Market failure: externalities and common pool or common access resources: notes and practice questions
- This topic covers market failures arising from externalities and common pool or common access resources, and government responses.
- Allocative efficiency is achieved when marginal social benefit (MSB) equals marginal social cost (MSC).
- Externalities are costs or benefits to third parties not involved in the production or consumption of a good or service.
- Negative externalities of production or consumption lead to overproduction or overconsumption relative to the socially optimum output.
- Positive externalities of production or consumption lead to underproduction or underconsumption.
- Common pool resources are rivalrous but non-excludable, often leading to the tragedy of the commons.
- Government interventions include indirect (Pigouvian) taxes, carbon taxes, legislation, education, tradable permits, subsidies, and government provision.
How it is examined
Extremely common. May 2025 Paper 3 Q1(a)(ii) asked for a diagram plus explanation of market failure in the market for gym memberships and expected a positive externality of consumption diagram with MPB below MSB, for 4 marks. The externality diagram is a recurring Paper 2 part, and the AO3 rows carry Paper 1 part (b) questions on whether government policy actually corrects the failure.
- Socially optimum output, where marginal social benefit equals marginal social cost, giving allocative efficiency and maximised social or community surplus. (AO2, AO4)
- Positive externalities of production and of consumption, and the resulting welfare loss. (AO2, AO4)
- Merit goods. (AO2, AO4)
- Negative externalities of production and of consumption, and the resulting welfare loss. (AO2, AO4)
Calculating welfare loss from a diagram. (AO4)
Guiding questions
- Where the market's private calculation misses a social cost or benefit, what goes wrong and what can be done?
Linking questions
- Sits on top of the surplus framework from 2.3.
- The tax and subsidy diagrams overlap with 2.7 but here they are aimed at a divergence between private and social cost, not at revenue or support.
- Carbon taxes and tradable permits are also 4.7 sustainable development content.
- Merit goods link to 4.10, provision of merit goods as a development strategy.
Practice questions
12 questions · 1 medium · 11 hardQuestion 1
MediumPaper 1 · no calculator25 marksGovernments intervene in markets to correct market failures and to influence the consumption of certain goods and services.
Explain one policy that could be used to correct a market failure and one policy that could be used to influence consumption.
Using real-world examples, evaluate the effectiveness of a government imposing a maximum price (price ceiling) on a particular good or service.
For the first policy, think about externalities. What kind of policies can address the difference between private costs/benefits and social costs/benefits? For the second policy, consider merit and demerit goods. How can a government encourage or discourage their consumption?
Start by explaining how a price ceiling works using a diagram. Then, consider its effects on different stakeholders (consumers, producers, government). For your evaluation, think about the intended goals of the policy versus its unintended consequences, such as shortages and black markets. Use a specific real-world example, like rent control or a cap on fuel prices, to support your arguments.
Question 2
HardPaper 1 · no calculator25 marks(a) Distinguish between negative externalities of production and negative externalities of consumption.
(b) Using real-world examples, evaluate the view that indirect taxes are a more effective policy than government regulations for correcting the market failure associated with demerit goods.
Start by defining a negative externality. Then, explain the difference between one that arises from the production process and one that arises from the act of consuming a good. Use a different diagram and a different example for each.
Analyse how both indirect taxes and regulations work to reduce consumption of demerit goods. For your evaluation, consider the strengths and weaknesses of each policy. Think about issues like efficiency, government revenue, fairness, and ease of implementation. Use examples like taxes on cigarettes versus bans on smoking in public places.
Question 3
HardPaper 1 · no calculator25 marks(a) Explain how the production of goods with negative externalities leads to a misallocation of resources and market failure.
(b) Using real-world examples, discuss the effectiveness of government policies, such as regulation and tradable permits, in correcting market failures arising from negative externalities of production.
Start by defining the key terms: negative externalities, market failure, and misallocation of resources. Then, draw a diagram showing the marginal private cost (MPC), marginal social cost (MSC), and marginal social benefit (MSB). Use the diagram to explain why the free market produces a quantity that is greater than the socially optimal quantity, leading to a welfare loss.
Start by explaining how government policies like regulation (e.g., setting pollution limits) and tradable permits (cap and trade) aim to solve the problem of overproduction. For each policy, consider its advantages and disadvantages. For example, how easy is it to implement? What are the costs? Does it create the right incentives? Use specific real-world examples, like the EU's carbon trading scheme or national laws on industrial emissions, to support your arguments.
Question 4
HardPaper 1 · no calculator25 marks(a) Explain two non-price determinants that could increase the market supply of a good.
(b) Using real-world examples, evaluate the effectiveness of providing subsidies to producers to increase the consumption of merit goods.
Think about what makes it cheaper or easier for a firm to produce a good. Consider factors related to costs, technology, and government actions. Remember to show the effect on a supply curve diagram.
Start by defining a merit good and explaining why it is under-consumed in a free market. Then, explain how a subsidy works. For your evaluation, consider the pros and cons of using subsidies from the perspective of different stakeholders (consumers, producers, government) and the economy as a whole. What are the challenges in implementing this policy effectively? Make sure to use a specific real-world example.
Question 5
HardPaper 1 · no calculator25 marks(a) Using a production possibilities curve (PPC) diagram, explain the difference between actual economic growth and potential economic growth.
(b) Using real-world examples, evaluate the view that imposing an indirect tax is the most effective government response to the market failure arising from industrial pollution.
Start by drawing a standard PPC diagram. Think about what a point inside the curve represents versus a point on the curve. Then consider what would cause the entire curve to move. How do these two different types of change on the diagram relate to 'actual' versus 'potential' growth?
First, explain why industrial pollution is a market failure, using the concept of negative externalities of production. Then, analyze how an indirect tax can address this. To evaluate, you must consider the weaknesses of this policy and compare its effectiveness to at least one alternative policy, such as tradable permits or government regulation. Use real-world examples to support your arguments.
Question 6
HardPaper 1 · no calculator25 marks(a) Explain how an increase in the price of gasoline (petrol) might affect the price and output of electric vehicles and of home charging stations.
(b) Using real-world examples, evaluate the view that imposing an indirect tax on gasoline (petrol) is the most effective way for a government to reduce air pollution from road transport.
Start by defining substitute and complement goods. Then, consider the relationship between gasoline-powered cars and electric vehicles. How does a change in the cost of using one affect the demand for the other? Finally, think about the relationship between electric vehicles and the equipment needed to run them.
To evaluate this view, you need to consider both the strengths and weaknesses of a gasoline tax. Explain how it is intended to work using the concept of negative externalities. Then, critically assess its effectiveness. Crucially, the question asks if it is the 'most effective' way, so you must compare it with alternative policies designed to achieve the same goal.
Question 7
HardPaper 1 · no calculator25 marks(a) Explain why negative externalities of production, such as industrial pollution and noise from airports, may lead to market failure.
(b)
Using real-world examples, evaluate the view that government regulation is the most effective way to deal with the negative externalities of production.
Start by defining market failure and negative externalities. Then, use a diagram to show how the market equilibrium differs from the socially optimal equilibrium when external costs are present. Apply this theory to both industrial pollution and airport noise.
Start by explaining how government regulations (e.g., emission standards) can address negative externalities. Then, evaluate the strengths and weaknesses of this approach. To provide a balanced argument, you must also consider and evaluate alternative policies, such as indirect taxes or tradable permits. Use real-world examples to support your points.
Question 8
HardPaper 1 · no calculator25 marks(a) Explain two reasons why a government might choose to subsidize the production of a good or service.
(b) Using real-world examples, discuss the view that government regulation is the most effective policy to correct market failures arising from negative externalities.
Think about situations where the market, left on its own, produces too little of something. What are these situations called? Also, consider non-economic reasons or goals a government might have for supporting certain industries or consumers.
Start by explaining how government regulation works to address negative externalities. Then, to 'discuss' the view, you must consider both sides. What are the strengths of regulation? What are its weaknesses? Compare its effectiveness to other policies like indirect taxes or tradable permits, using real-world examples for each policy you mention.
Question 9
HardPaper 2 · calculator40 marksRead the extracts and answer the questions that follow.
Text A, Overview of the economy and government policies in Vietnam
1 Vietnam has one of the fastest-growing economies in Asia, driven by strong exports and high levels of foreign direct investment (FDI). This growth has transformed the country, lifting millions out of poverty. Major multinational corporations have established large-scale manufacturing facilities, particularly in electronics and textiles, turning Vietnam into a key hub in global supply chains.
2 This rapid industrialization, however, has created challenges. Inflation has become a persistent concern, fueled by rising domestic demand and higher global energy prices. The economy's heavy reliance on imported raw materials and components makes it vulnerable to supply chain disruptions and currency fluctuations.
3 To support its transition to a higher-value economy, the government has offered various incentives. For instance, it provides a subsidy to domestic producers of electric vehicles (EVs) to encourage green technology and reduce reliance on imported fossil fuels. The government has also been actively managing its currency, the Vietnamese dong (VND), to maintain export competitiveness.
Text B, Labour market and social development in Vietnam
1 Vietnam's economic boom has led to a significant structural shift, with millions of workers moving from agriculture to the industrial and service sectors. To ensure a basic standard of living, the government regularly increases the minimum wage. In 2022, the minimum wage was raised by an average of 6%.
2 While poverty has fallen dramatically, inequality is a growing concern. There is a widening gap in income and opportunities between major urban centres like Ho Chi Minh City and Hanoi, and the more remote, rural provinces. Although youth literacy rates are high, there is a recognized skills gap, where the education system is not fully equipping graduates for the demands of the modern high-tech manufacturing sector.
Text C, Vietnam's trade integration and environmental challenges
1 Vietnam is a member of numerous free trade agreements, including the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) and the Regional Comprehensive Economic Partnership (RCEP). These agreements have boosted exports but also increased competition for domestic firms.
2 The environmental cost of industrialization is becoming increasingly apparent. Air and water pollution in industrial zones are significant problems, creating negative externalities that affect public health and long-term sustainability. The government acknowledges these issues and has set ambitious targets for renewable energy, aiming to attract FDI into solar and wind power projects.
Table 1: Selected macroeconomic data for Vietnam
| 2016 | 2022 | |
|---|---|---|
| Real GDP (USD billion) | 205 | 409 |
| Inflation rate (%) | 2.7 | 3.2 |
| Unemployment rate (%) | 2.3 | 2.3 |
| GNI per capita (USD) | 2190 | 4010 |
Table 2: Vietnam's current account, 2023 (billions of USD)
| 2023 | |
|---|---|
| Exports of goods | 355 |
| Imports of goods | 330 |
| Balance of trade in services | –10 |
| Primary income | –20 |
| Secondary income | 15 |
| Current account balance |
Table 3: Development and trade data for Vietnam
| 2016 | 2022 | |
|---|---|---|
| Population (million) | 93 | 99 |
| Gini coefficient | 0.344 | 0.357 |
| FDI inflows (USD billion) | 12.6 | 15.7 |
(a) (i) Define the term subsidy indicated in bold in the text (Text A, paragraph 3).
(a) (ii) Define the term Gini coefficient indicated in bold in Table 3.
(b) (i) Using information from Table 2, calculate Vietnam's balance of trade in goods for 2023 in billions of USD.
(b) (ii) Using information from Table 2 and your answer to part (b)(i), calculate Vietnam's current account balance for 2023 in billions of USD.
(b) (iii) Sketch a demand and supply diagram to show the effect of a subsidy on the market for electric vehicles in Vietnam (Text A, paragraph 3).
(c) Using an AD/AS diagram, explain how an increase in foreign direct investment (FDI) could affect economic growth in Vietnam (Text A, paragraph 1).
(d) Using a Lorenz curve diagram, explain the change in income inequality in Vietnam between 2016 and 2022 as shown in Table 3.
(e) Using an externalities diagram, explain how industrial production can lead to market failure in Vietnam (Text C, paragraph 2).
(f) Using an exchange rate diagram, explain how a rise in export revenue could affect the value of the Vietnamese dong (VND).
(g) Using information from the text/data and your knowledge of economics, discuss the challenges Vietnam faces in achieving sustainable economic development.
Think about what a government gives to a firm to help it produce more or sell at a lower price. What is the nature of this financial support?
This is a numerical measure of income inequality. How is it derived and what do its extreme values (0 and 1) represent?
The balance of trade in goods is the value of goods exported minus the value of goods imported.
The current account balance is the sum of the balance of trade in goods, the balance of trade in services, primary income, and secondary income.
A subsidy lowers the cost of production for firms. How does this affect the supply curve? Show the new equilibrium price and quantity.
FDI is a form of investment. Which component of aggregate demand (AD) does investment fall under? How would an increase in this component affect the AD curve and, consequently, real GDP?
First, look at the Gini coefficient data in Table 3. Did it increase or decrease? What does this mean for income inequality? Then, draw a Lorenz curve diagram showing two curves, one for 2016 and one for 2022, that reflects this change.
Industrial production often creates pollution. Is pollution a cost to the producer or to society? This creates a divergence between private costs and social costs. Illustrate this on a diagram and explain why it leads to overproduction.
When Vietnam's export revenue rises, what must foreigners do to pay for these exports? Does this affect the demand for or supply of the Vietnamese dong? Show the effect on an exchange rate diagram.
Sustainable development has economic, social, and environmental dimensions. Use the stimulus material to identify challenges in each of these areas (e.g., inflation, inequality, pollution). Then, consider any mitigating factors or policies mentioned. Conclude with a balanced judgement on the severity of these challenges.
Question 10
HardPaper 1 · no calculator25 marks(a) Explain how the imposition of an indirect tax on products with high sugar content could address the market failure associated with their consumption.
(b) Using real-world examples, discuss the view that government-led health information campaigns are the most effective policy for encouraging healthier eating habits.
Start by identifying the type of market failure caused by consuming high-sugar products. Then, draw a diagram to show the market before and after the tax, and explain how the tax helps to correct the over-consumption.
Consider what type of market failure is associated with 'healthier eating habits'. Explain how information campaigns work. Then, evaluate their effectiveness against other policies like subsidies for healthy food or regulation. Use specific country examples to support your arguments.
Question 11
HardPaper 1 · no calculator25 marks(a) Explain why the price elasticity of supply for many primary commodities is relatively low, while for many manufactured goods it is relatively high.
(b) Using real-world examples, evaluate the view that market-based policies are the most effective way to deal with the negative externalities of production.
Start by defining price elasticity of supply (PES). Then, consider the key determinants of PES, such as the time period, ability to store stock, and spare capacity. Apply these determinants to both primary commodities (like agricultural products or minerals) and manufactured goods (like cars or smartphones) to build your explanation.
Start by explaining what a negative externality of production is, using a diagram. Then, describe market-based policies like carbon taxes and tradable permit schemes. To evaluate, you must compare these policies with an alternative, such as command-and-control regulation. Consider the pros and cons of each approach in terms of efficiency, effectiveness, and equity. Use real-world examples to support your arguments.
Question 12
HardPaper 1 · no calculator25 marks(a) Explain why the price elasticity of demand (PED) for a good, such as gasoline (petrol), is likely to be lower in the short run than in the long run.
(b) Using real-world examples, discuss the view that a government's ability to influence consumer behaviour through indirect taxation is heavily dependent on the price elasticity of demand.
Think about the determinants of PED. Which determinant is most relevant when comparing different time periods? Consider how consumers can change their behaviour over time in response to a price change.
Consider the two main goals of an indirect tax on a demerit good: to raise government revenue and to reduce consumption. How does PED affect the success of each of these goals? Use examples like taxes on tobacco, alcohol, or sugary drinks.
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Where marks are lost
- No real-world example, or a stated one. An answer that names a country and stops cannot reach the top two bands.
- One-sided argument. Balance is an explicit axis. A student who argues only that a policy works is capped at 9 out of 15 on that axis alone.
- Diagram present but not explained. The diagram bullet escalates across three bands: included, included and explained, included and fully explained. A diagram dropped into an answer without prose that refers to it sits at 5 to 6 on a 10-mark part.
