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A-Level · Economics

ECO.MIC21 Externalities: Negative and Positive Production and Consumption Effects

AQA 7136 · Calculators not allowed · about 75 minutes

Total Marks

Name: _______________________________ Date: ____ / ____ / ______

Answer all questions in full sentences where appropriate. Show working for any calculations. Allow about 75 minutes for the whole pack. At least three questions require full sentence answers (look for 'Explain' or 'Assess' command words).

Define the term 'externality' as it is used in microeconomics, naming whether it can arise from production or consumption and giving one concise example of each.

(Total for Question 1 is 2 marks)

State the difference between marginal private cost (MPC) and marginal social cost (MSC) in the context of a firm producing bricks that generate dust pollution for nearby households.

(Total for Question 2 is 2 marks)

Define marginal private benefit (MPB) and marginal social benefit (MSB) for the case of a person receiving a seasonal influenza vaccine, and state which is larger when positive consumption externalities are present.

(Total for Question 3 is 2 marks)

Explain why, for a good that creates a negative production externality such as airborne emissions from an urban power plant, the free-market output tends to exceed the socially optimal output.

(Total for Question 4 is 3 marks)

Explain one limitation of using a Pigovian tax to correct a negative production externality from an urban brickworks that emits dust affecting nearby residents.

(Total for Question 5 is 3 marks)

Diagram task: Draw a correctly labelled marginal private cost and marginal social cost diagram for a good produced with negative production externalities, clearly showing the free-market equilibrium and the socially optimal output, and shade the welfare loss triangle between the MPC and MSC. In your answer explain briefly which curves you have drawn and why the triangle represents welfare loss.

(Total for Question 6 is 8 marks)

State two examples of positive consumption externalities other than vaccination, naming a specific good or service and briefly explaining the external benefit for each example.

(Total for Question 7 is 2 marks)

Explain, using a brief numerical example, how a subsidy to buyers can correct a positive consumption externality for a good such as seasonal flu vaccination. Show how the subsidy shifts private benefit to social benefit and calculate the change in equilibrium quantity if initial MPB intersects supply at Q1 and a subsidy of GBP 5 per dose increases MPB by GBP 5 at each quantity, moving equilibrium from Q1 = 40 doses to Q2 = 60 doses.

(Total for Question 8 is 8 marks)

Explain one possible unintended consequence of regulating a negative production externality by imposing a quantity limit (tradable permits) on firms emitting particulate dust in a city brickworks cluster.

(Total for Question 9 is 4 marks)

Calculate the marginal social cost (MSC) per unit if a small brewery's marginal private cost (MPC) per unit brewed is GBP 8 and the estimated marginal external cost to nearby residents is GBP 2. Then calculate the Pigovian tax per unit that would internalise the externality and state its value.

(Total for Question 10 is 4 marks)

Explain briefly why information failures are not the focus of this pack on externalities, and give one short example of how information problems might interact with externalities without repeating material on public goods or moral hazard.

(Total for Question 11 is 6 marks)

Evaluate the view that government intervention is necessary to correct the negative production externalities caused by urban brickworks emitting dust, considering alternatives such as negotiation, regulation, taxes or tradable permits, and practical limitations such as measurement problems, enforcement costs and potential distributional effects. Use diagrammatic reasoning where appropriate and reach a supported judgement.

(Total for Question 12 is 15 marks)

Explain briefly how the concept of marginal social benefit could justify government subsidising adult education courses, and give one potential drawback of such a subsidy.

(Total for Question 13 is 3 marks)

A small town has three brickworks. The marginal private cost schedule per unit of dust-producing output is constant at GBP 7. If the marginal external cost per unit is estimated at GBP 3 and the market demand for brickworks output is such that without intervention the equilibrium quantity is 100 units, explain using arithmetic what the socially optimal price and quantity would be if supply were perfectly competitive and the social optimum requires setting price equal to MSC. Assume demand at price GBP 10 is Q = 100 and that demand is perfectly elastic at that price for the purposes of this calculation. State the socially optimal price and the Pigovian tax required.

(Total for Question 14 is 6 marks)

Mark scheme · ECO.MIC21 Externalities: Negative and Positive Production and Consumption Effects

Question 1

B1 a cost or benefit from an economic activity that affects a third party who is not part of the market transaction and is not reflected in market prices
B1 one example each: production e.g. factory air pollution; consumption e.g. vaccination giving herd immunity
Answer: A cost or benefit from production or consumption that affects third parties but is not reflected in market prices; examples: production externality, factory air pollution; consumption externality, vaccination.

Question 2

B1 MPC is the additional cost to the firm of producing one more unit, including private inputs and operating costs
B1 MSC equals MPC plus the external cost imposed on third parties, such as health and cleaning costs from dust pollution
Answer: MPC is the firm's extra cost of producing one more brick; MSC is MPC plus the external costs borne by nearby households, for example higher cleaning and health costs from dust.

Question 3

B1 MPB is the benefit to the individual consumer from consuming one more unit, e.g. reduced own risk of illness from the vaccine
B1 MSB equals MPB plus external benefits to others, so when vaccines produce positive consumption externalities MSB > MPB
Answer: MPB is the private benefit to the vaccinated person; MSB is MPB plus benefits to others (reduced transmission), so MSB is larger than MPB when vaccines give positive externalities.

Question 4

M1 private firms choose output where MPC = MPB and do not account for external harms
A1 because external costs are omitted the MSC curve lies above the MPC curve at each level of output
A1 therefore the market equilibrium where MPC = MPB occurs at a higher quantity than the social optimum where MSC = MSB (or MSC = MPB if benefits are private), producing overproduction
Answer: Firms equate MPC and MPB and ignore external harms; this makes MSC greater than MPC, so the market output at MPC = MPB is larger than the social optimum at MSC = MPB, causing overproduction.

Question 5

M1 identifies a plausible limitation, for example the practical difficulty of measuring the true marginal external cost per unit of output
A1 explains the consequence, e.g. if the tax is set too low the externality is not corrected, if too high it creates excessive firm costs and deadweight loss
B1 offers a further developed evaluative point, for example political resistance or administrative costs may make precise Pigovian taxes impractical and reduce net welfare gains
Answer: Measuring the true marginal external cost is difficult, so a tax set incorrectly may under- or over-correct; additionally political and administrative costs can reduce the net welfare benefit.

Question 6

B1 correctly labelled vertical axis 'Price/Cost' and horizontal axis 'Quantity, Q'
B1 MPC curve drawn upward sloping and labelled 'MPC' or 'MPC (private cost)'
B1 MSC curve drawn above and to the left of MPC at each output, upward sloping and labelled 'MSC' or 'MSC (social cost)'
B1 MPB or demand curve drawn downward sloping and labelled 'MPB' or 'Demand' to show private benefit
B1 free-market equilibrium marked where MPC = MPB at quantity Qm and price Pm
B1 socially optimal equilibrium marked where MSC = MPB at quantity Qs and price Ps
B1 welfare loss triangle correctly shaded/identified as the triangle between MSC and MPC above Qm and bounded by the demand curve, with brief explanation that it represents external costs not accounted for by the market
B1 brief verbal explanation that the triangle represents the net welfare loss because extra units between Qs and Qm impose external costs exceeding private benefits

Question 7

B1 first valid example with brief explanation, e.g. education: better-educated citizens increase productivity and innovation benefiting other workers and firms
B1 second valid example with brief explanation, e.g. public transport use: reduces road congestion and local air pollution, benefiting other road users and residents
Answer: Examples: education, which raises skills and productivity benefiting employers and other workers; public transport use, which reduces congestion and pollution, benefiting other road users and residents.

Question 8

M1 identifies that a subsidy to buyers increases the private benefit at each quantity, shifting MPB rightwards towards MSB by the subsidy amount
M1 applies the numerical subsidy: MPB increases by GBP 5 per dose
M1 shows the initial equilibrium Q1 = 40 where original MPB = supply (or price)
M1 shows the new equilibrium Q2 = 60 where MPB + subsidy = supply, hence increased quantity
A1 calculates the change in quantity as Q2 - Q1 = 20 doses
A1 explains that the subsidy reduces the private price paid or increases perceived benefit, encouraging more consumption towards the social optimum
B1 notes a limitation, for example subsidy cost to the government or risk of overconsumption if MSB is overestimated
B1 concludes that the subsidy can increase consumption to a level closer to social optimum by internalising external benefits
Answer: A GBP 5 subsidy shifts MPB right by GBP 5, moving equilibrium from 40 to 60 doses, an increase of 20 doses. The subsidy internalises external benefits but has budgetary costs and requires correct sizing.

Question 9

M1 identifies an unintended consequence, e.g. permit markets can lead to permit price volatility or concentration of permits among larger firms
A1 explains how concentration could occur: larger firms can buy permits and expand output while smaller firms are forced to exit, reducing competition
M1 offers a second consequence or elaboration, e.g. if permit prices rise unexpectedly costs are passed to consumers or firms may relocate production outside the urban area, shifting pollution rather than reducing it
A1 explains the welfare implication, e.g. potential loss of local jobs, higher consumer prices, or 'leakage' of pollution to other locations
Answer: Tradable permits can concentrate permits with large firms, harming competition, and permit price volatility can raise costs or push firms to relocate, shifting pollution rather than eliminating it.

Question 10

M1 MSC = MPC + marginal external cost = 8 + 2
A1 MSC = GBP 10 per unit
M1 Pigovian tax should equal the marginal external cost to internalise the externality
A1 Pigovian tax = GBP 2 per unit
Answer: MSC = GBP 10 per unit; Pigovian tax = GBP 2 per unit.

Question 11

M1 states that this pack focuses specifically on external costs and benefits that affect third parties and the associated MPC/MSC and MPB/MSB distinctions
A1 explains that information failures concern imperfect or asymmetric information between market participants, a different market-failure mechanism
M1 gives a concrete example of interaction, e.g. consumers underestimating vaccine benefits could mean subsidies are less effective because demand remains low, so information campaigns may complement subsidies
A1 explains the interaction briefly, e.g. without good information the shift from MPB to MSB via subsidy may be smaller than expected
B1 notes this keeps focus on externalities by showing information failure is a distinct but interacting issue
B1 concludes with a short policy implication, e.g. combining information provision with subsidy can be more cost effective
Answer: This pack concentrates on external costs and benefits and MPC/MSC and MPB/MSB distinctions; information failures are about imperfect knowledge but can interact, for example if people underestimate vaccine benefits then subsidies alone may not shift demand to the social optimum and information campaigns are needed alongside subsidies.

Question 12

Level 1 (1-5): Basic points about externalities and possible interventions, limited development, little or no use of diagrammatic reasoning, judgement absent or unsupported.
Level 2 (6-10): Clear explanation of how intervention (e.g. Pigovian tax, regulation, permits) could correct the externality, with some evaluation of alternatives and practical constraints, partial diagram use and a tentative conclusion.
Level 3 (11-15): Detailed analysis of multiple policy options with diagrams, evaluation of measurement, enforcement and distributional issues, consideration of second-best or complementary policies, and a well-supported final judgement.
Indicative content:
- Explain how a negative production externality leads to MSC > MPC and market overproduction, with reference to a MPC/MSC diagram and the welfare loss triangle.
- Analyse Pigovian taxes: how a tax equal to marginal external cost can internalise the externality and restore the social optimum; discuss measurement difficulties in estimating marginal external cost and administrative costs of applying the tax.
- Consider regulation and technology standards: how emission limits or required filters can reduce emissions; discuss monitoring/enforcement costs and potential for firms to pass costs to consumers or relocate.
- Discuss tradable permits: how cap-and-trade sets a clear emissions cap and allows cost-effective reductions; evaluate permit market volatility, initial allocation consequences and potential for market concentration.
- Consider negotiation and Coasean solutions: where property rights are clear and transaction costs low, bargaining between brickworks and residents might achieve efficient outcomes without government action; assess the realism given many affected households and high transaction costs.
- Evaluate distributional and political economy issues: who bears costs of intervention, potential job losses, impact on housing prices and local businesses, and acceptability of policies.
- Consider complementary measures: combining subsidies for cleaner technology, information provision, or relocation support to affected households to increase acceptability and efficiency.
- Conclude with a balanced judgement: government intervention is often justified when transaction costs prevent bargaining and when external costs are significant, but the choice of instrument must consider measurement, enforcement, cost effectiveness and fairness; a mix of regulation and market-based measures, possibly with targeted compensation, may be best.

Question 13

M1 states that MSB > MPB for education because there are wider benefits such as higher productivity and lower crime
A1 explains that a subsidy shifts MPB toward MSB, increasing consumption of education towards the social optimum
B1 gives one drawback, e.g. fiscal cost to the government, risk of deadweight loss if subsidy is poorly targeted, or displacement of private provision
Answer: MSB exceeds MPB for education because others benefit from higher skills; a subsidy raises private take-up towards the socially optimal level, but it has fiscal costs and risks being poorly targeted.

Question 14

M1 calculates MSC = MPC + external cost = 7 + 3 = GBP 10
A1 states that if demand is perfectly elastic at GBP 10 and equilibrium without intervention is at price GBP 10 and Q = 100, then setting price equal to MSC keeps quantity at 100
M1 identifies the Pigovian tax equals marginal external cost = GBP 3 per unit
A1 states socially optimal price is GBP 10 and quantity Qs = 100 under these assumptions
B1 explains briefly that the tax raises private supply cost to MSC, internalising the externality so firms face the social cost when deciding output
B1 notes limitation: real demand is rarely perfectly elastic, so in practice quantity would change and the calculation is a simplification
Answer: MSC = GBP 10, so socially optimal price = GBP 10 and quantity remains 100 under the perfect elasticity assumption; Pigovian tax = GBP 3 per unit.

Externalities: Negative and Positive Production and Consumption Effects - Worksheets, Questions and Revision