1The idea in one paragraph

A market price counts the costs and benefits of the two people doing the deal, and nobody else. When a cement works sells a tonne of cement the money covers limestone, fuel and wages, but not the dust settling on the town. When you pay for a flu jab you buy your own protection, not the protection you hand to everyone you stand next to all winter. That leftover cost or benefit, landing on a third party who was not part of the transaction, is an externality, and it means the quantity the market settles on is wrong: too much when the spillover is a cost, too little when it is a benefit. The rest of this subtopic is that one idea drawn four times, then applied to resources everyone can use and nobody owns.

2Private, external and social

Five curves, all built from two ordinary ones.

Marginal private cost (MPC) is the cost to the producer of one more unit: the supply curve. Marginal private benefit (MPB) is the benefit to the consumer of one more unit: the demand curve. A marginal external cost falls on a third party, and so does a marginal external benefit. Add them in and you get the curves the market never sees.

• Marginal social cost (MSC) = MPC + marginal external cost. The cost to everybody, not just the producer.
• Marginal social benefit (MSB) = MPB + marginal external benefit. The benefit to everybody, not just the consumer.

An externality is a cost or benefit of an economic activity that falls on a third party and is not reflected in the market price. With no externality MSC sits on top of MPC and MSB on top of MPB, and the market gets the answer right. Figure 1 is that case.

The output where MSB = MSC is the socially optimum output, and producing it is allocative efficiency. One line earns the mark: left of Q\* the next unit is worth more to society than it costs society, so making it adds to welfare; right of Q\* each unit subtracts. Welfare is largest where the two are equal, and there community surplus, consumer plus producer surplus, is maximised. Market failure is a market left alone not reaching that output, and an externality is one cause of it.

3Which curve splits, and which way

Learn this before anything else here, because it decides your diagram marks.

An externality attaches to one side of the market and pulls one curve away from its twin. The other pair stays together, drawn as a single line with a double label.

• An externality in production comes from making the good. It sits on the cost side, so MSC comes away from MPC, and the benefit curves stay together as one line labelled MPB = MSB.
• An externality in consumption comes from using the good. It sits on the benefit side, so MSB comes away from MPB, and the cost curves stay together as MPC = MSC.

The sign then says which way the loose curve goes. A negative externality is an extra cost, so it moves the social curve the unhelpful way: MSC up above MPC, or MSB down below MPB. A positive externality does the opposite.

Production externalities split the cost curves. Consumption externalities split the benefit curves. Whichever pair does not split, draw it as one line and give it both names.

One more rule holds in all four cases. Q\*, the socially optimum output, is always where MSC meets MSB. Where MPC meets MPB you get the free market outcome Q₁ instead, because those are the only two curves the buyer and the seller can see.

4Externalities of production

Negative. Grit Cement burns coal to fire its kilns. It pays for coal, limestone and wages, and those are its MPC. The dust and the carbon dioxide are paid for by the town, in dirty washing, childhood asthma and a warmer climate, and none of it reaches any invoice. So MSC lies above MPC, and the vertical gap is the external cost per tonne.

Read Figure 3 in four steps, which is the order to write the answer in. The market trades where MPC meets MPB, at Q₁. Society would want MSC = MSB, at the smaller Q\. So the market over-produces: on every unit between Q\ and Q₁ the cost to society exceeds the benefit to society, and adding those excesses up gives the shaded welfare loss — community surplus that could have existed and does not.

Positive. Kestrel Engineering runs an apprenticeship. Training costs money now, and some apprentices will leave in three years for a rival, which then gets a skilled worker without paying to train one. The cost to society of a trained apprentice is therefore lower than the cost to Kestrel, so MSC lies below MPC.

Same four steps, opposite answer. The market trains Q₁ and society wants the larger Q\, so the market under-produces, and the triangle between Q₁ and Q\ is the benefit society missed. In both figures the demand side is a single line, MPB = MSB, because nothing happens to a third party when the cement or the training is used.

5Externalities of consumption, and merit and demerit goods

Negative. Blaze is a high-caffeine energy drink. The buyer gets the lift and pays for it. Everyone else pays for the disrupted lesson next morning, and through their taxes for the treatment that follows years of it. The benefit to society of a can is smaller than the benefit to the drinker, so MSB lies below MPB.

The market consumes Q₁, where MPB meets MPC. The socially optimum Q\, where MSB meets MSC, is smaller: the market over-consumes, and the welfare loss sits between Q\ and Q₁. A demerit good is a good considered harmful to the consumer and to society, which will be over-consumed if the market is left alone — cigarettes, alcohol, gambling. Two things cause that at once: the negative consumption externality you have just drawn, and consumers underestimating the harm the good does to them. The label is a judgement about the good, not a different diagram.

Positive. The winter flu jab at our town pharmacy. You buy your own protection; everyone you then fail to infect gets protection they never bought, and so does everyone they would have infected. MSB lies above MPB.

The market consumes Q₁ and the socially optimum Q\* is larger, so the market under-consumes, and the welfare loss sits between Q₁ and Q\*. A merit good is a good considered beneficial to the consumer and to society, which will be under-consumed if the market is left alone: health care, education, vaccination. The reasons come in the same pair — a positive consumption externality, and consumers who underestimate what the good is worth to them.

Compare Figures 3 and 5. Both are negative externalities and both end with too much traded. But in Figure 3 the loose curve is MSC, sitting above its twin; in Figure 5 it is MSB, sitting below its twin. Getting that the wrong way round is the most expensive mistake in this subtopic.

6Common pool resources and the tragedy of the commons

Common pool resources, also called common access resources, are resources nobody owns and everybody can use: ocean fish stocks, the atmosphere, an aquifer, a grazing common, a rainforest. The guide gives them two characteristics.

• Rivalrous: one person's use reduces what is left for everybody else. A tonne of cod in my hold is a tonne nobody else can catch.
• Non-excludable: nobody can be stopped from using them. There is no gate on the sea.

Together they produce the tragedy of the commons. Each user weighs the private benefit of one more unit against their own private cost, and leaves out the cost to every other user, now and in the future, of a smaller stock. So MPC sits below MSC, and every boat has a private reason to fish harder even though every skipper knows where it ends. Nobody is behaving irrationally; the rules of access produce the outcome.

The cost landing on third parties is the shrinking stock, which is why the guide calls this unsustainable production creating negative externalities. Sustainability here means taking no more than the stock replaces. Q\* is that rate; Q₁ is above it, so the stock falls every year, the possible catch falls with it, and eventually there is no fishery for anybody. The loss is not only this year's triangle but the future of the resource. Two things stop the tragedy: somebody gains the right to control access, so the resource stops being non-excludable, or the users agree among themselves to limit their use and police each other.

8What a government can do

The guide lists nine responses.

Indirect (Pigouvian) taxes. A tax per unit set equal to the marginal external cost. It raises the firm's costs until MPC sits on MSC, so the market's own choice of output falls to Q\*. The externality has been internalised: the polluter now pays it.

Carbon taxes. A Pigouvian tax charged per tonne of carbon dioxide emitted, or on the carbon content of the fuel burned.

At €20 a tonne the tax lifts supply to MSC, output falls from 25 to 20 thousand tonnes, buyers pay €80 instead of €70, the firm keeps €60, and the government collects €400,000 a week. The tax bans nothing: each firm chooses between cutting output, switching fuel and fitting a filter, whichever is cheapest for it.

Legislation and regulation. A rule with the law behind it: an emissions standard, a maximum catch, a ban, a minimum age for buying a demerit good. The left panel of Figure 10 shows the simplest form, a legal maximum output at Q\*.

Education, awareness creation. Campaigns, labelling and school programmes that change what people believe about a good. As they understand the harm their private valuation falls, so MPB shifts down towards MSB, as in the right panel of Figure 10. For a merit good it works the other way.

Tradable permits. The government caps total pollution, issues that many permits and lets firms trade them. A firm that can cut cheaply cuts and sells its spare permits to one that cannot, so the cap fixes the total while the market decides where the cutting happens.

International agreements. Treaties in which countries commit to targets, because a tonne of carbon dioxide emitted here warms the climate everywhere and no country can fix that alone.

Collective self-governance. The users of a common pool resource write and enforce their own rules — a fishing community agreeing seasons, net sizes and a share for each boat, and policing each other. No government is involved, which is what makes it a real alternative to regulation.

Subsidies. A payment per unit that lowers the cost of supplying a good, used where there is a positive externality. Supply shifts down, the price consumers pay falls, and consumption rises to Q\*.

Government provision. The state supplies the good itself, free or below cost, out of taxation: a vaccination programme, state schools, public parks.

9How well do these work

An evaluation question asks what a policy depends on, and what happens when that thing is missing.

Measuring the externality is hard, and everything follows from the measurement. A Pigouvian tax is only correct if it equals the external cost, so somebody must price a childhood asthma case or a degree of warming in 2080. Those prices are contested, and much of the harm falls on people who cannot be asked, including people not yet born. Set the tax too low and the market still over-produces; too high and it under-produces.

Effectiveness depends on elasticity and on who has to act. A tax on a good with inelastic demand, which is what a demerit good usually is, changes quantity very little and raises a lot of revenue — poor if the aim was to cut consumption, fine if the aim was to fund treatment, so say which aim you are judging. Regulation is the reverse: certain about quantity, but blunt, because it tells every firm to do the same thing whatever cutting costs that firm, and it needs inspectors. Tradable permits give the certainty of a cap with the flexibility of a price. Education is slow and hard to prove, but it is the only response that moves the curve rather than the point on it.

Stakeholders gain and lose unevenly. Under the carbon tax in Figure 9 consumers pay more and lose surplus; producers keep less per tonne, sell less and may cut jobs, which matters more if the plant is the town's only large employer; the government gains revenue it can spend on the harm; third parties gain cleaner air. A tax on a necessity also takes a larger share of a small income than of a large one, so an equity argument sits beside the efficiency one.

Sustainability problems are global, so they need cooperation. Emissions are local but the damage and the benefit of cutting are shared, which creates between countries the problem the commons creates between boats: a country that cuts pays the whole cost and keeps a slice of the benefit, while one that does nothing keeps the benefit anyway. Countries also disagree about who should cut most, since high-income countries emitted most of the historical stock while low- and middle-income ones argue that cutting would slow the growth that lifts people out of poverty. Once a treaty is signed, monitoring leans on self-reported data and enforcement has no world government behind it. That is a limitation to write about, not a reason to call agreements pointless: the ozone treaties worked, and saying why — few substances, cheap substitutes, a handful of measurable factories — is a strong evaluative point.