What is market failure How can it happen? Market failure occurs when scarce resources are not allocated efficiently. e.g. The price of something is too high or too low and therefore too much of something is consumed, or too little.

Externalities (spill-over effects) arise when private costs and benefits are different from social costs and benefits. A private cost is the cost of an activity to an individual economic unit (e.g. a consumer or firm). A social cost is the cost of an activity to society as a whole. The greater the externality the greater the likelihood of market failure. What are externalities? How do they link to market failure?

Producers are only concerned with “private costs” so this is all they take into account when deciding their quantity of output Consumers are only concerned with “private benefit” so this is all they take into account when deciding their quantity of consumption Social Cost = private cost + external cost Social benefit = private benefit + external benefit Private Costs & Social Costs How do they link to market failure?

What are externalities? How can it happen? If the social benefit is greater than the private benefit there is a positive externality (external benefit).

What are externalities? How can it happen? If the social cost is greater than the private cost there is a negative externality (external cost).

What are externalities? How can it happen? A chemical plant pumps waste into a river: 1.What are the private costs? 2.What are the social costs? 3.What is the private benefit? 4.What is the social benefit? 5.Is this a positive or negative externality? 6.Is this an external cost or benefit?

Positive or Negative Externality? PowerPoint Presentation TASK: You have been given an economic activity. You must: 1)Determine if your economic activity is a positive or negative externality. 2)Research the social and private benefits or the social costs and private costs to support your decision. 3)Present your finings to the class.

TASK: You have been given an economic activity. You must: 1)Determine if your economic activity is a positive or negative externality. 2)Research the social and private benefits or the social costs and private costs to support your decision. 3)Present your finings to the class as a PowerPoint presentation. Positive or Negative Externality? The market for cigarettes

TASK: You have been given an economic activity. You must: 1)Determine if your economic activity is a positive or negative externality. 2)Research the social and private benefits or the social costs and private costs to support your decision. 3)Present your finings to the class as a PowerPoint presentation. Positive or Negative Externality? The market for cars

TASK: You have been given an economic activity. You must: 1)Determine if your economic activity is a positive or negative externality. 2)Research the social and private benefits or the social costs and private costs to support your decision. 3)Present your finings to the class as a PowerPoint presentation. Positive or Negative Externality? The market for healthcare

TASK: You have been given an economic activity. You must: 1)Determine if your economic activity is a positive or negative externality. 2)Research the social and private benefits or the social costs and private costs to support your decision. 3)Present your finings to the class as a PowerPoint presentation. Positive or Negative Externality? The market for religion

TASK: You have been given an economic activity. You must: 1)Determine if your economic activity is a positive or negative externality. 2)Research the social and private benefits or the social costs and private costs to support your decision. 3)Present your finings to the class as a PowerPoint presentation. Positive or Negative Externality? The market for computer games

TASK: You have been given an economic activity. You must: 1)Determine if your economic activity is a positive or negative externality. 2)Research the social and private benefits or the social costs and private costs to support your decision. 3)Present your finings to the class as a PowerPoint presentation. Positive or Negative Externality? The market for metal

TASK: You have been given an economic activity. You must: 1)Determine if your economic activity is a positive or negative externality. 2)Research the social and private benefits or the social costs and private costs to support your decision. 3)Present your finings to the class as a PowerPoint presentation. Positive or Negative Externality? The market for libraries

TASK: You have been given an economic activity. You must: 1)Determine if your economic activity is a positive or negative externality. 2)Research the social and private benefits or the social costs and private costs to support your decision. 3)Present your finings to the class as a PowerPoint presentation. Positive or Negative Externality? The market for fast-food

External Costs Cost Quantity MPC=S MSC Externality If the negative externality were included in the “cost”, MPC would shift to MSC by the vertical amount of the negative externality. S would decrease.

External Benefits Cost Quantity Externality MPB=D MSB If the positive externality were included in the “demand”, MPB would shift to MSB by the vertical amount of the positive externality. D would increase.

Free market equilibrium is where marginal private cost = marginal private benefit (MPC=MPB) Socially optimum equilibrium is where marginal social cost = marginal social benefit (MSC = MSB) Market Optimum vs. Socially Optimum Output

Cost Quantity MPC=S MSC MPB=MSB=D Q free mkt Q socially optimum P free mkt P socially optimum Where there are external costs, the free market will overproduce and underprice.

Market Optimum vs. Socially Optimum Output Cost Quantity MPB=D MSB MPC=MSC=S P free mkt P socially optimum Q free mkt Q socially optimum Where there are external benefits, the free market will underconsume & underprice.

Welfare Loss Cost Quantity MPB=D MSB MPC=MSC=S P free mkt P socially optimum Q free mkt Q socially optimum - loss to society from not producing at the socially optimum output and price = area between the two curves from the free market output to the socially optimum output WELFARE LOSS

With reference to Diagram B, define the term “negative externalities”. (2) Knowledge 1, application 1 Definition: a cost borne by a third party as a result of an economic decision; the difference between MSC and MPC Application: the vertical distance between the MSC and MPC curves or example of a negative externality arising from the use of video games e.g. greater obesity problem leading to shortage of dr appointments for other patients

(e) With reference to Extract B, discuss the reasons why the Chinese government has taken action to reduce the amount of pollution caused by vehicles. [15 marks] Tutor2u Paper 1

Sample assessment paper 6(f) Using the concept of external costs, evaluate the possible economic effects of increased beef production. Use an appropriate diagram in your answer. (20)