DP Economics HL 2.8 Market Failure: Externalities and Common Pool Resources

DP Economics HL 2.8 Market Failure: Externalities and Common Pool Resources - Full notes

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DP Economics HL | 2.8 Market Failure: Externalities and Common Pool Resources

DP ECONOMICS · UNIT 2: MICROECONOMICS

2.8

Market Failure: Externalities and Common Pool Resources

Full notes for HL · IB-style

Contents

1	Market failure and allocative efficiency
2	Externalities: private and social costs and benefits
3	Negative externalities of production
4	Negative externalities of consumption
5	Positive externalities of production and consumption
6	Policies to correct negative externalities
7	Policies to correct positive externalities
8	Common pool resources and sustainability
9	Market failure and welfare loss
10	Positive production externalities
11	Negative consumption externalities
12	Positive consumption externalities
13	Carbon taxes
14	Tradable permits (cap and trade)
15	Comparing carbon taxes and permits
16	Common pool resources
17	Collective self-governance
18	Mixed review: worked problems
19	Additional exam-style practice
20	International cooperation
21	Common misconceptions and links
22	Exam-style question with markscheme
23	Check your understanding
24	Summary and topic map

These are full teaching notes. Read each section in order, try the Think about it question before you read on, and do every Quick check before moving to the next section.

Before you start

Rate yourself on each statement now, and again after you've worked through the notes. Shade R (not yet), A (getting there) or G (confident).

I can…	R	A	G
explain market failure as a failure to achieve allocative efficiency
define MPC, MSC, MPB, MSB and external costs and benefits
draw and explain diagrams for the four types of externality, showing the welfare loss
explain and evaluate Pigouvian taxes, tradable permits, regulation and education
explain and evaluate subsidies, direct provision and legislation for positive externalities
explain the characteristics of common pool resources and the tragedy of the commons
evaluate policies for sustainability, including collective self-governance and international cooperation

Externalities and common pool resources are studied at the same depth at SL and HL. HL students also study asymmetric information and market power (2.10 and 2.11) as separate topics.

Guiding questions

Why do markets produce too much pollution and too little education? Who should pay for the damage caused by climate change? Why do fish stocks collapse even though no fisher wants them to?

How this topic is examined

Externalities are among the most frequently examined topics in the whole course. Paper 1 regularly asks you to explain an externality with a diagram in part (a) and to evaluate a policy, such as a carbon tax, in part (b). Paper 2 texts on pollution, health, education or the environment almost always lead to externality diagrams.

The diagrams must be precise: correct labels (MPC, MSC, MPB, MSB), the market and socially optimal quantities, and the welfare loss triangle pointing towards the optimum.

Command term	What the examiner wants
Define	the precise meaning, ideally in the IB wording, in one or two sentences
Draw / Sketch	a fully labelled diagram with every axis, curve, equilibrium and change labelled
Explain	a causal chain linked to economic theory, usually supported by a diagram
Analyse	break a situation into its parts and trace the effects of each
Evaluate / Discuss	weigh up arguments, question assumptions and reach a justified conclusion using real-world examples
Calculate	state MSC = MPC + MEC and show the calculation

How to use these notes

Each section teaches one part of the syllabus in full. You'll see these boxes throughout; each has one job:

Box	What it's for
Think about it	a question to get you thinking before a section; the answer comes in the section
Key point	the one idea you must not forget
Common mistake	an error examiners see every year, and how to avoid it
In the real world	where the economics shows up outside the classroom
Try this	something quick you can do yourself to test the idea
Worked example	full solutions with IB-style marks (M1 method, A1 answer, R1 reasoning)
Quick check	short questions to test yourself at the end of each section

1 Market failure and allocative efficiency

A market fails when it produces the wrong quantity from society's point of view.

Think about it

A factory produces steel that people want, and makes a profit. But it pollutes a river used by a fishing village. Is the market for steel working well?

In 2.3 you saw that a competitive market produces where demand equals supply, and that this is allocatively efficient: social surplus is maximized at the quantity where marginal benefit equals marginal cost. That conclusion depends on an important condition: the demand curve must reflect all the benefits of the good to society, and the supply curve must reflect all the costs.

Market failure occurs when the free market fails to allocate resources efficiently: it produces too much or too little of a good compared with what is best for society. The result is a welfare loss.

Allocative efficiency, in its full form, requires that marginal social benefit (MSB) equals marginal social cost (MSC). When private decisions ignore some costs or benefits that fall on others, the market quantity differs from the socially optimal quantity. This topic covers two important causes of market failure: externalities and common pool resources.

Key point

Market failure is about the wrong quantity: too much or too little relative to the socially optimal output where MSB = MSC.

Quick check

1. Define market failure.

2. What condition gives allocative efficiency from society's point of view?

Answers: 1. the free market fails to allocate resources efficiently 2. MSB = MSC

2 Externalities: private and social costs and benefits

An externality is a spillover onto someone outside the transaction.

An externality occurs when the production or consumption of a good creates an external cost or benefit for third parties: people who are not involved in buying or selling the good, and who are not compensated (or do not pay) for it.

To analyse externalities, economists separate private and social values.

Term	Meaning
Marginal private cost (MPC)	the cost to the producer of producing one more unit; the supply curve
Marginal external cost (MEC)	the cost of one more unit imposed on third parties
Marginal social cost (MSC)	MPC + MEC: the full cost to society
Marginal private benefit (MPB)	the benefit to the consumer of one more unit; the demand curve
Marginal external benefit (MEB)	the benefit of one more unit enjoyed by third parties
Marginal social benefit (MSB)	MPB + MEB: the full benefit to society

MSC = MPC + MEC and MSB = MPB + MEB

A free market produces where MPB = MPC, because buyers and sellers consider only their own costs and benefits. Society is best off where MSB = MSC. When there is an externality, these two quantities differ.

Externalities can be negative (external costs) or positive (external benefits), and they can arise from production or from consumption. This gives four types, each with its own diagram.

	Negative (external cost)	Positive (external benefit)
Production	pollution from a factory: MSC > MPC	a firm's training spills over to other firms: MSC < MPC
Consumption	smoking harms others: MSB < MPB	vaccination protects others: MSB > MPB

Common mistake

Calling any cost an externality. The cost must fall on a third party who is not part of the transaction. The price a smoker pays for cigarettes is a private cost; the harm to others from passive smoking is the externality.

Quick check

1. Define an externality.

2. Write the formula for MSC.

3. Where does a free market produce?

4. Give an example of a positive consumption externality.

Answers: 1. a cost or benefit to third parties not involved in the transaction 2. MSC = MPC + MEC 3. MPB = MPC 4. vaccinations

3 Negative externalities of production

When producers don't pay for the damage they cause, they produce too much.

A negative production externality occurs when production creates external costs for third parties. Examples are air and water pollution from factories, noise from airports, and greenhouse gas emissions from power stations.

The firm bases its output on its private costs (MPC, the supply curve) and ignores the external cost. The full cost to society is higher, so MSC lies above MPC by the amount of the marginal external cost.

Figure 1. A negative production externality: the market produces Qm where MPB = MPC, but the optimum is Qopt where MSB = MSC. The shaded triangle is the welfare loss.

Read the diagram carefully. The free market produces Qm at price Pm, where demand (MPB, which here equals MSB because there is no consumption externality) meets supply (MPC). The socially optimal quantity is Qopt, where MSB = MSC. So the market overproduces: Qm is greater than Qopt, and the price Pm is too low because it does not reflect the external cost.

For every unit between Qopt and Qm, the cost to society (MSC) is greater than the benefit to society (MSB). These units reduce social welfare. The welfare loss is the triangle between MSC and MSB from Qopt to Qm, pointing towards the optimum.

In the real world

Burning coal for electricity releases carbon dioxide, which contributes to climate change, and particulates that cause respiratory illness. These costs fall on people around the world and on future generations, none of whom are party to the electricity purchase.

Quick check

1. Why is MSC above MPC for a polluting factory?

2. Does the market over- or underproduce?

3. Where is the welfare loss?

Answers: 1. MSC includes the external cost 2. overproduces 3. the triangle between MSC and MSB from Qopt to Qm

4 Negative externalities of consumption

Some goods harm others when they are consumed.

A negative consumption externality occurs when consumption imposes external costs on third parties. Smoking (passive smoking, health care costs), alcohol (accidents, violence), loud music late at night and driving in congested cities are examples.

The consumer considers only their own benefit (MPB). Because of the harm to others, the benefit to society is lower: MSB lies below MPB. The market consumes at Qm, where MPB = MPC, but the optimum is Qopt, where MSB = MSC. There is overconsumption and a welfare loss.

Figure 2. A negative consumption externality: MSB lies below MPB, so the market overconsumes. The shaded triangle is the welfare loss.

Goods that are overconsumed because of negative consumption externalities, and often also because consumers underestimate their harm to themselves, are called demerit goods. Tobacco, alcohol and sugary drinks are standard examples.

Quick check

1. Give two examples of negative consumption externalities.

2. What is a demerit good?

Answers: 1. smoking, alcohol, congestion, noise 2. a good overconsumed because of negative effects, often with imperfect information

5 Positive externalities of production and consumption

Some goods benefit others too, so the market produces too little of them.

5.1 Positive consumption externalities

A positive consumption externality occurs when consumption creates external benefits for third parties. Education benefits not only the student but also society: a more productive workforce, lower crime, better-informed voters. Vaccination protects not only the vaccinated person but also others, through herd immunity.

Because consumers consider only their private benefit, MSB lies above MPB. The market consumes Qm where MPB = MPC, but the optimum Qopt, where MSB = MSC, is larger. There is underconsumption and a welfare loss. Goods that are underconsumed in this way are often called merit goods.

Figure 3. A positive consumption externality: MSB lies above MPB, so the market underconsumes.

5.2 Positive production externalities

A positive production externality occurs when production benefits third parties. When a firm trains its workers and some later move to other firms, those firms benefit. When a firm's research leads to new knowledge that others can use, the benefit spreads beyond the firm. Beekeepers' bees pollinate nearby orchards.

The social cost of production is lower than the private cost, because of the external benefit: MSC lies below MPC. The market produces Qm, less than the optimum Qopt. There is underproduction and a welfare loss.

Figure 4. A positive production externality: MSC lies below MPC, so the market underproduces.

Type	Curves	Market vs optimum	Example
Negative production	MSC > MPC	overproduction	factory pollution
Negative consumption	MSB < MPB	overconsumption	smoking, alcohol
Positive consumption	MSB > MPB	underconsumption	education, vaccinations
Positive production	MSC < MPC	underproduction	worker training, research

Common mistake

Drawing the welfare loss triangle on the wrong side of the market quantity. It always lies between Qm and Qopt, and points towards Qopt.

Quick check

1. Why is education underconsumed in a free market?

2. What curve shifts in a positive production externality diagram?

3. What is a merit good?

Answers: 1. MSB > MPB: students ignore external benefits 2. MSC lies below MPC 3. a good underconsumed because of positive externalities or imperfect information

6 Policies to correct negative externalities

The aim is to make polluters face the full social cost.

Think about it

Should a government ban plastic bags, tax them, or simply ask people to bring their own? What are the trade-offs?

6.1 Pigouvian (indirect) taxes

A Pigouvian tax, named after the economist Arthur Pigou, is a tax equal to the marginal external cost. It internalizes the externality: by making the producer (or consumer) pay the external cost, it shifts MPC up to MSC, so the market produces the socially optimal quantity. A carbon tax on fossil fuels is the leading example.

Advantages: it uses the price mechanism, so firms find the cheapest ways to cut pollution; it raises revenue that can fund clean energy or compensate households; and it gives a continuing incentive to reduce emissions.

Disadvantages: the marginal external cost is very hard to measure; if demand is inelastic, consumption may fall only a little; the tax can be regressive, hitting low-income households hardest; and firms may move production abroad to avoid it (carbon leakage).

6.2 Tradable permits (cap and trade)

Under a tradable permit scheme, the government sets a cap on total emissions and issues permits, each allowing one unit of pollution. Firms that cut emissions cheaply can sell spare permits to firms for which cutting emissions is expensive. The cap guarantees the total amount of pollution, while trading ensures it is reduced where it is cheapest to do so. The EU Emissions Trading System is the largest example.

Advantages: certainty about the quantity of emissions; reductions happen at the lowest cost; the cap can be tightened over time. Disadvantages: setting the right cap is difficult; too many permits make the price collapse (as happened in the EU after 2008); permit prices can be volatile; and monitoring is costly.

6.3 Regulation and legislation

Command and control regulation sets legal limits: emission standards for cars, bans on certain chemicals, rules on factory waste. Regulation is simple to understand and gives certainty about outcomes, but it gives no incentive to go beyond the limit, may impose higher costs than necessary, and requires enforcement.

6.4 Education, awareness and nudges

Information campaigns and nudges (2.4) aim to shift MPB towards MSB by changing tastes: health warnings on cigarette packs, anti-drink-driving campaigns. They are cheap and preserve choice, but their effects may be slow and uncertain.

6.5 International agreements

Some externalities, above all climate change, cross national borders. No single country can solve them alone, and each has an incentive to free ride on others' efforts. International agreements such as the Paris Agreement (2015) aim to coordinate action, but enforcement is weak because there is no global government.

Policy	Strengths	Weaknesses
Pigouvian tax	market-based; revenue; continuing incentive	hard to measure MEC; regressive; carbon leakage
Tradable permits	certain total emissions; low-cost reductions	setting the cap; volatile prices; monitoring
Regulation	simple; certain outcomes	no incentive beyond limit; enforcement costs
Education / nudges	cheap; preserves choice	slow, uncertain effects
International agreements	address global externalities	free riding; weak enforcement

Quick check

1. What does a Pigouvian tax aim to do?

2. How does cap and trade guarantee the level of emissions?

3. Why is a carbon tax often regressive?

Answers: 1. internalize the externality: shift MPC to MSC 2. the cap fixes total permits 3. low-income households spend more of their income on energy

7 Policies to correct positive externalities

The aim is to encourage more of the good.

Subsidies. A subsidy to producers lowers costs and increases supply; a subsidy to consumers (for example, a grant for students) increases demand. Either moves output towards the optimum. Subsidies for vaccinations, education and renewable energy are common. They have an opportunity cost and the right size is hard to estimate.

Direct government provision. The government can provide merit goods itself, often free at the point of use: state schools, public health services, vaccinations. This guarantees access regardless of income, but can be costly and may be less efficient than private provision.

Legislation. Laws can make consumption compulsory, such as compulsory schooling up to a certain age, or required vaccinations for school entry.

Advertising and information. Campaigns encourage consumption of merit goods, such as promoting healthy eating or exercise.

Quick check

1. Name three policies to deal with positive externalities.

2. Give one disadvantage of a subsidy.

Answers: 1. subsidies, direct provision, legislation, information 2. opportunity cost / hard to set correctly

8 Common pool resources and sustainability

When everyone can use a resource and nobody owns it, it is overused.

Think about it

No fisher wants the fish to disappear. So why have so many fisheries collapsed?

A common pool resource is a resource that is rivalrous (one person's use reduces the amount available for others) but non-excludable (it is difficult or impossible to stop people from using it). Fish in the ocean, groundwater, forests, grazing land and the atmosphere's capacity to absorb pollution are examples.

Because no one owns the resource, no one has an incentive to conserve it. Each user gains the full benefit of taking more but bears only a small share of the cost of depletion. The result is the tragedy of the commons, described by Garrett Hardin: individually rational decisions lead to overuse and, eventually, depletion of the resource, harming everyone, including future generations.

The overuse of common pool resources threatens sustainability: meeting present needs without compromising the ability of future generations to meet their own. Overfishing, deforestation, groundwater depletion and climate change are all examples.

8.1 Policies for common pool resources

Policy	How it works	Example
Legislation and quotas	limits on use	fishing quotas, logging bans
Tradable quotas	caps that can be traded	individual transferable fishing quotas in New Zealand and Iceland
Taxes on use or extraction	raise the private cost of use	taxes on groundwater extraction
Collective self-governance	communities set and enforce their own rules	community forests, local fishing cooperatives
International cooperation	agreements on shared resources	Paris Agreement, international fishing treaties
Funding clean technology	reduce the need to use the resource	subsidies for renewable energy

The economist Elinor Ostrom, who won the Nobel Prize in 2009, showed that communities can often manage common resources successfully without government control or private ownership, through collective self-governance: clear rules, monitoring by the users themselves, graduated sanctions and local conflict resolution. Her work challenged the idea that the tragedy of the commons is inevitable.

In the real world

The collapse of the Grand Banks cod fishery off Canada in 1992 put about 35 000 people out of work. Decades of overfishing had depleted stocks so far that a fishing ban was imposed, and stocks have still not fully recovered.

Key point

Common pool resources are rivalrous and non-excludable. Without ownership or rules, individual incentives lead to overuse: the tragedy of the commons.

Quick check

1. Define a common pool resource.

2. What is the tragedy of the commons?

3. What did Elinor Ostrom show?

Answers: 1. rivalrous but non-excludable 2. individually rational use leads to depletion 3. communities can manage commons through collective self-governance

9 Market failure and welfare loss

When markets misallocate.

Market failure occurs when the free market fails to allocate resources efficiently, so MSB ≠ MSC at the market output. The welfare (deadweight) loss is the triangle between MSB and MSC from the market quantity to the optimum quantity.

WORKED EXAMPLE 1 Welfare loss (standard)

Explain why overproduction causes a welfare loss.

Solution

Units beyond the optimum have MSC > MSBR1

Society loses the difference on each unitR1

10 Positive production externalities

Training and research.

When firms train workers or carry out research, others benefit (workers move to other firms; knowledge spreads). MSC < MPC, so the market underproduces. Solutions: subsidies, government provision of research, tax credits.

Figure 5. A positive production externality leads to underproduction.

WORKED EXAMPLE 2 Research (exam level)

Explain why a free market underinvests in research and development.

Solution

Firms cannot capture all benefits; others copy innovationsR1

MSC below MPC; market output below optimumR1

11 Negative consumption externalities

Smoking, alcohol, noise.

Consumption of some goods harms third parties: passive smoking, drunk driving, loud music. MSB < MPB, so the market overconsumes. Solutions: indirect taxes, regulation (bans in public places), education.

WORKED EXAMPLE 3 Alcohol (standard)

Identify two external costs of alcohol consumption.

Solution

Costs to healthcare systems; accidents and crimeA2

12 Positive consumption externalities

Vaccines and education.

Consumption of vaccines and education benefits others (herd immunity, a more productive workforce). MSB > MPB, so the market underconsumes. Solutions: subsidies, free provision, mandates, information campaigns.

Quick check

1. Explain why vaccines are often provided free.

Answers: 1. large positive externalities; underconsumed in free market

13 Carbon taxes

Pricing pollution.

A carbon tax charges polluters per tonne of CO2 emitted, internalizing the external cost. It raises the price of carbon-intensive goods, encouraging switching to cleaner alternatives, and raises revenue.

WORKED EXAMPLE 4 Evaluation (exam level)

Evaluate the use of carbon taxes.

Solution

Internalizes externality; creates incentives; raises revenueR1

Hard to set the right tax; regressive; firms may relocate (carbon leakage)R1

In the real world

Sweden introduced a carbon tax in 1991; at over 100 euros per tonne it is one of the highest in the world, and emissions have fallen while the economy has grown.

14 Tradable permits (cap and trade)

Markets for pollution.

Governments set a cap on total emissions and issue permits; firms that cut emissions cheaply can sell spare permits to firms that find it costly. The cap guarantees the total quantity of pollution; the market sets the price.

WORKED EXAMPLE 5 Cap and trade (exam level)

Explain how tradable permits reduce emissions at the lowest cost.

Solution

Total emissions limited by the capR1

Firms with low abatement costs reduce emissions and sell permitsR1

15 Comparing carbon taxes and permits

Price versus quantity.

Feature	Carbon tax	Tradable permits
controls	price of pollution	quantity of pollution
certainty	price certain, emissions uncertain	emissions certain, price uncertain
revenue	always raises revenue	only if permits auctioned
administration	simpler	requires monitoring and trading system

16 Common pool resources

Tragedy of the commons.

Common pool resources (fish stocks, forests, groundwater) are rivalrous but non-excludable. Individuals overuse them because they do not bear the full cost, leading to depletion (tragedy of the commons). Solutions: quotas, permits, community management, international agreements.

WORKED EXAMPLE 6 Overfishing (standard)

Explain why fish stocks are often overexploited.

Solution

Non-excludable: anyone can fishR1

Rivalrous: each catch reduces stocks for others; no incentive to conserveR1

17 Collective self-governance

Ostrom's insights.

Elinor Ostrom showed that communities can successfully manage common resources without government or privatization, through clear rules, monitoring, sanctions and local participation (Swiss alpine meadows, Philippine irrigation systems).

Quick check

1. What did Elinor Ostrom show about common pool resources?

Answers: 1. communities can manage them sustainably with local rules and monitoring

18 Mixed review: worked problems

Bringing the ideas together.

WORKED EXAMPLE 7 Mixed problem (exam level)

Using a diagram, explain how a subsidy can correct a positive consumption externality.

Solution

MSB > MPB; underconsumption at QmR1

Subsidy shifts supply right; price falls; quantity rises towards QoptR1

19 Additional exam-style practice

Paper 1 and Paper 2.

WORKED EXAMPLE 8 Paper 1 part (b) (exam level)

Using real-world examples, evaluate government responses to negative production externalities. [15]

Solution

Diagram of negative production externality and welfare lossR1

Carbon tax, permits, regulation, examplesR1 R1

Strengths and weaknesses; judgementR1 R1

20 International cooperation

Global externalities.

Climate change is a global externality: emissions anywhere affect everyone. International agreements (Kyoto Protocol, Paris Agreement) face free-rider problems because countries can benefit from others' reductions without cutting their own.

Quick check

1. Why is climate change hard to solve through national policy alone?

Answers: 1. global externality; free-rider problem between countries

21 Common misconceptions and links

Students often think…	Actually…
any cost to a buyer is an externality	only costs or benefits to third parties are externalities
MSC is always above MPC	only for negative production externalities
a carbon tax should eliminate pollution	the optimum is where MSB = MSC, not zero pollution
common pool resources are public goods	they are rivalrous; public goods are not
the tragedy of the commons is inevitable	Ostrom showed communities can manage commons

How 2.8 connects to the rest of the course

Topic	Connection
2.3 Equilibrium	allocative efficiency and welfare loss
2.7 Role of government	taxes, subsidies and regulation
2.9 Public goods	another cause of market failure
3.3 and 4.7 Sustainability	climate change and sustainable development
2.4 Behavioural economics	nudges for demerit and merit goods

22 Exam-style question with markscheme

Try this under exam conditions (about 18 minutes) before reading the markscheme.

Figure 6. Price of EU emission allowances.

Text A. The EU Emissions Trading System caps total emissions from power stations and heavy industry. After 2008 too many permits were issued and the carbon price collapsed. Reforms tightened the cap, and the price rose above €80 by 2023.

(a) Define negative externality. [2]

(b) Using a diagram, explain why power generation is an example of market failure. [4]

(d) Explain why the carbon price was very low between 2012 and 2016. [2]

Markscheme

Part	Answer	Marks
(a)	a cost imposed on third parties	A1
	not involved in the transaction / not compensated	A1
(b)	diagram: MSC above MPC; Qm > Qopt; welfare loss	A1
	emissions impose external costs (climate change, health)	R1
	producers ignore external cost	R1
	overproduction; allocative inefficiency	R1
(c)	cap limits total emissions	R1
	permits allocated or auctioned	R1
	firms that cut emissions sell spare permits	R1
	reductions made where cheapest	R1
(d)	too many permits issued	R1
	supply of permits exceeded demand, lowering the price	R1

Examiner's comments. In (b), weaker answers drew the welfare loss to the right of Qm. In (c), the best answers explained why trading makes the reductions efficient, not just that the cap limits emissions.

23 Check your understanding

Section A: multiple choice

1. A negative externality occurs when

A. production or consumption imposes costs on third parties B. a firm makes a loss C. prices rise D. the government taxes a good

2. Marginal social cost equals

A. MPB B. price C. MPC plus MEC D. MEB

3. With a negative production externality the market produces

A. less than optimal B. more than the socially optimal quantity C. the optimal quantity D. nothing

4. Education is an example of

A. a negative production externality B. a public good C. a common pool resource D. a positive consumption externality

5. A Pigouvian tax aims to

A. raise maximum revenue B. make producers pay the external cost C. subsidise firms D. lower prices

6. Common pool resources are

A. rivalrous but non-excludable B. non-rivalrous and non-excludable C. excludable and rivalrous D. non-rivalrous but excludable

7. The tragedy of the commons refers to

A. public goods underprovision B. monopoly pricing C. unemployment D. overuse of shared resources

8. A subsidy is an appropriate response to

A. a negative externality B. monopoly profits C. a positive externality D. excess demand

Section B: structured

9. Using a diagram, explain why vaccinations are underconsumed in a free market. [4]

10. Evaluate the use of a carbon tax to reduce greenhouse gas emissions. [8]

11. Explain why fish stocks tend to be overused. [4]

12. Distinguish between a tax and tradable permits as responses to pollution. [4]

Answers

1. A 2. C 3. B 4. D 5. B 6. A 7. D 8. C

9. MSB > MPB (herd immunity); market at MPB = MPC below Qopt; welfare loss; underconsumption.

10. Internalizes externality, market-based, revenue; but MEC hard to measure, regressive, carbon leakage, inelastic demand; judgement.

11. Rivalrous and non-excludable; no ownership; each fisher gains full benefit of extra catch but shares cost; tragedy of the commons.

12. Tax fixes the price of pollution, quantity uncertain; permits fix the quantity, price uncertain.

24 Summary and topic map

Idea	Remember
Market failure	wrong quantity; MSB ≠ MSC at market output
MSC / MSB	MPC + MEC / MPB + MEB
Negative production	MSC > MPC; overproduction
Negative consumption	MSB < MPB; overconsumption
Positive consumption	MSB > MPB; underconsumption
Positive production	MSC < MPC; underproduction
Policies (negative)	tax, permits, regulation, information, agreements
Policies (positive)	subsidy, provision, legislation, information
Common pool resources	rivalrous, non-excludable; tragedy of the commons

Before the exam, make sure you…

•label MPC, MSC, MPB and MSB exactly
•mark Qm and Qopt and shade the welfare loss towards Qopt
•evaluate every policy with strengths and weaknesses
•use Ostrom and real fisheries or climate examples for common pool resources

Externalities and Common Pool Resources on one page

Cover this page with a sheet of paper and try to rebuild it from memory. Whatever you can't recall is what to revise next.

Figure 7. Topic map for Externalities and Common Pool Resources.

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