- Noise pollution from loud parties.
Because the consumer ignores the third-party cost, the market over-consumes these goods.
Positive externality of production
A benefit enjoyed by third parties as a by-product of producing the good. > private benefit.
Examples:
- A bee-keeper produces honey; bees also pollinate neighbouring orchards (the orchard owners benefit free of charge).
- A pharmaceutical firm's research generates knowledge that other firms can use.
- A managed forest produces timber for sale but also absorbs CO₂ and provides habitat.
Because the producer cannot capture the third-party benefit in revenue, the market under-produces these goods.
Positive externality of consumption
A benefit enjoyed by third parties when others consume the good.
Examples:
- A person who is vaccinated against measles protects others by reducing transmission.
- A student who completes a university degree contributes higher tax payments and innovation to society.
- A neighbour who maintains an attractive garden raises the value of nearby houses.
Because consumers cannot capture the third-party benefit themselves, the market under-consumes these goods.
Why externalities mean market failure
The price mechanism only looks at private costs and benefits. Externalities are, by definition, outside that calculation. When they are present:
| Type of externality | Market outcome |
|---|---|
| Negative (production or consumption) | Over-production / over-consumption of the good |
| Positive (production or consumption) | Under-production / under-consumption of the good |
Either way, the free-market quantity is wrong from society's standpoint, and resources are misallocated.
Social cost, external cost and the social cost formula
What comes up: MCQ or short-answer questions asking for the definition of external cost or external benefit, or testing the formula.
Write: An external cost is a cost borne by third parties who are not the buyer or seller in the transaction — for example, harm to neighbours from a factory's pollution. Social cost = private cost + external cost. By the same logic, external benefit = social benefit − private benefit.
Watch out: External cost is a cost to a third party, not to the producer or consumer themselves. A mark-scheme MCQ specifically tests this: the tax on cigarettes and the harm to the smoker are private costs, not external costs — only the harm to non-smokers counts as an external cost.