Negative production externality on a diagram.

MSC lies above MPC; the market overproduces (Qm > Q*), with a welfare loss triangle pointing towards the optimum.

What is the tragedy of the commons?

Overuse and depletion of a common pool resource because individuals gain the full benefit of using it but share the cost.

Economics

2.8 Market failure - externalities and common pool resources

Externalities and common pool resources cause markets to produce too much or too little compared with the social optimum, where marginal social benefit equals marginal social cost. Study guide, 4 practice questions with markschemes and 3 flashcards. Free.

Socially optimum output: MSB = MSC · negative externalities of production and consumption · positive externalities of production and consumption · merit and demerit goods · common pool resources and tragedy of the commons · policy responses: Pigouvian taxes, carbon taxes, tradable permits, legislation, education · international agreements and collective self-governance · (HL) calculating welfare loss

Practise all 4 questions Study 3 flashcards

Study guide

The social optimum

Market prices reflect private benefits and costs. When a transaction affects third parties, social and private values differ. Marginal social benefit (MSB) = private benefit + external benefit; marginal social cost (MSC) = private cost + external cost. The socially optimal output is where MSB = MSC. A free market produces where MPB = MPC. If the two differ, there is market failure: resources are over- or under-allocated and a welfare loss results.

Negative externalities

Production (a factory polluting a river). Diagram in words: P on the vertical axis, Q horizontal. D = MPB = MSB slopes down. MPC (supply) slopes up, and MSC lies above it, the vertical gap being the external cost. The market produces at Qm (MPB = MPC); the optimum is Qopt (MSB = MSC), lower. The welfare loss triangle lies between MSC and MSB from Qopt to Qm, pointing towards the optimum.

Consumption (smoking near others, driving in congestion). Now MPC = MSC, and MSB lies below MPB. Again too much is consumed; the welfare loss triangle sits between MPB and MSB from Qopt to Qm.

Positive externalities

Production (a firm training workers who later work elsewhere; research spillovers). MSC lies below MPC. The market produces too little.
Consumption (vaccination, education). MSB lies above MPB. The market underconsumes; the welfare loss triangle lies between MSB and MSC from Qm to Qopt.

Merit and demerit goods

Merit goods (healthcare, education) are underconsumed because they create positive externalities and because people underestimate their personal benefits (imperfect information). Demerit goods (tobacco, alcohol, sugary drinks) are overconsumed for the opposite reasons.

Common pool resources

Common pool resources (fish stocks, forests, groundwater, the atmosphere) are rivalrous but non-excludable: one person's use reduces what is left, but it is hard to stop people using them. Each user gains from using more while the cost of depletion is shared, so overuse leads to the tragedy of the commons. This threatens sustainability: meeting present needs without harming future generations.

Policy responses

Pigouvian (indirect) taxes equal to the external cost shift MPC up to MSC. Carbon taxes charge per tonne of CO2. Strengths: revenue, incentive to cut pollution. Weaknesses: hard to value external costs, may be regressive, demand may be inelastic.
Tradable permits (cap and trade): a cap on total pollution, permits traded so cuts happen where they are cheapest. Certainty over quantity, but price volatility and setting the cap is political.
Legislation and regulation: bans, emission limits, quotas on fishing. Simple and clear but inflexible and costly to monitor.
Education and nudges: raise awareness of costs or benefits; slow and uncertain.
Subsidies and direct provision for positive externalities (free vaccines, funded schools).
International agreements for global problems, as no country can solve them alone, though free riding weakens them.
Collective self-governance: communities managing shared resources through local rules and monitoring, often effective where users know each other and can sanction rule-breakers.

(HL) Calculating welfare loss

Market output 400 units, price USD 30. MSB: $P = 70 - 0.1Q$; MPC: $P = -10 + 0.1Q$. External cost USD 10 per unit, so MSC: $P = 0.1Q$.

Optimum: $70 - 0.1Q = 0.1Q \Rightarrow Q = 350$, P = USD 35.
At Q = 400, MSC = 40 and MSB = 30, a gap of 10.
Welfare loss $= \frac{1}{2} \times (400 - 350) \times 10 = 250$.
A Pigouvian tax of USD 10 per unit moves output to 350.

Common mistakes

Pointing the welfare loss triangle the wrong way (it always points towards the optimum).
Mixing up which curve moves: production externalities affect cost curves; consumption externalities affect benefit curves.
Calling a common pool resource a public good. It is rivalrous.

Exam tips

10-mark questions: one accurate diagram, labels MSB, MSC, MPB, MPC, Qm, Qopt and shaded welfare loss, with explanation in context.
15-mark questions: compare at least two policies, consider effectiveness, cost, equity, enforcement and time scale, and end with a reasoned judgement.

Cheat sheet

MSC = MPC + external cost · MSB = MPB + external benefit
Market: MPB = MPC · Optimum: MSB = MSC

Externality	Curve moved	Result
Negative production	MSC above MPC	overproduction
Negative consumption	MSB below MPB	overconsumption
Positive production	MSC below MPC	underproduction
Positive consumption	MSB above MPB	underconsumption

Welfare loss (HL) = $\frac{1}{2} \times$ (Qm − Qopt) $\times$ gap between social curves at Qm
Optimal Pigouvian tax = external cost per unit at the optimum
Common pool: rivalrous + non-excludable → overuse
Policies: Pigouvian/carbon tax, permits, regulation, education, subsidies, international agreements, self-governance
Diagram checklist: label all four curves, Qm, Qopt, shaded triangle pointing to Qopt

Key definitions

Externality: A cost or benefit of production or consumption that falls on a third party not involved in the transaction.
Marginal social cost: The total cost to society of producing one more unit, equal to marginal private cost plus marginal external cost.
Marginal social benefit: The total benefit to society from one more unit, equal to marginal private benefit plus marginal external benefit.
Socially optimal output: The level of output at which marginal social benefit equals marginal social cost.
Merit good: A good that is underconsumed in a free market because people underestimate its benefits and it creates positive externalities.
Demerit good: A good that is overconsumed in a free market because people underestimate its harm and it creates negative externalities.
Common pool resource: A resource that is rivalrous but non-excludable, so it tends to be overused.
Tragedy of the commons: The depletion of a shared resource because individuals pursue their own gain while the costs of overuse are shared.
Pigouvian tax: A tax set equal to the external cost per unit to bring output to the socially optimal level.
Tradable permits: Permits that allow a set amount of pollution, which firms can buy and sell under an overall cap.

Practice questions

SLPaper 1Challenging

Question 1

(a) [10]

Using a diagram, explain why negative production externalities lead to market failure.

Markscheme

1 Defines the key economic terms used in the question accurately
2 Accurate diagram: MSC above MPC (supply), MPB = MSB, market output Qm greater than optimum Q*, welfare loss triangle shaded
2 Explains that firms do not pay for the external costs imposed on third parties
2 Explains that the market overproduces: output where MPC = MSB exceeds the socially optimal output where MSC = MSB
2 Explains that resources are overallocated, causing a welfare loss
1 Uses a real-world example, e.g. a cement plant releasing dust into a nearby town

(b) [15]

Evaluate the use of carbon taxes compared with tradable emission permits to reduce greenhouse gas emissions.

Markscheme

1 Defines carbon tax and tradable permits
2 Diagram(s): carbon tax shifting MPC up towards MSC, or permit market with fixed supply of permits
3 Explains how each policy internalises the externality by putting a price on emissions
2 Uses a real-world example of a carbon tax or permit scheme
2 Evaluates: a tax gives price certainty but not certainty about the quantity of emissions; permits fix quantity but the price can be volatile
2 Evaluates: difficulty of measuring external cost; risk that firms relocate to countries without the policy
2 Evaluates: effects on low-income households and use of revenue (e.g. rebates)
1 Reaches a supported conclusion

SLPaper 2Standard

Question 2

Extract: Low flu jab uptake worries doctors

Only 38% of adults in Ostria received a flu vaccine last winter. Doctors note that each person vaccinated also lowers the chance that elderly neighbours and colleagues become ill, but many young adults say the jab is "not worth the trip".

(a) [2]

Define the term merit good.

Markscheme

1 A good that is beneficial to consumers/society
1 and would be underprovided/underconsumed by the free market

(b) [4]

Using a diagram, explain why the free market leads to too few people being vaccinated against flu.

Markscheme

1 Diagram with MSB above MPB, MPC = MSC, market quantity below optimum
1 Welfare loss triangle identified
1 Explains the positive consumption externality: vaccinated people reduce infection risk for others
1 Explains that individuals consider only private benefits, so consumption is below the socially optimal level

(c) [2]

Explain one policy the government of Ostria could use to increase vaccination rates.

Markscheme

1 Identifies a policy, e.g. a subsidy, free provision or an information campaign
1 Explains how it moves consumption towards the social optimum (lower price raises quantity demanded, or information shifts MPB right)

HLPaper 3Challenging

Question 3

A chemical plant produces 500 tonnes per month in a free market, where MPC = MSB. Each tonne causes an external cost of $10 to local residents (constant). At the socially optimal output, 400 tonnes would be produced.

(a) [2]

Calculate the welfare loss caused by the externality.

Markscheme

1 Triangle with height $10 (external cost per unit) and base 500 − 400 = 100 units
1 Welfare loss $= \frac{1}{2} \times 10 \times 100 = 500$

(b) [1]

State the size of the per-unit tax that would achieve the socially optimal output.

Markscheme

1 $10 per unit (equal to the marginal external cost)

(c) [2]

Explain one reason why it may be difficult for a government to set this tax at the correct level in practice.

Markscheme

1 Identifies a difficulty, e.g. external costs are hard to measure in money terms
1 Explains the consequence, e.g. a tax set too low still leaves overproduction, too high causes underproduction

Key facts

What is the socially optimal level of output?: Where marginal social benefit equals marginal social cost (MSB = MSC).
Negative production externality on a diagram.: MSC lies above MPC; the market overproduces (Qm > Q*), with a welfare loss triangle pointing towards the optimum.
What is the tragedy of the commons?: Overuse and depletion of a common pool resource because individuals gain the full benefit of using it but share the cost.