According to The World Bank, 16 of the 20 most polluted cities

in the world are in China. A plan to lift Beijings shroud of

pollution ahead of the Olympic Games includes stopping half
of Beijings 3.3 million vehicles and shutting down chemical
plants, power stations and foundries to cut emissions by 30%.

(a) Using appropriate examples, explain and illustrate the
terms externality and public goods. [10]
(b) Assess whether the measures stated above is the best way
to curb pollution in China. [15]
(a) Using appropriate examples, explain and illustrate
the terms externality and public goods. [10]
INTRODUCTION
Define market failure
Failure of unregulated free market to achieve efficient
allocation of resources and/or other social goals
Two examples of sources of market failure:
externalities and public goods
DEVELOPMENT
Externalities
Definition: third-party effects arising from production
or consumption of a good or service, for which the
third-party neither pays nor receives any
compensation
There can be negative or positive externalities
(a) Using appropriate examples, explain and illustrate
the terms externality and public goods. [10]
(a) Using appropriate examples, explain and illustrate
the terms externality and public goods. [10]
DEVELOPMENT
Negative externalities
An example of negative externalities is ___.
In the pursuit of self-interest, producers of ___ will only
consider their own private costs,
ignoring external cost imposed on society, such as ___.
As shown in the diagram, this creates a divergence
between MSC and MPC of the distance of the MEC
You may want to assume
constant or increasing MEC
(a) Using appropriate examples, explain and illustrate
the terms externality and public goods. [10]
DEVELOPMENT
Negative externalities
Assuming that that MSB = MPB,
the free market results in an overproduction of ___,
above the socially optimal level of output (___) where
MSB = MSC.
The resulting deadweight loss of area ___ indicates an
inefficient allocation of resources in the free market.
6
A
E
E
1
Quantity
Price
0
MPB = MSB
MPC

Q

R
Socially ideal
output = 0R
Actual output = 0Q
Overproduction
Welfare Loss
to Society
(DWL)
MSC = MPC + MEC
MEC
What you need to know
Deadweight loss
is the decrease in
total society
surplus that
results from an
inefficient level of
production
Introduction to Negative Externalities
7
A
E
E
1
Quantity
Price
0
MPB = MSB
MPC

Q

R
Welfare Loss
to Society
(DWL)
MSC = MPC + MEC
MEC
How to draw the diagram
Introduction to Negative Externalities
1. Draw MPC and
MPB diagram
2. Indicate Qty
(free market)
3. Draw MSC
4. Indicate MEC
5. Indicate Qty
(socially optm)
6. Highlight DWL
8
Practice time: Activity -
Smoking
Introduction to Negative Externalities
1. Identify good / service as one with negative externalities

The consumption of cigarettes; smoking creates negative
externalities which are costs spilled over to 3
rd
parties not
involved in the consumption of the good.
9
Practice time: Activity -
Smoking
Introduction to Negative Externalities
2. Identify MEC such that MSC > MPC

In such an activity, there incurs external cost on 3
rd
parties and
this external cost is not taken into account by private consumers
of cigarettes. This causes the marginal social cost of smoking to
be greater than the marginal private cost due to the marginal
external cost burdened on 3
rd
parties.

This marginal external cost comes in the form of 2
nd
hand
smoke which non-smokers inhale, possibly leading to health
problems such as lung cancer.
10
Practice time: Activity -
Smoking
Introduction to Negative Externalities
3. Explain that when left to a free market, production
(consumption) will be at MPB=MPC

When left to the free market, a smoker will choose to consume
cigarettes to the point where his marginal private benefit is
equal to his marginal private cost.

In this case, his satisfaction and happiness will determine his
marginal private benefit and the cost of the cigarettes as well as
the health damage to himself makes up his marginal private
cost.
11
Practice time: Activity -
Smoking
Introduction to Negative Externalities
4. Explain that societys welfare will instead be at MSB=MSC

However, societys welfare is not maximised in this case as the
socially optimum level of consumption should be where
marginal social benefit to society is equal to the marginal social
cost. Because the external cost to 3
rd
parties are not considered
in a smokers consumption of cigarettes, marginal social cost is
thus greater than marginal private cost.
12
Practice time: Activity -
Smoking
Introduction to Negative Externalities
5. Identify over production of good

Thus, an over-consumption of cigarettes occur, whereby qty
when left to the free market is higher than where it is allocatively
efficient for society.
13
Practice time: Activity -
Smoking
Introduction to Negative Externalities
6. Explain dead weight loss is observed and thus society is not at
allocative efficient point.

This overconsumption of cigarettes that causes society to be
allocatively inefficient thus result in a dead weight loss to
society, thus explaining market failure in smoking.
(a) Using appropriate examples, explain and illustrate
the terms externality and public goods. [10]
DEVELOPMENT
Positive externalities
Example (e.g., vaccination)
Self-interest
External benefit
Diagram
Divergence between MSB and MPB
(a) Using appropriate examples, explain and illustrate
the terms externality and public goods. [10]
DEVELOPMENT
Positive externalities
Assuming MSC = MPC
Underconsumption
Socially optimal level of output where MSB = MSC
Deadweight loss
Inefficient allocation of resources
(a) Using appropriate examples, explain and illustrate
the terms externality and public goods. [10]
DEVELOPMENT
Public Goods
2 key features: non-rivalry and non-excludability
Non-rivalry: consumption of a good or service by one person
does not reduce amount available to others
Non-excludability: not possible or very costly to exclude a
non-payer from consuming the good or service
An example is ___.
(a) Using appropriate examples, explain and illustrate
the terms externality and public goods. [10]
DEVELOPMENT
Public Goods
It is non-rivalrous because ___. Once produced, the marginal
cost of providing ___ to the additional user is zero,
meaning that the price has to be zero for allocative efficiency.
It is non-excludable because ___. This leads to the free rider
problem, where no one has the incentive to pay for ___.
Typically, a public good will not be provided by the free
market, even though people want to consume it.
This represents an inefficient allocation of resources.
(a) Using appropriate examples, explain and illustrate
the terms externality and public goods. [10]
CONCLUSION (an example)
As a result of sources of market failure such as
externalities and public goods, the unregulated
free market will be unable to achieve an efficient
allocation of resources. Hence, government
intervention may be required to correct the
market failure, and this will be discussed in (b).
(b) Assess whether the measures stated above is the
best way to curb pollution in China. [15]
INTRODUCTION
Clarify that pollution is a form of externality
Clarify measures
Stopping vehicles in Beijing
Shutting down chemical plants, etc
Clarify objective specified in question
Curbing pollution in China
Criteria for best
Effectiveness
Desirability
Feasibility
Note: best, most effective, only
must consider alternatives!
(b) Assess whether the measures stated above is the
best way to curb pollution in China. [15]
DEVELOPMENT
Briefly explain the stated measures
Stopping vehicles in Beijing
A form of quota limit max no. of cars on roads in Beijing
Diagram with perfectly inelastic supply curve
Shutting down chemical plants, etc
Ban on production of such goods altogether within Beijing
Diagram indicating production of the good is zero
(b) Assess whether the measures stated above is the
best way to curb pollution in China. [15]
DEVELOPMENT
Advantages of the stated measures
Effectiveness
Meets objective of reducing pollution from cars and the
industrial entities in Beijing
Desirability
Less congestion and pollution for non-car owners
Also good for tourism and future growth
Feasibility
Relatively quick to implement

(b) Assess whether the measures stated above is the
best way to curb pollution in China. [15]
DEVELOPMENT
Limitations of the stated measured
Effectiveness
Depends on estimation of optimal quantity (information)
Does not curb pollution in China, only in Beijing
Desirability
May result in varying degrees of allocative inefficiency
(depending on type of measures and effectiveness)
Possible losses in production (from industrial entities) and
productivity (for car drivers who did not obtain the permit)
(b) Assess whether the measures stated above is the
best way to curb pollution in China. [15]
DEVELOPMENT
Limitations of the stated measured
Feasibility
May not be sustainable over time
May not be feasible across whole of China
Ease of enforcement (corruption?)
(b) Assess whether the measures stated above is the
best way to curb pollution in China. [15]
DEVELOPMENT
Explain and examine pros and cons of at least
two other alternatives, e.g.,
Education (dd-side)
Long term measure
May not reap immediate results
Results not guaranteed
(b) Assess whether the measures stated above is the
best way to curb pollution in China. [15]
DEVELOPMENT
Explain and examine pros and cons of at least
two other alternatives, e.g.,
Tax (ss-side)
Market-based approach which internalises the externality
Tax revenue can be further channelled to R&D
Difficulty in estimating the right amount of tax
Tradeable permits
Other regulatory measures
(b) Assess whether the measures stated above is the
best way to curb pollution in China. [15]
CONCLUSION
Make a stand and justify
Overall, which is the best measure? Why?
Relate back to aim of curbing pollution in China
Cost-benefit analysis
Cost of implementation / enforcement compared
with the LR and SR benefits of the measures
Combination of measures