Market
Government
power
IB ECONOMICS HL
Market
Market Failure
Externalities
failure
Chapter2-7.
Public goods
IUM 이음
Tutoring & Consulting
IB ECONIOMICS HL
Market mechanism _ Price mechanism
Signalling
Incentives
Rationing
Allocating
IB ECONIOMICS HL
Types of Market failure
1. Negative externalities in 7. Demerit goods
production 8. Other Information
2. Negative externalities in failures
consumption 9. Monopolies (A2)
3. Positive externalities in 10.Factor immobility
production
11. Moral hazard
4. Positive externalities in
12.Inequalities in the
consumption
distribution of income
5. Public goods & wealth (A2)
6. Merit goods
IB ECONIOMICS HL
Market failure = loss social welfare Signalling
Market failure happens when the price
mechanism fails to allocate scarce Incentives
resources efficiently or when the
operation of market forces lead to a Rationing
net social welfare loss
Allocating
In essence, the market is ‘failing’ to bring about either:
1. An efficient allocation of resources
2. An equitable (fair) allocation of resources
IB ECONIOMICS HL
Market Failure
It’s important to understand that many markets suffer from market
failure. Like other concepts, markets are never as good as expected.
Partial market Complete
failure market failure
Under or over Missing markets
production /consumption
TOO MUCH NOTHING AT ALL
TOO LITTLE
IB ECONIOMICS HL
Market is not simple
(Private cost)
A market is more complicated than
just supply and demand. There are
“external” factors to consider.
The demand curve reflects the value to
buyers, and the supply curve reflects the
costs of sellers. The equilibrium quantity,
(Private value) QMARKET, maximizes the total value to
buyers minus the total costs of sellers. In
the absence of externalities, the market
equilibrium is efficient.
IB ECONIOMICS HL
Why does market failure matter?
Market failure matters because it reduces the
potential level of welfare in the economy.
In other words market failure causes a
deadweight loss to society.
(Remember, a central part of economics is the assumption
that we aim to maximise utility/welfare)
IB ECONIOMICS HL
Types of market failure
1. Negative externalities
2. Positive externalities
3. Public goods
4. Merit goods & Demerit goods
5. Other Information failures
6. Monopolies (A2)
7. Factor immobility
8. Moral hazard
9. Inequalities in the distribution of
income & wealth (A2)
IB ECONIOMICS
Externalities
HL
The external ‘spill-over’ consequences of production or
consumption of a good. They can be positive or negative.
Externalities are unintended side effects of production
or consumption that impact third parties who aren’t
directly involved the activity.
As the impacts spill-over from the original producer or
consumer, others feel these impacts without making a
choice to do so.
The original producer/consumer does not include the
This is the
external impacts in their private assessments of the market failure
benefits and costs, and therefore neither does the
market.
IB ECONIOMICS HL
Pair work: Spot the externalities
If driving is the
activity, what are
the positive and
negative
externalities?
Are these externalities
in CONSUMPTION or
PRODUCTION? Do
you think the drivers
care about these
externalities?
IB ECONIOMICS HL
Private cost vs. External cost
vs.
Private costs are the internal costs External costs occur when the activity
faced by the producer or consumer of one agent has a negative effect on
directly involved in a transaction. the wellbeing of a third party. They
i.e, the private cost of owning and impose costs on other agents. This
running a vechile. causes social > private cost.
IB ECONIOMICS HL
Private benefit vs. External benefit
vs.
Private benefit is the benefit, Social benefits include private
satisfaction or utility that an benefits but also add in the external
individual agent such as a consumer benefits that might occur from
or a business derives from producing production and/or consumption.
or consuming something
IB Economics
Marginal : Marginal benefit & Marginal Cost
Marginal in economics means having a little more or a little less
of something. It refers to the effects of consuming and/or
producing one extra unit of a good or service.
e.g.Marginal benefit – is the change in total private benefit from
one extra unit
IB Economics
MB(Marginal benefit) & MC(Marginal Cost)
Marginal = extra _____ for each unit
In the free market, goods
Price
The demand curve shows us the are allocated to the point
Supply =
utility or benefit gained from each of MPB=MPC MPC
additional unit consumed.
The demand curve = Marginal
Private Benefit (MPB)
P1
The supply curve shows us the cost
incurred from each additional unit
produced.
Demand =
The supply curve = Marginal Private MPB
Cost (MPC)
Q1 Quantity
IB ECONIOMICS HL
Marginal benefit Only the external costs and benefits are the externalities....
‣ Marginal Private Benefit (MPB): the additional benefit of consuming or producing
an extra unit to individuals or firms.
e.g. the profit made by using electricity to power a factory
‣ Marginal External Benefit (MEB): the additional benefit of consuming or producing
an extra unit to those around you or more widely, society
e.g. new factory will bring new jobs
IB ECONIOMICS HL
Marginal cost
‣ Marginal Private Cost (MPC): the additional cost of consuming or producing an
extra unit to individuals and firms, this could be financial or less tangible such as to
reputation
e.g. the cost of buying the electricity from the supplier
‣ Marginal External Cost (MEC): the additional cost of consuming or producing an
extra unit to those around you or more widely, society
e.g. negative effects of pollution
IB ECONIOMICS HL
Social Benefit / Cost
Are there more benefits or costs? If society took these into account they WOULD DEMAND
LESS CARS!
PB + (-ve)EB = SB
The private benefit plus the cost imposed onto others (the -ve external
benefit) is equal to the true benefit to society (the social benefit)
However, in this case we are consuming more than society would like us to!
IB ECONIOMICS HL
Optimum output
This is what we want to consider. The
social optimum is when the private
and external costs/benefits are
+ External = Social combined...
Private
Cost Cost Cost
Social
Private + External =
Benefit Benefit
Benefit
The market only considers the private (internal) costs and benefits when deciding optimum
output. The market ignores the external costs/benefits (the externalities), and therefore fails
to take account the true costs & benefits to society.
IB ECONIOMICS HL
PB + (-ve)EB = SB(Social benefit)
Notice the externality is slanted due to the proportional increase / decrease of the
externality.
‣ PB + (-ve)EB = SB
Example:
Driving a car 10 miles
PB = Convenience, speed of travel, comfort = £2.00 SB = £1.50
Negative EB = Congestion & pollution = 50p
Driving a car 100 miles
PB = Convenience, speed of travel, comfort = £20.00 SB = £15.00
-ve EB = Congestion & pollution = £5.00
The greater the number of miles, the greater the difference between the PB and the SB
IB ECONIOMICS HL
Social Welfare Loss
Price
TIP: MPC = MSC
The deadweight welfare loss
triangle ALWAYS points towards the
social optimum equilibrium
(MSB=MSC). P1 Deadweight
welfare loss
(and points away from the original P2
output level, Q1)
It is the difference between the MSC &
MSB at the free market equilibrium MPB
MSB
Q2 Q1 Quantity
IB ECONIOMICS HL
Externality : The effect on a 3rd party due to
consumption or production of a good/service
Externalities
Production Consumption
Negative Positive Negative Positive
IB ECONIOMICS HL
Negative externalities
Definition: A -ve externality is a cost imposed onto a third party by
the action/decision of others.
A -ve externality is also known as an external cost or a negative benefit
The market failure occurs because when a decision is made only the
private cost is considered whereas the full cost to society (the social
cost) should be considered.
This leads to over-consumption & a misallocation of scarce
resources.
IB ECONIOMICS HL
• We are not allocating our scarce resources
to produce the quantity of goods that
society wants
• Therefore, we are ALLOCATIVELY INEFFICIENT
– i.e. the market has FAILED to bring about
allocative efficiency
IB ECONIOMICS HL
Negative Externalities in Consumption
Occurs when consumers impose a cost (Negative
benefit) onto others when they consume goods/services
The MPB>MSB
IB ECONIOMICS HL
Externality of Consumption:
This is graph is from the perspective of the consumer!
Price/Cost/
Benefit
S = MPC
P1
D = MPB
Q Quantity
1
IB ECONIOMICS HL
Negative Externality of Consumption:
Negative externality from consumption
• e.g, the consumption of cigarettes leads to
external costs on third parties who inhale
second-hand smoke.
• Due to the presence of external costs from
consumption, MSB < MPB*. Assuming no
externality from production, MSC = MPC.
• At the market equilibrium (Qm), MSC> MSB
and thus there is overconsumption (QsQm)
and a welfare loss (shaded area).
IB ECONIOMICS HL
Price/Cost/ Notice the externality is slanted due to the
Benefit proportional increase / decrease of the externality.
S = MPC = MSC
-ve MEB
-ve ext
P1 Deadweight loss
to society
P2
-ve MEB
-ve ext
D = MPB
MSB
Q2 Q1 Quantity
Use different colours if it helps.
IB ECONIOMICS HL
-ve externalities in consumption cause market failure because:
• If left to the free market consumers only take into account their own private costs &
benefits.
• Because of the existence of a -ve externality:
• MSB<MPB (-ext in consumption) (the MSB curve lies below the MPB curve and the
vertical distance between the two is the size of the MEC/-ve externality/-ve benefit)
• Therefore we consume/ produce where MPC=MPB at P1, Q1
• This is the free market equilibrium
• However, the social optimum level of output is where MSC=MSB at P2, Q2
• Therefore goods which display -ve externalities in consumption are OVER-CONSUMED/
OVER-PRODUCED
• This means that TOO MANY SCARCE RESOURCES are being used to produce this good.
• Therefore we have a MISALLOCATION of SCARCE RESOURCES.
IB ECONIOMICS HL
Negative Externalities in Production
Occurs when producers impose a cost (Negative
benefit) onto others through their production processes
The MPC < MSC
PC + EC = SC
(MPC + MEC = MSC)
IB ECONIOMICS HL
Negative Externality of Production:
Negative externality from
production
• The private cost plus the cost
imposed onto others(the
external cost) is equal to the
true cost to society(the social
cost)
• Do not confuse the eternal cost
with the social cost
IB ECONIOMICS HL
Negative Externality of Production:
Negative externality from production
• Power-plants generate external costs
associated with burning fossil fuels. The
production of electricity generates external
costs in the form of greenhouse gases, which
contribute to environ mental degradation.
• Due to the presence of external costs from
production, MSC > MPC. Assuming no exter
nality from consumption, MSB = MPB.
• At the market equilibrium (Qe), MSC > MSB
and thus there is overproduction (QsQe) and
a welfare loss (shaded area).
IB Economics
MB(Marginal benefit) & MC(Marginal Cost)
Marginal = extra _____ for each unit
In the free market, goods
Price
The demand curve shows us the are allocated to the point
Supply =
utility or benefit gained from each of MPB=MPC MPC
additional unit consumed.
The demand curve = Marginal
Private Benefit (MPB)
P1
The supply curve shows us the cost
incurred from each additional unit
produced.
Demand =
The supply curve = Marginal Private MPB
Cost (MPC)
Q1 Quantity
IB ECONIOMICS HL
Externality of Production:
-ve Externalities in Production
Occurs when producers impose a cost onto others through their production processes
The MPC<MSC
If the firm took these into account they WOULD PRODUCE LESS PAPER!
PC + EC = SC
The private cost plus the cost imposed onto others (external cost) is equal to the true cost to society
(the social cost)
+ =
IB ECONIOMICS HL
Externality of Production:
Price/ MSC
Cost/ Why is the externality slanted?
Benefit
S = MPC
-ve ext
MEC
P2
P1
-ve ext
MEC
D = MPB = MSB
Q2 Q1 Quantity
Use different colours if it helps.
IB ECONIOMICS HL
Externality of Production: PC + EC = SC
Example:
Burning coal to make a small amount of electricity
PC = Wages, coal = £200
EC = Congestion & pollution = £10
SC = £210
Burning coal to make a large amount of electricity (2500 times as much)
PC = Wages, coal = £500,000
EC = Congestion & pollution = £25,000
SC = £525,000
The greater the amount of coal burned, the greater the difference between the PC and the SC
(i.e. the greater the size of the externality)
IBExternality
ECONIOMICS HL
of Production:
Where does our deadweight welfare loss go?
Price/ MSC Notice the externality is slanted
Cost/
due to the proportional
Benefit
increase / decrease of the
S = MPC externality.
-ve ext
MEC
P2 Deadweight
loss to society
P1
-ve ext
MEC
D = MPB = MSB
Q2 Q1 Quantity
IB ECONIOMICS HL
Externality of production:
-ve externalities in production cause market failure because……
• If left to the free market, firms only take into account their own private
costs & private benefits.
• Because of the existence of a -ve externality the MSC>MPC (the MSC
curve lies above the MPC curve and the vertical distance between
the two is the size of the MEC)
IB ECONIOMICS HL
Externality of production:
• Therefore we choose to produce where MPC=MPB at P1, Q1
• This is the free market equilibrium
• However, the social optimum level of output is where MSC=MSB at P2, Q2
• Therefore goods which display –ve externalities in production are OVER-
CONSUMED & OVER-PRODUCED
IB ECONIOMICS HL
Externality of production:
• This means that TOO MANY SCARCE RESOURCES are being used to
produce this good.
• Therefore, we have a MISALLOCATION of SCARCE RESOURCES.
• We are not allocating our scarce resources to produce the quantity
of goods that society wants
• Therefore, we are ALLOCATIVELY INEFFICIENT – i.e. the market has
FAILED to bring about allocative efficiency/ to allocate scarce
resources efficiently
IB ECONIOMICS HL
Externality of Production:
Externality of Production: This is graph is from the perspective of the producer!
Price/Cost/
Benefit
S = MPC
P1
D = MPB
Q1 Quantity
IB ECONIOMICS HL
Positive Externality :
Positive externalities – James Dyson
IB ECONIOMICS HL
Positive Externality :
• Definition: A +ve externality is a benefit imposed onto a third
party by the action/decision of others.
• A +ve externality is also known as an external benefit
• The market failure occurs because when a decision is made
only the private benefit is considered whereas the full
benefit to society (the social benefit) should be considered.
• This leads to under-consumption & a misallocation of scarce
resources
IB ECONIOMICS HL
Positive Externality :
• Definition: A +ve externality is a benefit imposed onto a third
party by the action/decision of others.
• A +ve externality is also known as an external benefit
• The market failure occurs because when a decision is made
only the private benefit is considered whereas the full
benefit to society (the social benefit) should be considered.
• This leads to under-consumption & a misallocation of scarce
resources
IB ECONIOMICS HL
Positive Externality of Consumption:
Positive externality from consumption
• e.g, the consumption of vaccination
generates external benefits for third parties
who face a lower probability of falling sick.
• Due to the presence of external benefits
from consumption,
MSB > MPB. Assuming no externality from
production, MSC = MPC.
• At the market equilibrium (Qm), MSB > MSC
and thus there is underconsumption (QmQs)
and a welfare loss (shaded area).
IB ECONIOMICS HL
Positive externality of consumption:
Price/ Externality of Consumption: This is graph is from the
Cost/ perspective of the consumer!
Benefit
S = MPC
P1
D = MPB
Q1 Quantity
IB ECONIOMICS HL
Positive externality of consumption:
What’s the main marginal external benefit of
being vaccinated.
Marginal External Benefit (MEB): the Marginal External Cost (MEC): the
additional benefit of consuming or additional cost of consuming or producing
producing an extra unit to those around you an extra unit to those around you or more
or more widely, society widely, society
e.g. new factory will bring new jobs e.g. negative effects of pollution
Would society want people to consume more or less vaccines?
IB ECONIOMICS HL
Positive externality of consumption:
If the people took this into account then WE WOULD CONSUME MORE VACCINES!
PB + EB = SB
The private benefit plus the benefit imposed onto others (external benefit) is
equal to the true benefit to society (the social benefit)
in this case we are consuming less than society would like us to!
IB ECONIOMICS HL
Positive externality of consumption:
PB + EB = SB
Example:
Vaccination
If a +ve externality in consumption exists then:
PB<SB
IB ECONIOMICS HL
Positive externality of consumption:
Price/Cost/ The deadweight welfare loss triangle
Benefit ALWAYS points towards the social
Deadweight optimum equilibrium
loss to society S = MPC = MSC
P2
P1
MSB
Notice the externality is
D = MPB slanted due to the proportional
increase / decrease of the
externality.
Use different Q1 Q2 Quantity
colours if it
helps. Under-consumption/production
IB +ve
ECONIOMICS
externalitiesHL
in consumption cause
market failure because……
• If left to the free market we only take into account our own private
costs & benefits.
• Because of the existence of a +ve externality:
– MSB>MPB (+ext in consumption)
• Therefore we consume/ produce where MPC=MPB at P1, Q1
• However, the social optimum level of output is where
MSC=MSB at P2, Q2
IB ECONIOMICS HL
Therefore goods which display +ve externalities in consumption
are UNDER-CONSUMED/ UNDER-PRODUCED
This means that NOT ENOUGH SCARCE RESOURCES are being used
to produce this good.
Therefore we have a MISALLOCATION of SCARCE RESOURCES.
We are not allocating our scarce resources to produce the
quantity of goods that society wants
Therefore we are ALLOCATIVELY INEFFICIENT
IB ECONIOMICS HL
Positive Externality of Production:
+ve Externalities in Production
Occurs when producers impose a benefit (lower costs) onto others through their
production processes
The MPC>MSC
IB ECONIOMICS HL
Positive Externality of Production:
Positive externality from production
•For instance, a beekeeper’s production of
honey may benefit a nearby farmer (a third
party) who gains a higher crop yield when
bees pollinate plants bearing fruits.
• Due to the presence of external benefits
from production, MSC < MPC*. Assuming no
externality from consumption, MSB = MPB.
• At the market equilibrium (Qe), MSB > MSC
and thus there is underproduction (QeQs)
and a welfare loss (shaded area).
IB ECONIOMICS HL
Positive Externality of Production:
Externality of Production: This is graph is from the
Price/Cost/ perspective of the producer!
Benefit
S = MPC
P1
D = MPB
Q1 Quantity
IB ECONIOMICS HL
Positive Externality of Production:
What’s the main marginal external benefit (-ve
external cost) of new inventions.
Marginal External Benefit (MEB): the Marginal External Cost (MEC): the additional
additional benefit of consuming or producing cost of consuming or producing an extra unit to
an extra unit to those around you or more those around you or more widely, society
widely, society
e.g. negative effects of pollution
e.g. new factory will bring new jobs
IB ECONIOMICS HL
Positive Externality of Production:
If the people took this into account then WE WOULD PRODUCE MORE INNOVATIVE PRODUCTS
PC + (-ve)EC = SC
The private cost plus the benefit imposed onto others (the -ve external cost) is
equal to the true cost to society (the social cost)
in this case we are producing less than society would like us to!
IB ECONIOMICS HL
Positive Externality of Production:
PC + -ve EC = SC
Example:
The Internet
If a +ve externality in production exists then:
SC<PC
IB ECONIOMICS HL
Positive Externality of Production:
Price/
Cost/ The deadweight welfare loss triangle ALWAYS points towards
Benefit the social optimum equilibrium
S = MPC
Deadweight
loss to society
MSC
P1 Notice the externality is
slanted due to the
P2
proportional increase /
decrease of the
externality.
D = MPB = MSB
Q1 Q2 Quantity
Under-consumption/
production
Use different colours if it helps.
IB ECONIOMICS HL
Positive Externality of Production:
+ve externalities production cause
market failure because……
• If left to the free market we only take into account our own private costs &
benefits.
• Because of the existence of a +ve externality:
– MSC<MPC (+ext in production)
• Therefore we consume/ produce where MPC=MPB at P1, Q1
• However, the social optimum level of output is where MSC=MSB at P2, Q2
IB ECONIOMICS HL
Positive Externality of Production:
Therefore goods which display +ve externalities in production are
UNDER-CONSUMED/ UNDER-PRODUCED
This means that NOT ENOUGH SCARCE RESOURCES are being used
to produce this good.
Therefore we have a MISALLOCATION of SCARCE RESOURCES.
We are not allocating our scarce resources to produce the
quantity of goods that society wants
Therefore we are ALLOCATIVELY INEFFICIENT
IB ECONIOMICS HL
Positive Externality of Production:
Task 1: From the above pictures find examples of:
Negative externalities in production Positive externalities in production
Negative externalities in consumption Positive externalities in consumption
Think about the point when the externality actually takes place
IB ECONIOMICS HL
Positive Externality of Production:
Task 2: What are the names Task 3: Private vs. Social Benefits and Costs
for these labels on a graph?
Private + External = Social
-VE =
Match these differences between private and
+VE = social costs/benefits to the correct externality.
MPC =
MSC = MSC>MPC
MPB = MSC<MPC
MSB = MSB>MPB
MEB = MSB<MPB
MEC =
IB Deadweight
ECONIOMICSloss
HL
IB Deadweight
ECONIOMICSloss
HL
IB ECONIOMICS HL Externality in Consumption :
Model Answer_Negative
