Allocation of Resources · 4 question types
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.
A cost imposed on third parties as a by-product of making the good. Social cost > private cost.
Examples:
Because the producer ignores the third-party cost, the market over-produces these goods at a socially inefficient level.
A cost imposed on third parties when consumers use the good. Social cost > private cost at the consumption stage.
Examples:
Because the consumer ignores the third-party cost, the market over-consumes these goods.
A benefit enjoyed by third parties as a by-product of producing the good. Social benefit > private benefit.
Examples:
Because the producer cannot capture the third-party benefit in revenue, the market under-produces these goods.
A benefit enjoyed by third parties when others consume the good.
Examples:
Because consumers cannot capture the third-party benefit themselves, the market under-consumes these goods.
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.