0455

Market Failure & Externalities

Allocation of Resources · 5 question types

Practise

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.

Positive externalities require the opposite policy mix: encourage more production and consumption.

Producer subsidies

A subsidy is a payment from the government to the producer per unit of output. The subsidy lowers the producer's effective cost, shifts the supply curve to the right, lowers the market price and raises the quantity sold. This boosts the production of goods that generate positive externalities (e.g. solar panels, electric vehicles).

Like a tax, a subsidy is shared between producer and consumer. The split depends on price elasticity of demand: an inelastic good's subsidy mostly reaches consumers as a lower retail price; an elastic good's subsidy is mostly retained by producers.

A producer subsidy shifts supply right from S to S + subsidy, lowering price from P₁ to P₂ and raising quantity from Q₁ to Q₂; area A is the benefit passed to consumers, area B the benefit kept by producers, and A + B together is the total cost of the subsidy to the government
Source: Solutions to Market Failure: Indirect Taxation & Subsidies by Save My Exams

State provision

The government can simply provide the good itself, free at the point of use, funded through taxation. This is common for education and basic healthcare. State provision guarantees that everyone can access the good regardless of ability to pay, capturing the positive externality fully.