1.3.2 Externalities

Edexcel A-Level Economics (9EC0) | Theme 1.3.2

Specification Coverage: This topic requires students to analyse negative production and positive consumption externalities using marginal analysis. Students must be able to calculate welfare loss/gain and evaluate government policy responses with reference to real-world examples.

Key Definitions

Externality: A cost or benefit imposed on third parties not involved in the economic transaction.

\(\text{Social Cost (SC)} = \text{Private Cost (PC)} + \text{External Cost}\)

\(\text{Social Benefit (SB)} = \text{Private Benefit (PB)} + \text{External Benefit}\)

Exam Technique: Always specify whether you're discussing production or consumption externalities. The specification only requires negative production and positive consumption cases.

Negative Production Externalities

Definition: When social costs exceed private costs during production (\(MSC > MPC\)).

Diagram Required: Standard negative externality diagram showing:
  • MPC and MSC curves diverging
  • Market equilibrium (MPC = MPB) vs social optimum (MSC = MSB)
  • Welfare loss triangle between Qmarket and Qopt

Worked Example: UK Air Pollution

Scenario: Coal power plant: MPC = £40/MWh | External cost = £25/MWh
Social Cost: \(£40 + £25 = £65/MWh\)
Welfare Loss: At Qmarket = 50,000MWh, triangle area = ½ × (50-30) × (£65-£40) = £250,000
Real-World Application: UK Carbon Price Support tax raised electricity prices by £18/MWh but reduced coal generation by 78% since 2015.

Positive Consumption Externalities

Definition: When social benefits exceed private benefits during consumption (\(MSB > MPB\)).

Diagram Required: Standard positive externality diagram showing:
  • MPB and MSB curves diverging
  • Market equilibrium (MPB = MPC) vs social optimum (MSB = MSC)
  • Welfare gain triangle between Qmarket and Qopt

Merit Goods Characteristics

  1. Under-consumed: Individuals undervalue long-term benefits (e.g., education)
  2. Information gaps: Consumers may not recognise full benefits (e.g., vaccinations)
  3. Positive spillovers: Third-party benefits exceed private gains (e.g., £1 invested in early education yields £13 social return)

Government Intervention Strategies

Policy Negative Externality Positive Externality Effectiveness
Indirect Taxes Carbon tax internalises 72% of external costs (OECD) N/A Regressive impact - poorest spend 8% of income vs 2% for richest
Subsidies N/A UK heat pump grants increased installations by 46% in 2023 £1 subsidy generates £1.80 in external benefits (DfT)
Regulation ULEZ reduced NOx by 26% in London Mandatory vaccinations in NHS High enforcement costs (ULEZ cameras = £130m)
Evaluation Framework: When assessing policies, consider:
  • Effectiveness: Does it fully internalise the externality?
  • Equity: Who bears the costs/benefits?
  • Enforceability: Monitoring costs and evasion risks

Exam Preparation Toolkit

Recent Exam Questions:
  1. "Using diagrams, analyse how a tax on plastic packaging could reduce welfare loss" (Edexcel 2023, 15 marks)
  2. "Evaluate the view that subsidies are the most effective solution to under-consumption of merit goods" (Edexcel 2022, 25 marks)
  3. "Discuss the likely impact of extending the sugar tax to high-salt foods" (Edexcel 2021, 20 marks)

Advanced Analysis Structure

Evaluation Angle Negative Externality Positive Externality
Time Lag Carbon taxes may take 5+ years to change behaviour Education benefits accrue over decades
Global Context UK steel faces £47/tonne carbon cost vs China's £8 Vaccination spillovers across borders
Examiner's Report Insight: In 2023, 68% of students correctly drew externality diagrams but only 29% effectively evaluated policy trade-offs. Top scripts referenced:
  • Dynamic efficiency gains from EV subsidies
  • Cross-elasticities between taxed/substitute goods
  • Administrative burden of monitoring regulations