Edexcel IAL Market Failure Revision Notes

A negative externality is a cost imposed on a third party not directly involved in a transaction (1 mark), which arises as a side effect of production or consumption (1 mark). For example, factory pollution harms local residents' health and property values (1 mark). Because the external cost is not reflected in the market price, the good is overproduced relative to the socially optimal level (1 mark).

Reason 1: Non-excludability (1 mark) — it is not possible to prevent non-payers from benefiting from the good, such as street lighting or national defence (1 mark). This means firms cannot charge a price and would make losses, so they have no incentive to supply (1 mark). Reason 2: Non-rivalry (1 mark) — one person's consumption does not reduce availability for others, so the marginal cost of an additional user is zero (1 mark). This leads to the free-rider problem — rational consumers will not voluntarily pay, expecting others to fund provision (1 mark).

Define demerit goods as goods that are over-consumed because consumers underestimate the private costs or ignore the negative externalities (2 marks). Arguments for intervention: information failure — consumers may not understand the health risks of tobacco or alcohol, leading to overconsumption (2 marks); negative externalities — e.g. passive smoking and alcohol-related crime impose costs on third parties (2 marks); the social marginal cost exceeds the private marginal cost, so the free market overproduces relative to the social optimum (2 marks). Methods include taxation, regulation or education campaigns (1 mark). However, there is debate about paternalism and the extent to which government should override individual choice (1 mark).

Introduction: Define negative externalities of production and explain why they cause market failure — the social cost exceeds the private cost, leading to overproduction (2 marks). For taxation: A Pigouvian tax can internalise the externality by raising the private cost to equal the social cost (3 marks); generates government revenue that can fund clean-up or compensate affected parties (2 marks); allows market forces to operate — firms decide how to reduce output or invest in cleaner technology (2 marks). Against — limitations of taxation: Difficult to set the correct tax rate because externalities are hard to quantify (2 marks); may be regressive, hitting poorer households harder (2 marks); firms may pass the cost to consumers rather than reducing output (1 mark). Alternative methods: Regulation — outright bans or emission limits can be more certain in reducing pollution (2 marks); tradable pollution permits — create market incentives with a guaranteed cap on emissions (2 marks). Evaluation: Taxation is effective but not always the most effective method. The best approach depends on the externality — for measurable, widespread externalities like carbon emissions, taxation or permits may work best; for toxic waste, regulation may be more appropriate (2 marks).