Pearson Edexcel · A-Level · Economics B
Course version: 9EB0 · Version from Sept 2015
Market failure in society: b) Positive and negative externalities
Full specification wording
Market failure in society: b) Positive and negative externalities
Externalities occur when the production or consumption of a good or service imposes costs or benefits on third parties not directly involved in the transaction.
Checked against the Pearson Edexcel 9EB0 specification (opens in a new tab) on .
- Point 2 of 6
- 4 key terms
Study notes
From the checked teaching notes for this specification point.
The idea
Externalities occur when the production or consumption of a good or service imposes costs or benefits on third parties not directly involved in the transaction. Positive externalities generate external benefits, such as a business training its workforce, which increases the overall skill level in the economy. Negative externalities generate external costs, such as a factory polluting a local river, which harms local fishermen. In a free market, goods with positive externalities are under-provided and under-consumed, while goods with negative externalities are over-provided and over-consumed, leading to a misallocation of resources and market failure.
What earns the marks
- Define positive externalities as external benefits to third parties not involved in the economic transaction.
- Define negative externalities as external costs imposed on third parties not involved in the economic transaction.
- Explain that positive externalities lead to under-production or under-consumption in a free market.
- Explain that negative externalities lead to over-production or over-consumption in a free market.
- Identify that the existence of externalities causes a divergence between private and social costs or benefits, resulting in market failure.
Common mistakes and how to put them right
Confusing private costs with external costs.
Put it right: Private costs are borne by the producer or consumer, whereas external costs are borne by third parties.
Assuming externalities only occur in production.
Put it right: Externalities can arise from both the production and consumption of goods and services.
Believing that positive externalities mean the market is functioning well.
Put it right: Positive externalities actually represent market failure because the good is under-consumed relative to the socially optimal level.
Exam tips
- Always explicitly identify the third party affected when providing an example of an externality.
- Use clear examples, such as pollution for negative externalities and education for positive externalities, to illustrate your points.
- Remember that social cost equals private cost plus external cost, and social benefit equals private benefit plus external benefit.
Try the lesson
The start of the Market failure in society: b) Positive and negative externalities lesson, made from checked teaching notes for this specification point.
Have a go first
Which of the following best defines a negative production externality?
Listen
Externalities occur when the production or consumption of a good or service imposes costs or benefits on third parties not directly involved in the transaction. Positive externalities generate external benefits, such as a business training its workforce, which increases the overall skill level in the economy. Negative externalities generate external costs, such as a factory polluting a local river, which harms local fishermen. In a free market, goods with positive externalities are under-provided and under-consumed, while goods with negative externalities are over-provided and over-consumed, leading to a misallocation of resources and market failure. A strong answer earns marks for these points. Define positive externalities as external benefits to third parties not involved in the economic transaction. Define negative externalities as external costs imposed on third parties not involved in the economic transaction. Explain that positive externalities lead to under-production or under-consumption in a free market. Explain that negative externalities lead to over-production or over-consumption in a free market. Exam tip: Always explicitly identify the third party affected when providing an example of an externality.
See it
Key words
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Market failure
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Third-party effects
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Resource misallocation
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Social versus private costs and benefits
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See every definition
- Market failure
- A situation in which the existence of externalities causes a divergence between private and social costs or benefits, leading to a misallocation of resources.
- Third-party effects
- Costs or benefits imposed on third parties not directly involved in the transaction when a good or service is produced or consumed.
- Resource misallocation
- Arises in a free market when goods with positive externalities are under-provided and under-consumed, while goods with negative externalities are over-provided and over-consumed.
- Social versus private costs and benefits
- Social cost equals private cost plus external cost, and social benefit equals private benefit plus external benefit.
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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