3.8 Limitations of markets — OCR GCSE Economics revision notes

Externalities

Markets allocate resources through price (2.4), but they do not always do it well. An externality is a cost or benefit that falls on a third party — someone who is neither the buyer nor the seller in a transaction.

The third party is the whole definition, and it is where marks are lost. A cost to the buyer is not an externality; it is the price. An externality lands on someone who had no say in the deal and receives nothing for bearing it.

The buyer and seller agree the transaction. The third party did not, and is affected anyway — which is why the market price does not reflect the full cost or benefit.

A negative externality is a cost imposed on a third party. A factory releasing pollution into a river imposes costs on people downstream, on fishermen and on anyone who has to clean it up. Those costs are real, but the factory does not pay them, so its production costs are lower than the true cost to society. Because the good appears cheaper than it really is, more of it is produced and consumed than is good for society — the market over-produces it.

A positive externality is a benefit received by a third party. Someone who is vaccinated protects not only themselves but everyone they would otherwise have infected. Someone who is educated becomes more productive, which benefits the firms they work for and the taxpayers they eventually support. But the individual deciding whether to be vaccinated or to stay in education weighs only their own benefit against their own cost, and ignores the benefit to everyone else — so less is consumed than is good for society, and the market under-produces it.

That pair of conclusions — over-produced and under-produced — is the reason government intervenes, and every policy below follows from one of them.

Externality: a cost or benefit that falls on a third party — someone who is neither the buyer nor the seller in a transaction
Negative externality: a cost falling on a third party, such as pollution from a factory
Positive externality: a benefit falling on a third party, such as the wider gain from someone being vaccinated

Government policies to correct externalities

Figure: The four policies the specification names

Policy	How it works	Used against
Taxation	A tax raises the producer's costs, shifting supply left, so price rises and quantity falls towards the socially desirable level	Negative externalities — fuel duty, tobacco and alcohol duty, carbon taxes, sugar levy
Subsidies	A subsidy lowers costs, shifting supply right, so price falls and quantity rises	Positive externalities — subsidised public transport, solar panels, apprenticeships
State provision	The government provides the good directly, free or below cost, funded through taxation	Positive externalities — the NHS, state schools, roads, street lighting
Legislation and regulation	Rules that ban or limit the activity, backed by fines or prosecution	Negative externalities — emission limits, the smoking ban, minimum ages, planning rules
Information provision	Campaigns, labelling and education that change what people choose, by correcting what they know	Either — health warnings on cigarettes, calorie labelling, advertising campaigns on recycling

The logic is symmetrical: a negative externality is over-produced, so it is taxed or restricted down; a positive one is under-produced, so it is subsidised or provided up.

Information provision deserves a note, because it works differently from the rest. The other policies change the price or make the activity illegal. Information provision changes what people want, by giving them facts they did not have — that the good is more harmful, or more beneficial, than they believed. It shifts demand rather than supply, and it leaves the choice with the individual.

Evaluating the policies

Figure: Strengths and weaknesses of each

Policy	Strengths	Weaknesses
Taxation	Raises revenue that can fund the clean-up or other services; makes the polluter pay; keeps choice with the consumer	If demand is inelastic, consumption barely falls, so it raises money without changing behaviour; regressive, hitting low incomes hardest; setting the right level is guesswork
Subsidies	Directly increases consumption of a beneficial good; can make it affordable to those on low incomes	Expensive, with an opportunity cost; firms may become dependent on them; taxpayers fund a good that not all of them use
State provision	Guarantees access regardless of ability to pay; captures the full external benefit	Very expensive; without competition there is less pressure to be efficient; the government may misjudge how much to provide
Legislation and regulation	Certain in effect if enforced — a ban stops the activity; clear and easy to understand	Costly to monitor and enforce; may create black markets; a blanket rule cannot fit every case; may drive firms abroad
Information provision	Cheap relative to the others; preserves freedom of choice; effects can be long-lasting once attitudes change	Slow, and may be ignored; hard to know whether it worked; competes with commercial advertising

Worked example

A government wants to reduce the harm caused by sugary drinks. Evaluate a tax on them against an alternative policy.

Identify the externality: the health costs of obesity fall on the NHS and on taxpayers, not on the buyer alone — a negative externality, so the market over-produces.
A tax raises the price, so quantity demanded falls, and it raises revenue that can fund health programmes.
But check elasticity, since that decides whether it works.
Demand for sugary drinks is fairly inelastic for regular buyers, so consumption may fall less than hoped, and the tax is regressive.
Consider the alternative: information provision through labelling and health campaigns.
That is cheaper and preserves choice, but is slow and easily ignored.
Reach a judgement that uses both rather than choosing blindly.

Answer: A tax is justified: the health costs falling on the NHS are a negative externality the buyer does not pay, so the drink is under-priced and over-consumed, and a tax brings the price closer to the true cost while raising revenue for health services. But demand is relatively inelastic, so consumption may fall less than intended, and the tax takes a larger share of a low income. Information provision through clear labelling and campaigns is cheaper and preserves choice, though it is slow. The strongest answer is to use both — the tax changes the price now, and information changes preferences over time, which is what makes the reduction last.

Common mistake

An externality falls on a third party, not on the buyer or the seller. The price paid by the buyer and the cost borne by the producer are private costs — they are exactly what the market already accounts for.

Before you practise

An externality is a cost or benefit falling on a third party, outside the transaction.
A negative externality means the market over-produces, because the producer does not pay the full cost.
A positive externality means the market under-produces, because the buyer does not receive the full benefit.
Taxation raises price and reduces quantity — used against negative externalities.
Subsidies lower price and raise quantity — used for positive externalities.
State provision supplies the good directly, funded by taxation.
Legislation and regulation ban or limit the activity.
Information provision changes demand by changing what people know.
A tax on an inelastic good raises revenue but changes behaviour little.
Every policy has an opportunity cost, and combining policies is often the strongest answer.

Externalities

Government policies to correct externalities

Evaluating the policies

Before you practise

Now practise it