2.8 Market failure - externalities and common pool or common access resources

Socially optimum output occurs where social marginal benefit equals social marginal cost, including relevant external benefits or costs.

The market outcome can overproduce a harmful good or underproduce a beneficial one when private incentives omit spillovers.

Compare private and social marginal curves and identify the welfare-maximising quantity.

If pollution adds $2 social cost per unit, social marginal cost lies above private cost and the optimum quantity is lower.

Optimum depends on the objectives, evidence and valuation used.

At $MSB=MSC$, the marginal social gain from the last unit equals its marginal social opportunity cost, so producing more would add more social cost than benefit and producing less would forgo net benefit. Under the model, this quantity is allocatively efficient and maximizes social/community surplus. Do not substitute private demand or supply for MSB or MSC when an externality separates them.

An externality is an uncompensated cost or benefit affecting a third party. The market quantity differs from the social optimum because decision-makers use private rather than social marginal costs or benefits.

Negative production: $MSC>MPC$, causing overproduction. Negative consumption: $MSB<MPB$, causing overconsumption. Positive production: $MSC<MPC$, causing underproduction. Positive consumption: $MSB>MPB$, causing underconsumption. Welfare loss lies between the relevant social curves over the misallocated units.

First identify production versus consumption and cost versus benefit; then choose which marginal curve separates, mark market and social quantities, and shade the welfare-loss region with arrows toward the efficient quantity.

Factory pollution is a negative production externality, so supply based on $MPC$ gives output above the $MSB=MSC$ optimum. Vaccination benefits others through consumption, so demand based on $MPB$ gives output below the optimum.

Merit goods are judged socially under-consumed and commonly linked to positive consumption externalities; demerit goods are judged over-consumed and commonly linked to negative consumption externalities. These judgments also involve information and values.

A common pool resource is rival but difficult to exclude users from, so individual extraction can deplete the shared stock.

Open access creates a “tragedy of the commons” when users ignore the cost imposed on others and future users.

Identify rivalry, exclusion difficulty and the governance rule that could protect the stock.

An open fishery may be overharvested because each boat gains while depletion is shared.

Common pool is not the same as a public good: rivalry matters.

Responses include Pigouvian or carbon taxes, subsidies, legislation and regulation, education, tradable permits, international agreements, collective self-governance and government provision. Each changes prices, information, rights, quantities or governance differently.

A tax can move private cost toward social cost; a subsidy can encourage an external benefit; permits cap total pollution and allow trading; regulation sets limits; education changes information; provision supplies the beneficial output; commons governance creates monitored access and shared rules.

Match the instrument to whether the failure is an external cost, external benefit or open-access depletion. On a carbon-tax diagram, shift supply/MPC upward by the tax toward MSC, raising price and reducing polluting output toward the social optimum.

A fishery may combine a monitored community quota with an international agreement when stocks cross borders. A subsidy for vaccination targets under-consumption from external benefit, while a carbon tax targets excessive polluting production.

Property rights or quotas alone are not the complete syllabus response set. Every policy depends on measurement, enforcement and stakeholder legitimacy and may create equity or administrative costs.

Policy evaluation compares effectiveness, efficiency, equity, administrative feasibility, unintended effects and sustainability.

A policy can meet its target at high cost or shift harm to another group or place; outcomes should be measured against a counterfactual where possible.

State the criterion, evidence and trade-off before recommending or rejecting a policy.

A carbon tax cuts emissions but burdens low-income households unless revenue is recycled or alternatives are available.

Evaluation is not a list of pros and cons without a clear objective.

For each policy, evaluate how accurately the externality can be measured, whether the intervention changes behaviour, administrative and enforcement costs, evasion and consequences for consumers, producers, government and third parties. Global sustainability problems cross borders, so international agreements can prevent free-riding or leakage, but differences in incentives, monitoring capacity and enforcement make cooperation difficult.