Market Failure and Externalities Assignment Sample

Why Does a Negative Externality Lead to Overproduction?

Because the producer only counts its own costs. Marginal social cost (MSC) equals marginal private cost (MPC) plus marginal external cost (MEC). A competitive market settles where demand meets MPC, which sits above the efficient level of output. The shaded gap between the two is the deadweight loss.

The numbers below are invented for illustration. They are not market data.

Item	Value
Marginal private benefit (demand)	P = 100 − 2Q
Marginal private cost	P = 20 + 2Q
Marginal external cost	£10 per unit
Marginal social cost	P = 30 + 2Q
Market output (MPB = MPC)	Q = 20, P = £60
Efficient output (MSB = MSC)	Q* = 17.5, P = £65
Deadweight loss at market output	½ × 2.5 × 10 = £12.50
Pigouvian tax that restores Q*	£10 per unit
Tax revenue at Q*	£175

Set the tax equal to the marginal external cost at the efficient output and the producer's own cost curve shifts up to the social one. Buyers pay £65, producers keep £55 after tax, and output falls to 17.5. That is Pigou's argument in a handful of lines of algebra.

Why Do Positive Externalities Lead to Underprovision?

The logic runs the other way. When a vaccination, a degree or a research breakthrough benefits people beyond the buyer, marginal social benefit sits above marginal private benefit. The buyer weighs only the private gain, so too little gets bought. A subsidy equal to the marginal external benefit closes the gap.

Which UK Examples Show the Problem?

Road congestion, aviation emissions, sugary drinks and plastic waste all follow the negative pattern. Stern (2007) went furthest, arguing that climate change is the largest and widest-ranging market failure the world has faced, because emitters rarely bear the global cost of what they emit.

b) Evaluate How Effective UK Policy Has Been in Correcting Externalities

Four tools dominate. The table sets them side by side before the UK evidence.

Instrument	How it works	UK example	Main strength	Main weakness
Pigouvian tax or levy	Prices the external cost into the good	Soft Drinks Industry Levy (2018)	Firms choose how to respond; raises revenue	Needs a credible estimate of the external cost
Charge on use	A small fee disrupts habit	Carrier bag charge, England (2015)	Cheap to run; fast response	Fee level is hard to link to measured damage
Tradable permits	Caps total emissions; firms trade allowances	UK Emissions Trading Scheme (2021)	Fixes the quantity; cost-effective	Allowance prices can swing
Regulation	Sets standards or bans	Emission standards (generic)	Certain outcome; easy to explain	Ignores differences in abatement cost between firms
Subsidy	Rewards a positive externality	Publicly funded education and immunisation	Raises output of under-provided goods	Costs taxpayers; may pay for what would happen anyway

Do Pigouvian Taxes Work? The Soft Drinks Industry Levy

The levy is a two-tier tax on manufacturers, announced in March 2016 and implemented in April 2018. Drinks with 8g or more sugar per 100ml pay 24p per litre; drinks with 5g to under 8g pay 18p (Rogers et al., 2023). Because it lands on producers rather than shoppers, it was designed to push reformulation.

The corrected evidence is more modest than the early headlines. One year on, purchased volume of high-tier drinks was 37.8% lower per household per week than the counterfactual, and low-tier drinks 85.8% lower. Yet total soft drink volume rose by 2.6%, and sugar bought across all soft drinks fell by just 8.0g, or 2.7% (Rogers et al., 2023). The original study had reported a 30g (10%) fall, but it was retracted after a weighting error (Pell et al., 2021, retracted).

My reading: modest and real, not transformative. The household purchase data also miss drinks bought and consumed out of the home, so the true effect is uncertain in both directions.

Can a Small Charge Change Behaviour? The Carrier Bag Charge

England introduced a mandatory 5p charge on single-use carrier bags from large retailers in October 2015. Wales, Northern Ireland and Scotland had moved earlier, in 2011, 2013 and 2014 (Thomas et al., 2019). Using a longitudinal survey (n = 1,230), supermarket observations (n = 3,764) and 43 interviews, Thomas et al. (2019) found that all age, gender and income groups cut their bag use within a month. Support for the charge rose too, and that predicted more support for other charges.

Five pence is a trivial sum. The speed of the response fits the idea that a visible charge breaks a routine, not only that it changes a price. For an assignment, that is a useful bridge to behavioural economics.

Is a Cap-and-Trade Scheme Better Than a Tax? The UK ETS

The UK ETS replaced UK participation in the EU scheme on 1 January 2021 and caps emissions from, among other sectors, energy-intensive industry, power generation and aviation (GOV.UK, n.d.). A tax fixes the price and lets quantity float. A permit scheme fixes the quantity and lets price float.

Weitzman (1974) showed that the better choice depends on the shape of the curves under uncertainty. Quantity controls win when damage rises steeply, for example near a threshold. Price controls win when marginal damage is relatively flat. Baumol and Oates (1988) add the cost-effectiveness case: trading moves abatement to the firms that can do it most cheaply. The price risk is real, though. The scheme's cost containment mechanism, a safeguard against price spikes, was triggered in late 2021 and early 2022 (GOV.UK, n.d.).

Can Government Intervention Fail Too?

Yes. Winston (2006) documents cases where government programmes performed worse than the market failure they targeted. Three problems recur. Regulators rarely know the true marginal external cost. Politicians set rates for electoral reasons. And Lipsey and Lancaster (1956) showed that fixing one distortion can lower welfare if others remain elsewhere in the economy.

The UK evidence is mixed rather than damning. The bag charge looks like a clear success, the sugar levy a modest one, and the ETS a work in progress.

c) Examine Whether the Coase Theorem Beats Government Intervention

What Does the Coase Theorem Actually Say?

Coase (1960) argued that where property rights are clearly defined and bargaining costs are negligible, the affected parties can negotiate to an efficient outcome whatever the starting allocation of rights. A farmer whose crops suffer from a neighbour's smoke needs no tax. The two can agree a payment. Who holds the right changes who pays, not the efficient output.

Why Does Bargaining Fail When Many People Are Affected?

Transaction costs. A power station's emissions reach millions of people. Nobody can organise them all, each has a reason to let others pay, and any one holdout can block a deal. Hardin (1968) describes the commons problem in the same terms: when use is free and shared, each user rationally overuses. Coasean bargaining suits small groups, such as neighbouring landowners.

Is Cap-and-Trade the Coase Theorem Applied at Scale?

Largely, yes. Tradable permits create a property right to emit, then let firms bargain over who uses it (Dales, 1968; Baumol and Oates, 1988). Government still sets the cap, which Coase's theory would leave to the market. So the sensible answer to part (c) is not Coase against government. Coase supplies the logic. Government supplies the property rights.

Conclusion

Pulling the three parts together: externalities explain why unregulated markets over-produce harmful goods and under-provide beneficial ones, and the worked example shows how a Pigouvian tax closes the gap on paper. UK evidence says policy works, but less neatly than the textbook. The sugar levy delivered a small fall in sugar bought, the bag charge changed behaviour quickly, and the ETS fixes quantity at the cost of price volatility. The Coase theorem is best treated as a benchmark. Its logic survives inside tradable permits, but its bargaining assumptions fail wherever many people are affected.

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References

• Bator, F.M. (1958) 'The anatomy of market failure', The Quarterly Journal of Economics, 72(3), pp. 351–379.
• Baumol, W.J. and Oates, W.E. (1988) The theory of environmental policy. 2nd edn. Cambridge: Cambridge University Press.
• Coase, R.H. (1960) 'The problem of social cost', The Journal of Law and Economics, 3, pp. 1–44.
• Dales, J.H. (1968) Pollution, property and prices: an essay in policy-making and economics. Toronto: University of Toronto Press.
• GOV.UK (n.d.) Participating in the UK Emissions Trading Scheme (UK ETS). Available at: https://www.gov.uk/government/publications/participating-in-the-uk-ets (Accessed: 1 November 2026).
• Hardin, G. (1968) 'The tragedy of the commons', Science, 162(3859), pp. 1243–1248.
• Lipsey, R.G. and Lancaster, K. (1956) 'The general theory of second best', The Review of Economic Studies, 24(1), pp. 11–32.
• Pell, D. et al. (2021) 'Changes in soft drinks purchased by British households associated with the UK soft drinks industry levy: controlled interrupted time series analysis', BMJ, 372, n254. RETRACTED. See Rogers et al. (2023).
• Pigou, A.C. (1920) The economics of welfare. London: Macmillan.
• Rogers, N.T. et al. (2023) 'Changes in soft drinks purchased by British households associated with the UK soft drinks industry levy: a controlled interrupted time series analysis', BMJ Open, 13(12), e077059. doi:10.1136/bmjopen-2023-077059.
• Stern, N. (2007) The economics of climate change: the Stern review. Cambridge: Cambridge University Press.
• Thomas, G.O., Sautkina, E., Poortinga, W., Wolstenholme, E. and Whitmarsh, L. (2019) 'The English plastic bag charge changed behavior and increased support for other charges to reduce plastic waste', Frontiers in Psychology, 10, article 266. doi:10.3389/fpsyg.2019.00266.
• Weitzman, M.L. (1974) 'Prices vs. quantities', The Review of Economic Studies, 41(4), pp. 477–491.
• Winston, C. (2006) Government failure versus market failure: microeconomics policy research and government performance. Washington, DC: AEI-Brookings Joint Center for Regulatory Studies.