Market Failure & Externalities

Allocation of Resources · 5 question types

Practise

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Exam Frequency Analysis

Past paper frequency (2018 to 2024)

This topic accounts for approximately 11% of your exam marks.

increasing

Medium

Increasing11%

Externalities and market failure corrective policies are increasingly tested; particularly in evaluate questions since 2020.

Two intervention tools that need separate diagrams.

Maximum price (price ceiling)

A maximum price is a legal price cap below the free-market equilibrium. Sellers cannot legally charge more.

Quantity supplied contracts (less profitable at a lower price).
Quantity demanded extends (cheaper, so more is wanted).
The result is a shortage (excess demand) at the legal maximum.

A maximum price P(max) set below the equilibrium P(e): quantity supplied contracts to Qs while quantity demanded extends to Qd, so the gap Qs to Qd is excess demand — a shortage — Source: Solutions to Market Failure: Maximum & Minimum Prices by Save My Exams

Used to protect consumers in essential markets: rent controls in a housing crisis, price caps on essential medicines, fuel price caps during shortages.

Advantages	Disadvantages
Lower prices protect low-income consumers	Shortages mean some buyers go without
Stabilises markets during emergencies	Black markets may emerge (illegal resale at higher prices)
Limits exploitation in rental and essential-goods markets	Reduces producer incentive to invest in supply

Minimum price (price floor)

A minimum price is set above the free-market equilibrium. Sellers cannot legally charge less.

Quantity supplied extends (more profitable at a higher price).
Quantity demanded contracts (more expensive, so less is bought).
The result is a surplus (excess supply) at the legal minimum.

A minimum price P(min) set above the equilibrium P(e): quantity demanded contracts to Qd while quantity supplied extends to Qs, so the gap Qd to Qs is excess supply — a surplus — Source: Price controls by Save My Exams

Used to support producers (agricultural floor prices) or to discourage consumption of a demerit good (minimum unit pricing for alcohol). The national minimum wage is a minimum price in the labour market designed to protect workers from low pay.

Advantages	Disadvantages
Producers receive a guaranteed income	Surplus output may need to be bought up by the government
Reduces consumption of demerit goods	Encourages over-production and waste
Minimum wage raises pay of the lowest paid	Higher costs may lead firms to lay off workers