Externalities and market failure
Externalities and market failure: build the core model, apply it to evidence and qualify conclusions where outcomes depend on context.
9708 section 7.4; A Level. Checked against Cambridge's 2026–2028 Version 2 (latest version published December 2025) and 2029 Version 1 (published September 2026). Cambridge states that neither version has significant changes affecting teaching. Always follow the syllabus for the candidate's examination year.
Before you begin
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
How is marginal social cost related to marginal private and marginal external cost?
What you will learn
- Calculate social and marginal costs and benefits
- Distinguish positive and negative production and consumption externalities
- Explain deadweight welfare losses
- Analyse asymmetric information and moral hazard
- Use cost-benefit evidence without net-present-value calculations
Core model and terms
Social cost equals private cost plus external cost; social benefit equals private benefit plus external benefit. The same addition applies at the margin: MSC = MPC + MEC and MSB = MPB + MEB. A negative production externality can make MSC exceed MPC; a positive consumption externality can make MSB exceed MPB. In the standard model, private decisions can then produce a quantity different from the socially efficient quantity, creating a deadweight welfare loss.
Apply and evaluate
Asymmetric information means one party has relevant information another lacks; moral hazard arises when protection changes behaviour because someone does not bear the full consequences. Cost-benefit analysis compares relevant private and external costs and benefits of a decision. Follow the syllabus scope: net present value calculation is not required, and estimates can be uncertain or distributionally incomplete.
Pause and explain
Which statement best applies externalities and market failure?
Worked example
At an output level, private cost is $70 and external cost is $25; private benefit is $110 and external benefit is $15. Calculate social cost, social benefit and net social benefit.
Show the worked solution
- Social cost = 70 + 25 = $95
- Social benefit = 110 + 15 = $125
- Net social benefit = 125 − 95 = $30
Answer Social cost = 70 + 25 = $95 → Social benefit = 110 + 15 = $125 → Net social benefit = 125 − 95 = $30
Try a topic test
Choose Easy, Normal or Difficult. Save your answers and open worked review after finishing.
Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
At an output level, private cost is $70 and external cost is $25; private benefit is $110 and external benefit is $15. Calculate social cost, social benefit and net social benefit.
Give me a hint
Add external effects to the corresponding private values, then subtract cost from benefit.
Compare my reasoning
- Social cost = 70 + 25 = $95
- Social benefit = 110 + 15 = $125
- Net social benefit = 125 − 95 = $30
Social cost = 70 + 25 = $95 Social benefit = 110 + 15 = $125 Net social benefit = 125 − 95 = $30
Look for these in your work
- Social cost = 70 + 25 = $95
- Social benefit = 110 + 15 = $125
- Net social benefit = 125 − 95 = $30
A factory’s pollution harms nearby residents, while its customers receive the product. Classify the externality and compare marginal social and private cost.
Give me a hint
Identify the activity creating the spillover and who bears it.
Compare my reasoning
- The harm comes from production and falls on third parties
- It is a negative production externality
- If marginal external cost is positive, MSC exceeds MPC
The harm comes from production and falls on third parties It is a negative production externality If marginal external cost is positive, MSC exceeds MPC
Look for these in your work
- The harm comes from production and falls on third parties
- It is a negative production externality
- If marginal external cost is positive, MSC exceeds MPC
A consumer buys a vaccine but does not consider reduced infection risk to others. Explain the likely market-failure direction.
Give me a hint
Compare private and social marginal benefit at the private choice.
Compare my reasoning
- The consumer considers private benefit
- Others also gain from reduced transmission
- MSB exceeds MPB, so private consumption may be below the socially efficient level
The consumer considers private benefit Others also gain from reduced transmission MSB exceeds MPB, so private consumption may be below the socially efficient level
Look for these in your work
- The consumer considers private benefit
- Others also gain from reduced transmission
- MSB exceeds MPB, so private consumption may be below the socially efficient level
An insurer cannot observe a customer’s risk-taking after coverage begins. Explain how asymmetric information can create moral hazard.
Give me a hint
Trace hidden behaviour after the contract changes incentives.
Compare my reasoning
- The insurer has less information about later behaviour
- Coverage can reduce the customer’s share of a loss
- Risk-taking may rise unless monitoring or contract design changes incentives
The insurer has less information about later behaviour Coverage can reduce the customer’s share of a loss Risk-taking may rise unless monitoring or contract design changes incentives
Look for these in your work
- The insurer has less information about later behaviour
- Coverage can reduce the customer’s share of a loss
- Risk-taking may rise unless monitoring or contract design changes incentives
Common mistakes
- Drawing a welfare-loss conclusion without identifying which marginal social curve differs from the private curve, or claiming cost-benefit estimates are exact.
What can you explain now?
How is marginal social cost related to marginal private and marginal external cost?
Compare with the explanation
MSC = MPC + MEC
Social marginal cost includes the producer’s marginal cost and the marginal external cost.
After trying it yourself, choose your next review. This is your self-assessment.
Your review choice appears on Today. Sign in to sync it across devices.
Make it stick
Before moving on, explain the central idea in externalities and market failure and state one condition that could change its effect.
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.