Theme 2.

3 Market Failure

Negative externalities
 Pg 3

How it all adds up..

Central Economic Problem (Theme 1):

Scarcity, Choice, Opp cost
2 Microeconomic
objectives of the
Price Mechanism (Theme 2.1): government:
Interaction of DD & SS → allocative 1. Equity
efficient 2. Efficiency

Our focus is on
BUT market outcomes could be allocative efficiency
allocative inefficient → Market in this topic!
Failure (Theme 2.3)
2
 Memorise the definitions of
Market Failure
Occurs when free the key concepts shown here!

market is…
Allocative inefficient
Due to…

Information Public Factor

Externalities
failure Goods Immobility
Only 2 causes Market
that need Asymmetric
dominance
diagrammatic Information
analysis in this Theme 2.2 Firms and Decisions
set of notes

Govt intervention & possibility of Govt Failure

3
 Pg 4 - 5

Note the differences!

DD/SS Diagram Benefit-Cost Diagram (MSC/MSB diagram)
Price, Benefit, Cost
Price MPC=MSC
Supply

P P

Demand MPB=MSB
0 Q Quantity 0 Q Quantity
Perspective-taking:
Consumers and Producers Perspective-taking:
Consumers or Producers
 Pg 4

How do we determine when a market fails?

◉ When is allocative
efficiency achieved? Recall: Theme 1 marginalist
➔ when resources are principle in rational decision-
making (MB vs MC)
allocated to produce
the combination of
goods and services MSC = MSB ➔
Allocative efficient!
most wanted by
Q* = socially
society ➔ society’s optimal qty
welfare maximised!
5
 Pg 4

How do we determine when a market fails?

◉ Market fails when
there is allocative
inefficiency! ➔
society’s welfare is
NOT maximised (there
At Q1 or Q2,
is deadweight loss) MSC ≠ MSB ➔
Allocative
inefficient!

6
Think about it – Qn 1 Did you copy the suggested answer from SLS? Pg 7

In Theme 2.1, you learnt about government intervention measures

such as subsidies, and maximum and minimum prices. In the
context of Theme 2.1, the main use of the above measures is to
improve equity in the market. True or False? Why?
True! Theme 2.1 → assumed no market failure! Market is allocative
efficient but objective of govt policies is to improve equity (e.g.
subsidies or price ceiling to improve affordability for consumers, or
price floor to protect producers' income and revenue). (Tradeoff: govt
intervention results in DWL i.e. allocative inefficiency )

Theme 2.3 → there is market failure present! Market is allocative

inefficient. We will be revisiting policies such as subsidies but objective
of govt policies is to achieve allocative efficiency.
 Negative
Externalities
8
The Adventures of Huck the Duck and Fin the Fish

https://www.youtube.com/watch?v=YHFp4coU69g

9
 Pg 8
Your qn from SLS:
Why do third parties only apply to economic
Negative Externalities agents and not others for example, as
earlier mentioned, birds? Do animals not
suffer from the costs?
◉ Spillover costs to third parties (economic agents who are
not directly involved in the consumption or production of
the good or service itself.)
◉ Aka external costs
◉ These costs are not internalised (i.e. not taken into
account) by consumers or producers in their decision-
making process
10
 Identifying the act that generates the negative externalities is
important in your analysis
Examples of negative externalities Examples of negative externalities
from Consumption (analyse from from Production (analyse from
consumers’ point of view) producers’ point of view)

11
 Identifying the act that generates the negative externalities is
important in your analysis
Examples of negative externalities Examples of negative externalities
from Consumption (analyse from from Production (analyse from
consumers’ point of view) producers’ point of view)
Your qns from SLS:
▪ Why is the diagram presented for Negative externalities in Production and
Consumption the same, apart from the labelling of the x-axis?

▪ is it possible that both production and consumption of a singular good results in

production and consumption negative externalities and what is its impact of
societal welfare

▪ Can there be a graph for things that are not consumed or produced like
pollution because how can there be a socially optimal production and a private
optimum production quantity for pollution when nobody consumed or produces
pollution 12
 Common question types for Negative Externalities
◉ Explain why a government intervenes in the market for car usage.

◉ Explain why there is a misallocation/an inefficient allocation of resources

in the market for _______.

◉ Explain why the market for _____ fails in the free market.

◉ Explain why when left on its own, there will be overconsumption /

overproduction in the market for _____.

The underlined words can be easily substituted with different contexts.

13
 2020 A Level EQ1

Discarded plastic and carbon emissions are among the biggest causes of
pollution. The environmental damage to the air and water runs into billions of
dollars. This affects not only our health but also our food supply.

Adapted from: Kimberly Amadeo, How Air, Water and Plastic Pollution Affect the
Economy, 18 June 2019

(a) Explain how pollution leads to market failure. [10] Cause → Process → Effect
question
(b) Discuss the extent to which government policy measures are likely to
address this market failure. [15] Policy type question
14
 Pg 9-10

P E T, D Q Q D
For Cause (externalities) → Process → Effect question

Step 1: Contextualise using PET PET must be contextualised to

• P – private benefits and cost the situation in the question
• E – externalities (external cost = MEC)
• T – third parties

Step 2: Using DQQD to explain how deadweight loss arises

with diagram
• D – divergence (MSC > MPC because MSC = MPC + MEC)
• QQ – Qp, Qs (Qp > Qs)
• D – deadweight loss DQQD is standard stock
explanation for externalities ☺
15
 Explanation is similar to Section 4.1.1
(p.9) and Section 4.1.2 (p.10)
PET DQQD in action

Example: Explain how the use of plastic bags lead to market

failure. Always determine the nature of the activity generating
the externalities → production or consumption??

◉ [P] When deciding on how much plastic bags to consume,

consumers only consider their own private costs and
benefits. The MPB is the convenience derived from
consuming that additional unit of plastic bag, while the
MPC is the cost of an additional unit of plastic bag.
Analysis is from consumers’ point of view! 16
 Your qns from SLS:
• Does marginal external cost always have to
be monetary costs, or can it be in the form
of intangible costs e.g time?
PET DQQD in action
• How is the external costs quantified
• How to measure social cost more accurately

◉ [E] When consuming plastic bags, it can lead to additional

waste being improperly disposed, of leading to water
pollution and killing marine life. This will lead to a reduction
in total revenue and profits of third parties
Monetise the cost!
i.e. external costs
◉ [T] such as fishermen who fish in the area as their
livelihood. i.e. third parties Be specific who are the
third parties!
17
 PET DQQD in action
Price, Costs, Benefits MSC

◉ [D] The presence of Marginal External MPC

Cost (MEC) creates a divergence
Ps
between the Marginal Social Cost
(MSC) and Marginal Private Cost (MPC), Pp
MEC
where MSC > MPC. Diagrammatically,
the MSC curve lies above the MPC
MPB = MSB
curve by the amount of the MEC as
0
shown. Assuming that there are no Qs Qp Quantity of
positive externalities, the Marginal plastic bags

Private Benefit (MPB) = Marginal Social Notice we assume no

Benefit (MSB). positive externalities 18
 PET DQQD in action MSC
Price, Costs, Benefits
MPC
◉ [QQ] If left to the free market,
consumers consume Qp units Ps
of plastic bags, where MPB =
Pp
MPC. However, the socially MEC
optimal level of consumption is
Qs units, where MSB = MSC. MPB = MSB
Since Qp>Qs, there is 0
Qs Qp Quantity of
overconsumption of plastic plastic bags
bags.
Must explain how Qp and
Qs are determined
19
 PET DQQD in action
Price, Costs, Benefits
MSC
◉ [D] From Qp to Qs units, the total social c
MPC
cost (area QsacQp) exceeds the total
a
social benefits (area QsabQp). The Ps
shaded area ‘abc ‘represents the Pp b
deadweight loss which is the welfare MEC
loss to society. OR
MPB = MSB
◉ [D] For every additional unit of good
consumed from Qp to Qs, MSC>MSB. 0
Qs Qp Quantity of
This leads to a deadweight loss of area plastic bags
‘abc’ which represents the welfare loss
to society. 20
Can you spot what is not right with these diagrams?
Buzz with a friend!

The DWL triangle should

point towards Qs!

21
 Your questions from SLS

▣ do we need to know the extent of deviation of MPC and MSC? If yes,

how so

▣ is mpc ever 0
▣ why is MPC increasing if the additional costs of purchase one unit of
a good stays the same?

22
 Your questions from SLS

▣ will negative externalities ever be equal to positive externalities?

▣ if negative externality = positive externality, will the optimal social
level of a product be equal to if there were no externality whatsoever?
▣ if a good has both +ve and -ve externalities but on different third
parties and of different extents, how do we determine the MSC
▣ if MPC and MPB differ from MSC and MSB respectively, but still have
the same market equilibrium quantity just at different price, is such a
scenario considered to have allocative efficiency?
▣ given shortages in the market would msb > mpb on the negative
externalities graph
23
 Your turn to practise!

The bad and the ugly of Pokémon GO

◉ Pokémon Go, a location-based augmented reality game where players catch,
battle and train virtual creatures on their mobile devices, has now been
blamed for a problem: Rubbish. Loads of it. At Yishun Park, the rubbish was
left behind by some 400 players who gather nightly at the popular site, known
for its many PokéStops, where the creatures spawn. And because of the
numbers who turn up, the cleaners work non-stop from the time their shifts
start to just before dawn. Empty bottles, cans, food wrappers and used tissues
are the typical litter left behind by players hooked on the game.
Using a diagram, explain how the playing of Pokémon GO leads to market
failure.
24
 Negative externality ➔ market failure
◉ [State cause(s) of market failure] The consumption of Pokémon GO
generates negative externalities in playing the game.
◉ [P] In deciding how much time to spend on Pokémon Go, players
consider only their private costs and benefits.
• The MPB of playing Pokémon GO could be the satisfaction gained
by the players from spending one more unit of their time playing
the game, while MPC of playing Pokémon GO could include the
additional costs they incur from purchasing in-app purchases and
the cost of the data bundle.
Did you contextualise consumers’ private benefits and costs
of playing Pokemon Go? 25
 Negative externality ➔ market failure

◉ [E] As mentioned in the extract, the consumption of Pokémon GO

generates external costs as it has resulted in large amount of rubbish
thrown at the parks where the players frequent.
◉ [T] This has resulted in the third parties such the cleaners, having to
work for longer hours to clear the rubbish.
Did you identify the
third parties clearly?

26
 Negative externality ➔ market failure
Price, Benefit, Cost
◉ [D] The presence of Marginal External MSC = MPC + MEC

Cost (MEC) creates a divergence c MPC

between Marginal Social Cost (MSC) Ps

a

and Marginal Private Cost, where MSC Pp

MEC b

> MPC. Diagrammatically, the MSC

curve lies above the MPC curve by the
MPB = MSB
amount of the MEC as shown in the 0 Quantity of
Figure. Assuming that there are no Qs Qp Pokemon Go

positive externalities, Marginal Private

Benefit (MPB) = Marginal Social Benefit Did you draw the
(MSB). divergence correctly?
27
 Negative externality ➔ market failure
Price, Benefit, Cost
◉ [QQ] If left to the free market, the MSC = MPC + MEC

players would only consider their MPC c MPC

and MPB and would consume Qp units Ps

a

of Pokémon GO, where MPB = MPC. Pp

MEC b

However, the socially optimum level of

consumption is Qs units, where MSB =
MPB = MSB
MSC. There is overconsumption QsQp Quantity of
0
units of Pokémon GO as the private Qs Qp Pokemon Go

level of consumption is more than the

socially optimal level of consumption; Did you identify Qp
Qp > Qs and Qs correctly?
28
 Did you shade the
DWL correctly?
Negative externality ➔ market failure
◉ [D] From Qs to Qp units, the total social Price, Benefit, Cost
MSC = MPC + MEC
costs (area QsacQp) exceeds the total
c MPC
social benefits (area QsabQp). The a
Ps
shaded area ‘abc’ represents deadweight MEC b
loss which is the welfare loss to society. Pp

OR
MPB = MSB
◉ [D] For every additional unit of good 0 Quantity of
consumed from Qs to Qp, MSC>MSB. Qs Qp Pokemon Go

This leads to a deadweight loss of area

‘abc’ which represents the welfare loss to Tip of triangle for DWL
society. should point towards Qs!! 29
 Negative externality ➔ market failure

◉ Since the external costs to the cleaners are not

factored in the decision-making in the playing of Concluding
Pokémon Go, there is distortion of price signals. statements to link
There is market failure as the private optimal back to question
quantity is allocative inefficient.
◉ The price mechanism hence fails to bring about a
socially optimal allocation of resources.

30
 Pg 10
Think About It Question 2 - Since pollution is undesirable, the
socially optimal level of pollution is zero. Do you agree? Why?
Did you copy the suggested answer from SLS?
◉ Disagree. Social optimal level of pollution is the level that
corresponds to the social optimal level of output for steel.
◉ Production of steel could generate benefits as well, eg.
revenue for sellers
◉ If zero pollution means that there is zero production of steel,
it would be too extreme and potential benefits could not be
gained → this may not maximise society’s welfare!
This understanding is relevant to analysing why a BAN (Section 4.1.3.2) on
production/consumption of a good may make matters worse! 31
▪ At Qs → society’s welfare is maximized → MEC still exists at Qs!
▪ Socially optimal level of pollution > 0 i.e. Qs is not zero!

Your questions from SLS:

▪ Why is social optimal level of

pollution equal to social
optimal level of production
of good?
Pp
▪ Why is social optimal
pollution equal to social
optimal level of output of
steel?
Qs ≠ 0!
32
 Pg 12

Think about it – Qn 3

MSC > MPC

Qp > Qs 33
 Your questions from SLS

▣ How is dynamic efficiency and allocative efficiency different?

Are there any similarities/overlap between the two?

▣ What does a firm's demand curve mean? how isit different

from marginal revenue Fig.4
▣ Why is marginal costs for a firm curved? (unit 3 diagram) on p.8
▣ Why is the graph of MC curved in an allocative efficient firm

These concepts will be learnt in Theme 2.2 Firms and Decisions

(Term 3)
34
 Market Failure SLS Homework
◉ By 24 Apr (Mon), 2359
[2023_H2_MF] 3. Govt Intervention for Negative Externalities

◉ By 25 Apr (Tues), 2359 (HBL task)

[2023_H2_MF] 4. Positive Externalities & Govt Intervention
When you attempt the SLS packages, you should have your lecture
notes with you and actively take down notes / highlight key points.
35
Aim to learn as much as you can from the SLS lessons!