Pearson Edexcel · A-Level · Economics B
Course version: 9EB0 · Version from Sept 2015
E) Weaknesses of the market economy: some markets fail because of the…
Full specification wording
Market failure and externalities: e) Weaknesses of the market economy: some markets fail because of the existence of external costs, leading to under/over production or consumption
A weakness of the market economy is market failure, occurring when the price mechanism misallocates resources.
Checked against the Pearson Edexcel 9EB0 specification (opens in a new tab) on .
- Point 5 of 5
- 4 key terms
Study notes
From the checked teaching notes for this specification point.
The idea
A weakness of the market economy is market failure, occurring when the price mechanism misallocates resources. Some markets fail because of the existence of external costs, which are negative third-party effects ignored by buyers and sellers. Because these costs are not reflected in the market price, goods are priced too low, leading to over-production or over-consumption relative to the socially optimum level. For example, a factory polluting a river imposes external costs on local fisheries. By only considering private costs, the factory over-produces, causing a net welfare loss. This divergence between private and social costs demonstrates how unregulated markets lead to over-production of harmful goods and under-production of welfare.
What earns the marks
- Define market failure as a situation where the free market mechanism fails to allocate resources efficiently, leading to a net welfare loss.
- Identify that the existence of external costs causes the social costs of production or consumption to exceed the private costs.
- Explain that external costs lead to over-production or over-consumption because the market price does not reflect the true cost to society.
- Recognise that the misallocation of resources due to external costs can also be framed as the under-production of social welfare or alternative goods.
Common mistakes and how to put them right
Stating that external costs lead to under-production.
Put it right: External costs lead to over-production because producers do not pay for the harm caused to third parties, making the good artificially cheap to produce.
Confusing external costs with private costs.
Put it right: Private costs are borne directly by the producer or consumer, whereas external costs are imposed on third parties outside the transaction.
Assuming that any market with externalities will completely collapse.
Put it right: The market continues to function but misallocates resources, resulting in over-production or under-production relative to the socially optimum level.
Exam tips
- When analysing a scenario, identify who the third party is to correctly classify the external cost.
- Remember that negative externalities result in over-production or over-consumption, while positive externalities result in under-production or under-consumption.
- Look out for multiple-choice distractors that swap the effects of external costs and external benefits on market output.
Try the lesson
The start of the Market failure and externalities: e) Weaknesses of the market economy: some markets fail because of the existence of external costs, leading to under/over production or consumption lesson, made from checked teaching notes for this specification point.
Have a go first
What is the typical outcome in a free market when the production of a good generates significant external costs?
Listen
A weakness of the market economy is market failure, occurring when the price mechanism misallocates resources. Some markets fail because of the existence of external costs, which are negative third-party effects ignored by buyers and sellers. Because these costs are not reflected in the market price, goods are priced too low, leading to over-production or over-consumption relative to the socially optimum level. For example, a factory polluting a river imposes external costs on local fisheries. By only considering private costs, the factory over-produces, causing a net welfare loss. This divergence between private and social costs demonstrates how unregulated markets lead to over-production of harmful goods and under-production of welfare. A strong answer earns marks for these points. Define market failure as a situation where the free market mechanism fails to allocate resources efficiently, leading to a net welfare loss. Identify that the existence of external costs causes the social costs of production or consumption to exceed the private costs. Explain that external costs lead to over-production or over-consumption because the market price does not reflect the true cost to society. Recognise that the misallocation of resources due to external costs can also be framed as the under-production of social welfare or alternative goods. A common slip: Stating that external costs lead to under-production. Instead, external costs lead to over-production because producers do not pay for the harm caused to third parties, making the good artificially cheap to produce. Exam tip: When analysing a scenario, identify who the third party is to correctly classify the external cost.
See it
Put it in order
Put these steps in the order they happen.
- 1. Market failure and net welfare loss
- 2. Relative to socially optimum level
- 3. External costs not reflected in market price
- 4. Over-production or over-consumption
- 5. External costs exist
- 6. Third-party costs ignored by buyers and sellers
- 7. Good priced too low
Key words
Say what each word means before you turn the card.
Market failure
Try answering aloud or in your head before turning the card.
External costs
Try answering aloud or in your head before turning the card.
Resource misallocation
Try answering aloud or in your head before turning the card.
Welfare loss
Try answering aloud or in your head before turning the card.
See every definition
- Market failure
- A weakness of the market economy occurring when the price mechanism misallocates resources.
- External costs
- Negative third-party effects that are ignored by buyers and sellers and not reflected in the market price.
- Resource misallocation
- The outcome when the price mechanism fails, so that goods are priced too low and over-produced or over-consumed relative to the socially optimum level.
- Welfare loss
- A net loss arising when a divergence between private and social costs leads to over-production of harmful goods.
Label the diagram
Some boxes have lost their names. Pick the right name for each number.
1Box 1
2Box 2
3Box 3
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