1.3.2 Externalities — Practice Questions
Ten original multiple-choice questions on externalities, written to the style and difficulty of Edexcel Paper 1 Section A. Two are calculations and one asks you to sketch the diagram.
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10 questions in this set
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1. Producing one tonne of a chemical costs a firm £340 in wages, materials and energy. The pollution released imposes £85 of health costs on nearby residents. The marginal social cost of that tonne is
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Answer: D (£425). Marginal social cost is the whole cost to society of producing one more unit:
MSC = MPC + MEC.
Marginal private cost, borne by the firm: £340.
Marginal external cost, borne by residents: £85.
MSC = £340 + £85 = £425.
The firm decides on the £340 it actually pays, which is why it produces more than is socially optimal. The whole purpose of a tax here is to make the firm face something closer to £425.Why the other options are wrong
- A — £85 is the external cost alone — the part the firm does not pay. It is one component of social cost, not the total.
- B — This subtracts rather than adds: £340 − £85. External costs are added to private costs, because society bears both.
- C — £340 is the private cost alone. It is what appears in the firm's accounts, and the fact that it omits the £85 is precisely the market failure.
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2. A good whose consumption generates positive externalities, so that society gains more from it than the consumer alone does, is called
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Answer: B (A merit good.). A merit good generates positive externalities: the benefit to society exceeds the private benefit the consumer receives. Education and healthcare are the standard examples.
Because consumers weigh only their own benefit, merit goods are under-consumed by the free market, which is the case for subsidising or directly providing them.Why the other options are wrong
- A — A demerit good is the mirror image — it generates negative externalities, imposing costs on society beyond those the consumer bears, and is over-consumed.
- C — A private good is excludable and rival. That classification is about who can be stopped from consuming it, not about spillover effects.
- D — A public good is non-excludable and non-rival. Most merit goods fail both tests: a school place can be charged for, and one pupil taking it means another cannot.
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3. Sketching a market with a negative externality in production, with MSC drawn above and parallel to MPC, the vertical gap between the two curves measures
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Answer: C (The external cost per unit.). Read the diagram vertically. At any quantity, the height of MPC is what the firm pays and the height of MSC is what society pays in total.
The gap between them is what society pays and the firm does not — the external cost per unit. That follows directly from MSC = MPC + MEC, rearranged as MEC = MSC − MPC.
It also tells you the size of the tax that would internalise the externality: set it equal to that gap and the firm's private cost curve rises onto the social one.Why the other options are wrong
- A — The private cost per unit is the height of the MPC curve itself, measured from the horizontal axis — not the distance between the two curves.
- B — The social cost per unit is the height of the MSC curve from the axis. The gap is the difference between the two heights.
- D — The welfare loss is the shaded triangle between Q1 and Q2, bounded by MSC and MSB. It is an area, not a vertical distance.
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4. In a market with a negative externality in production, the free market produces at Q1 while the social optimum is at Q2. To move from Q1 to Q2
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Answer: A (Output must fall and price must rise.). Because producers ignore the external cost, they treat the good as cheaper to make than it really is. The result is that it is over-produced and under-priced: Q1 lies to the right of Q2.
Correcting that means cutting output back to Q2. Moving left along the demand curve, a smaller quantity is only bought at a higher price — so output falls and price rises. That combination is what an indirect tax achieves, by shifting MPC up towards MSC.Why the other options are wrong
- B — Price and quantity move in opposite directions along a downward-sloping demand curve. A smaller quantity cannot be sold at a lower price.
- C — Output is already too high. Raising it further would enlarge the welfare loss rather than remove it.
- D — Both halves are wrong. Output must fall, and a falling price would encourage still more consumption.
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5. Table 1 shows the values attaching to one extra training place.
Using Table 1, the marginal social benefit of that place isTable 1: Values attaching to one extra training place, £ Value Marginal private benefit 2,400 Marginal external benefit 900 Marginal social cost 2,800 Show model answer
Answer: D (£3,300). Marginal social benefit is the whole benefit to society of one more unit:
MSB = MPB + MEB.
MSB = £2,400 + £900 = £3,300.
Now compare it with the marginal social cost of £2,800. Society gains £3,300 from the place and gives up £2,800 to provide it, so it is worth providing.
The trainee alone, though, weighs only their private £2,400 against the cost — and £2,400 is less than £2,800, so they decline. That gap is exactly why training is under-provided without a subsidy.Why the other options are wrong
- A — £900 is the external benefit alone — the part that falls on other people. It is one component of social benefit.
- B — This subtracts rather than adds: £2,400 − £900. External benefits are added to private ones.
- C — £2,400 is the private benefit alone. It is what the individual acts on, and its being below the £2,800 cost is the market failure.
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6. On a diagram showing a positive externality in consumption, the shaded triangle between Q1 and Q2 represents
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Answer: A (The benefit society forgoes on units never consumed.). Between Q1 and Q2 sits a block of units where the marginal social benefit exceeds the marginal social cost — society would gain from each of them. The free market does not produce them, because private consumers do not see the external part of the benefit.
The triangle measures the value of those forgone gains. It is the social welfare loss from under-consumption, and it is the quantity a subsidy is trying to recover.Why the other options are wrong
- B — No subsidy has been introduced. The triangle exists in the uncorrected market and measures a loss to society, not a cost to the Exchequer.
- C — The external benefit per unit is the vertical gap between MPB and MSB. The triangle is the welfare given up on the units that never get consumed at all.
- D — Producer revenue is a private figure, and would be shown as a rectangle. The triangle measures welfare, which includes the benefit to third parties.
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7. A government raises the duty on domestic heating fuel to reflect its external costs. A common criticism is that the duty is regressive, meaning that it
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Answer: D (Takes a larger share of income from poorer households.). A regressive tax takes a larger proportion of a low income than of a high one. Heating fuel is close to a necessity, and poorer households spend a much bigger share of what they earn on it, so a duty on it costs them proportionally more.
This is a distributional objection, and it sits alongside rather than against the environmental case. A government persuaded by both usually keeps the duty and pairs it with targeted support, so the price signal survives while the burden is offset.Why the other options are wrong
- A — That would be a statement about tax incidence, which depends on the relative elasticities of demand and supply. Regressive describes how a burden is spread across incomes, not across buyers and sellers.
- B — That describes an effect on revenue as rates rise, which is a separate argument altogether and says nothing about fairness.
- C — A weak effect on consumption is a criticism of the duty's effectiveness. Regressive is about who pays, not about whether it works.
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8. A government caps total emissions and auctions tradable permits that firms must hold in order to pollute. One drawback of the scheme is that it
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Answer: C (Presses hardest on small firms, which may be forced out.). Permits have to be bought, so they raise costs — and a small firm has a smaller output over which to spread that cost, and less cash with which to bid at auction, than a large rival.
The risk is that smaller producers are squeezed out, leaving the industry more concentrated than before. The scheme then cuts emissions as designed while weakening competition, which is a real cost to set against the environmental gain.Why the other options are wrong
- A — The opposite holds. A firm that pollutes less needs fewer permits and can sell its spare ones, so cleaning up pays directly.
- B — The cap is the limit, and it is the scheme's main advantage. Total emissions cannot exceed the number of permits issued.
- D — Permits raise costs rather than lowering them. That is the mechanism by which the external cost is internalised, not a drawback.
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9. A public health campaign publicises the damage caused by a demerit good. On the externality diagram, the intended effect is to shift
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Answer: A (MPB down towards MSB.). For a demerit good, consumers over-value the good relative to what it is really worth to society, so MPB lies above MSB.
An information campaign works on what consumers believe, which is the demand side. Persuading them that the good is more harmful than they thought pulls their perceived private benefit down towards the true social benefit, reducing demand and cutting consumption towards the optimum.
Note what it does not touch: the cost of producing the good is unchanged.Why the other options are wrong
- B — Shifting MPB up would raise demand. That is what a campaign about a merit good aims at — publicising the benefits of vaccination, for instance.
- C — MPC is the supply side. A campaign changes consumers' perception of benefit, not producers' costs.
- D — Shifting MPC up is what an indirect tax does. It cuts consumption by raising price rather than by changing what consumers believe.
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10. Rather than taxing petrol, a government subsidises rail travel in order to cut road emissions. Compared with a tax on petrol, the strongest argument for this approach is that it
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Answer: C (Leaves the cost of motoring unchanged for drivers.). Subsidising the alternative and taxing the activity both aim to shift journeys off the road, but they land very differently on households.
A petrol duty raises motoring costs for everyone, including people with no realistic alternative — rural households, shift workers, those without a station nearby. A rail subsidy leaves their costs where they are and simply makes the alternative more attractive to those who can use it.
That is a genuine advantage on distributional grounds. It is bought at a price: the subsidy costs money rather than raising it, and it leaves petrol still priced below its social cost.Why the other options are wrong
- A — Nothing is guaranteed. Whether drivers switch depends on how good a substitute rail is for the journeys they actually make, and for many it is not one at all.
- B — This is what a tax does. A subsidy on the alternative leaves the price of petrol below its social cost, so the externality is not internalised.
- D — A subsidy costs the Exchequer money rather than raising it. Revenue is an argument for the tax, not for the subsidy.