Free Markets are inefficient in allocation resources because it only considers the private costs and private benefits of consuming or producing
a certain good – external costs and benefits also need to be considered to reach a socially optimal equilibrium where allocation of resources is
most efficient and socially optimal.
In Free markets : Where there are negative externalities, firms prod. Higher levels of output than if they had to pay the full social cost of
production (good overproduced). Where there are negative externalities, cons. consume Higher levels of output than if they had to pay the
full social cost of consumption (good overconsumed). Where there are positive externalities, firms prod. lower levels of output than if they
had to pay the full social benefit of production (good underproduced). Where there are positive externalities, cons. consume lower levels of
output than if they had gained the full social benefit of consumption (good under consumed).
Social Cost (cost of econ. Activity to whole of society) = Private Costs Social Benefit (benefit of econ. Activity enjoyed by
(cost to individual firm/cons) + External Costs whole of society) = Private Benefits (benefit to
individual firm/cons) + External Benefits
Externality is the impact of an economic transaction on a third-party
A positive externality is the beneficial effect of an economic transaction on a third party (those not involved in original transaction), also
known as an external benefit.
A negative externality is the harmful effect of an economic activity on a third party (those not involved in original transaction), also known
as an external cost.
Wind Farms :
Private Costs: installation cost, price, cost of manufacture, land, labour
Private Benefits : cheaper electricity in long run , less impact on health , revenue, satisfaction
External Costs: visual pollution, falling property prices in area,
External Benefits : fewer harmful gasses emitted, employment created,
The government uses taxation, subsidies, state provision, legislation and regulation, and information provision to correct positive and
negative externalities.
→ Indirect Taxation: Government’s collection of money from individuals and firms. An indirect tax will increase the costs of production
for firms, causing a decrease in supply ( Increase in cost means less profit incentive) and increase in price and in response, the quantity
demanded falls , external cost falls as there are fewer negative externalities from the economic activity. It also means fewer resources are
used in production of good with harmful side effects . Where markets have + externality, lower VAT or no VAT (like medicine or healthy
food)
Use and Impact: - Size of tax – it is difficult to set the correct size of tax to cover externalities. Also depends on PED – if inelastic,
consumers are less responsive to change in price, so tax will create a smaller proportional fall in Qd, than the rise in price, so may have
minimal impact – If elastic, will have large impact.
Advantages: Reduces negative externalities , Very precise and targeted – only the polluter pays and no one else , Tax revenue – can be
used to subsidize goods with + externalities, tax revenue from PED inelastic significant cos consumer still buying good so gov gets higher
tax rev. , product is still available and not banned altogether – consumer choice preserved, The tax revenue can be hypothecated –
gov. spends revenue they collect from tax back onto that problem, which can lead to behavioural changes in long term – if gov takes sugar
tax, and spends it on healthy school meal, children will grow up eating healthy food, so there might be a behavioural change where when
children grow up they eat healthily.
Disadvantages: Tax may be regressive – if same tax amount is taken it is a greater prop. Of lower incomes, leaving poorer consumers with
less income to buy necessities, increasing inequality. Cost to administer and enforce taxation- goods may be sold illegally so not
regulated so product safety may be reduced and gov. wont get tax rev.
→ Subsidies: A sum of money given by the government to firms to encourage production and consumption. A subsidy decreases the costs of
production for a firm which increases supply as now firms have more profit incentive to supply. This leads to a decrease in equilibrium price
increasing the quantity demanded. – used for + externality
Use and Impact: size of subsidy – difficult to set correct size of subsidy to increase consumption to the level that is best for society, and
impact depends on PED – if elastic has more impact
Pros : more job creation in subsidised market, encourages production and consumption of good with + externality
Cons: O.C – gov. could spend this money on somewhere else , O.C to taxpayers – gov. may increase taxes to pay for subsidy. , firms may
not use subsidy efficiently and may not pass on Cop decrease to consumers
, → State Provision: Government intervention in a market to supply a good or service directly to consumers. These products tend to be
underproduced and under consumed.
Currently, only S is supplied, and thus prices id at P, meaning only Q can
demand goods with positive externalities, like healthcare. If government
decides to provide the product, then the supply increases to S1 . The
government supplies a fixed quantity of healthcare, that is free where it
meets demand at equilibrium price of zero .As a result, a lot more ppl can
access good – Q1.
Use an Impact: difficulty in setting correct level of supply – impact of state
provision depends on whether government provides enough of good or service,. If
government supplies too low a quantity of healthcare at S, then when the service is
free of charge, Q1 is demanded, but only Q is supplied – this means there is excess
demand, leading to a shortage (waiting list in hospitals), or price may increase ,
there is a time lag to see effects – build schools + hospitals takes time, so a long
term plan.
Pros: Improved standard of living – ability for low-income consumers to access essential goods and services. Also if gov. state provides
education, then reduction in inequality. Increased benefits for society – education skilled workforce increases productivity and
output. Healthcare healthier workforce more productive output, better SoL
Cons: O.C for gov. , O.C for taxpayers – gov. may raise taxes to pay for state provision, meaning individuals/firms sacrifice other uses for
income they lose – may be offset by free provision of state goods and services. Shortages over time – demand may shift right , creating ot
increasing shortage and making it more dif. For some consumers to access (e.g due to increasing population size, or external shocks like
pandemics), no price mechanism to guide resource allocation, so may lead to too many/ too few goods.
→ Legislation and Regulation: Legislation is a law created by the government to control the way individuals and firms behave. Regulation
is a rule from the government to control the way firms and/or consumers have to follow. They try to reduce or eliminate the impact of
negative externalities by adding restrictions e.g. alcohol and may also try to close a market entirely e.g. guns , illegal drugs.
Use and Impact: making production/consumption illegal can have significant impact on reducing negative externalities , Can successfully
change attitudes so positive habits become a norm in society, impact may be reduced if not enforced properly, as firms/individuals may
ignore rules
Advantages : Simple to understand and cheap to enforce, often giving quantifiable instructions on what can / can't be done (e.g. age
restrictions for the purchase of tobacco / alcohol; similar for leaving education) , Those who break the rules are often fined heavily
(especially regarding pollution), which gives the government revenues for cleaning up and acts as a deterrent to discourage other firms
polluting. , Consumer protection laws give consumers direct address against false claims made by firms - especially useful for eliminating
info asymmetries
Disadvantages : For pollution, difficult for government to set the right level of regulation to ensure economic efficiency (e.g. fall in
CO2 worth £40m but cost firms only £30m) or toa tight (fall in CO2 worth £20m but cost firms £30m) , Regulations prevent the operation
of the price mechanism - Regulations impose specific requirements on firms regardless of the cost, disrupting the natural price signals that
would otherwise guide efficient resource allocation (contrast with pollution permits - Under a pollution permit system, the government
issues a limited number of permits that allow firms to emit a certain amount of pollution. Firms can buy, sell, or trade these permits in a
market, creating a price for pollution. This allows the price mechanism to operate while still achieving the desired environmental outcome. ) ,
banning product by law doesn’t mean consumption will fall – unofficial markets illegal activity, smuggling – cost of policing black
markets – O.C to this , Some people / firms ignore regulations, e.g. firms will dump waste in rivers, some children will truant, some
motorists drive without insurance, etc. These increase the government's cost of monitoring, policing and enforcement – O.C to this . ,
Regulations forcing people to buy goods with positive externalities (e.g. health insurance in USA) may impose disproportionately heavy
costs on poorer families
→ Information Provision: Government intervention in a market to give knowledge that might change behaviour. Information may
encourage consumption of goods with positive externalities by giving consumers facts about the benefits of consuming specific goods and
services, causing an outward shift in demand. On the other hand, information may discourage consumption of demerit goods with negative
externalities by giving consumers facts about the harmful costs of consuming specific goods and services, causing an inward shift of demand.
Use and Impact: aims to fill information gaps in market, so consumers and producers can make economic choices when they are fully
aware of all impacts. However, consumers may be unresponsive to information, especially if addictive good, and there may also be
difficulty in delivering information to consumers (like limited attention spans , information overload, complex information, conflicting
information – consumers may encounter conflicting/misleading info from different sources), which may reduce impact.
Pros: Relatively cheap method of changing behaviour, so the opportunity cost is lower , increased / decreased consumption of goods
with + / - externalities
Disadvantages : Consumers may take little notice of the information provided - especially if the consumption is due to their social
norms/addiction , There may be significant time lags before consumers change their behaviour . , People may not care about the
externality - people may only interested in private costs/benefits. , O.C – costs involved with producting and delivering this
information
a certain good – external costs and benefits also need to be considered to reach a socially optimal equilibrium where allocation of resources is
most efficient and socially optimal.
In Free markets : Where there are negative externalities, firms prod. Higher levels of output than if they had to pay the full social cost of
production (good overproduced). Where there are negative externalities, cons. consume Higher levels of output than if they had to pay the
full social cost of consumption (good overconsumed). Where there are positive externalities, firms prod. lower levels of output than if they
had to pay the full social benefit of production (good underproduced). Where there are positive externalities, cons. consume lower levels of
output than if they had gained the full social benefit of consumption (good under consumed).
Social Cost (cost of econ. Activity to whole of society) = Private Costs Social Benefit (benefit of econ. Activity enjoyed by
(cost to individual firm/cons) + External Costs whole of society) = Private Benefits (benefit to
individual firm/cons) + External Benefits
Externality is the impact of an economic transaction on a third-party
A positive externality is the beneficial effect of an economic transaction on a third party (those not involved in original transaction), also
known as an external benefit.
A negative externality is the harmful effect of an economic activity on a third party (those not involved in original transaction), also known
as an external cost.
Wind Farms :
Private Costs: installation cost, price, cost of manufacture, land, labour
Private Benefits : cheaper electricity in long run , less impact on health , revenue, satisfaction
External Costs: visual pollution, falling property prices in area,
External Benefits : fewer harmful gasses emitted, employment created,
The government uses taxation, subsidies, state provision, legislation and regulation, and information provision to correct positive and
negative externalities.
→ Indirect Taxation: Government’s collection of money from individuals and firms. An indirect tax will increase the costs of production
for firms, causing a decrease in supply ( Increase in cost means less profit incentive) and increase in price and in response, the quantity
demanded falls , external cost falls as there are fewer negative externalities from the economic activity. It also means fewer resources are
used in production of good with harmful side effects . Where markets have + externality, lower VAT or no VAT (like medicine or healthy
food)
Use and Impact: - Size of tax – it is difficult to set the correct size of tax to cover externalities. Also depends on PED – if inelastic,
consumers are less responsive to change in price, so tax will create a smaller proportional fall in Qd, than the rise in price, so may have
minimal impact – If elastic, will have large impact.
Advantages: Reduces negative externalities , Very precise and targeted – only the polluter pays and no one else , Tax revenue – can be
used to subsidize goods with + externalities, tax revenue from PED inelastic significant cos consumer still buying good so gov gets higher
tax rev. , product is still available and not banned altogether – consumer choice preserved, The tax revenue can be hypothecated –
gov. spends revenue they collect from tax back onto that problem, which can lead to behavioural changes in long term – if gov takes sugar
tax, and spends it on healthy school meal, children will grow up eating healthy food, so there might be a behavioural change where when
children grow up they eat healthily.
Disadvantages: Tax may be regressive – if same tax amount is taken it is a greater prop. Of lower incomes, leaving poorer consumers with
less income to buy necessities, increasing inequality. Cost to administer and enforce taxation- goods may be sold illegally so not
regulated so product safety may be reduced and gov. wont get tax rev.
→ Subsidies: A sum of money given by the government to firms to encourage production and consumption. A subsidy decreases the costs of
production for a firm which increases supply as now firms have more profit incentive to supply. This leads to a decrease in equilibrium price
increasing the quantity demanded. – used for + externality
Use and Impact: size of subsidy – difficult to set correct size of subsidy to increase consumption to the level that is best for society, and
impact depends on PED – if elastic has more impact
Pros : more job creation in subsidised market, encourages production and consumption of good with + externality
Cons: O.C – gov. could spend this money on somewhere else , O.C to taxpayers – gov. may increase taxes to pay for subsidy. , firms may
not use subsidy efficiently and may not pass on Cop decrease to consumers
, → State Provision: Government intervention in a market to supply a good or service directly to consumers. These products tend to be
underproduced and under consumed.
Currently, only S is supplied, and thus prices id at P, meaning only Q can
demand goods with positive externalities, like healthcare. If government
decides to provide the product, then the supply increases to S1 . The
government supplies a fixed quantity of healthcare, that is free where it
meets demand at equilibrium price of zero .As a result, a lot more ppl can
access good – Q1.
Use an Impact: difficulty in setting correct level of supply – impact of state
provision depends on whether government provides enough of good or service,. If
government supplies too low a quantity of healthcare at S, then when the service is
free of charge, Q1 is demanded, but only Q is supplied – this means there is excess
demand, leading to a shortage (waiting list in hospitals), or price may increase ,
there is a time lag to see effects – build schools + hospitals takes time, so a long
term plan.
Pros: Improved standard of living – ability for low-income consumers to access essential goods and services. Also if gov. state provides
education, then reduction in inequality. Increased benefits for society – education skilled workforce increases productivity and
output. Healthcare healthier workforce more productive output, better SoL
Cons: O.C for gov. , O.C for taxpayers – gov. may raise taxes to pay for state provision, meaning individuals/firms sacrifice other uses for
income they lose – may be offset by free provision of state goods and services. Shortages over time – demand may shift right , creating ot
increasing shortage and making it more dif. For some consumers to access (e.g due to increasing population size, or external shocks like
pandemics), no price mechanism to guide resource allocation, so may lead to too many/ too few goods.
→ Legislation and Regulation: Legislation is a law created by the government to control the way individuals and firms behave. Regulation
is a rule from the government to control the way firms and/or consumers have to follow. They try to reduce or eliminate the impact of
negative externalities by adding restrictions e.g. alcohol and may also try to close a market entirely e.g. guns , illegal drugs.
Use and Impact: making production/consumption illegal can have significant impact on reducing negative externalities , Can successfully
change attitudes so positive habits become a norm in society, impact may be reduced if not enforced properly, as firms/individuals may
ignore rules
Advantages : Simple to understand and cheap to enforce, often giving quantifiable instructions on what can / can't be done (e.g. age
restrictions for the purchase of tobacco / alcohol; similar for leaving education) , Those who break the rules are often fined heavily
(especially regarding pollution), which gives the government revenues for cleaning up and acts as a deterrent to discourage other firms
polluting. , Consumer protection laws give consumers direct address against false claims made by firms - especially useful for eliminating
info asymmetries
Disadvantages : For pollution, difficult for government to set the right level of regulation to ensure economic efficiency (e.g. fall in
CO2 worth £40m but cost firms only £30m) or toa tight (fall in CO2 worth £20m but cost firms £30m) , Regulations prevent the operation
of the price mechanism - Regulations impose specific requirements on firms regardless of the cost, disrupting the natural price signals that
would otherwise guide efficient resource allocation (contrast with pollution permits - Under a pollution permit system, the government
issues a limited number of permits that allow firms to emit a certain amount of pollution. Firms can buy, sell, or trade these permits in a
market, creating a price for pollution. This allows the price mechanism to operate while still achieving the desired environmental outcome. ) ,
banning product by law doesn’t mean consumption will fall – unofficial markets illegal activity, smuggling – cost of policing black
markets – O.C to this , Some people / firms ignore regulations, e.g. firms will dump waste in rivers, some children will truant, some
motorists drive without insurance, etc. These increase the government's cost of monitoring, policing and enforcement – O.C to this . ,
Regulations forcing people to buy goods with positive externalities (e.g. health insurance in USA) may impose disproportionately heavy
costs on poorer families
→ Information Provision: Government intervention in a market to give knowledge that might change behaviour. Information may
encourage consumption of goods with positive externalities by giving consumers facts about the benefits of consuming specific goods and
services, causing an outward shift in demand. On the other hand, information may discourage consumption of demerit goods with negative
externalities by giving consumers facts about the harmful costs of consuming specific goods and services, causing an inward shift of demand.
Use and Impact: aims to fill information gaps in market, so consumers and producers can make economic choices when they are fully
aware of all impacts. However, consumers may be unresponsive to information, especially if addictive good, and there may also be
difficulty in delivering information to consumers (like limited attention spans , information overload, complex information, conflicting
information – consumers may encounter conflicting/misleading info from different sources), which may reduce impact.
Pros: Relatively cheap method of changing behaviour, so the opportunity cost is lower , increased / decreased consumption of goods
with + / - externalities
Disadvantages : Consumers may take little notice of the information provided - especially if the consumption is due to their social
norms/addiction , There may be significant time lags before consumers change their behaviour . , People may not care about the
externality - people may only interested in private costs/benefits. , O.C – costs involved with producting and delivering this
information
