Market Failure Diagrams – Positive & Negative Externality as well as Imperfect Information (Consumer Ignorance)

Perennial headache!

“Cher, why my school’s market failure diagrams are so different ah?”

“Mr Hong, why different school teachers teach me different diagrams for the same externality ah?

“Cher, my new teacher’s diagrams are different from my school notes!!”

“I don’t understand my school’s diagrams!”

You get the idea………….

So I decided to produce a video and this blog post so that I don’t have to repeat myself on this issue every year!

Different schools use different frameworks. Even different teachers in the same school may advocate different frameworks! Some teach more than 1 framework (not a bad thing but can be confusing initially).

Hence I produced a video to clarify all that:

if you just what to know what I recommended, here it is:

1. As long as it is a Positive Externality (don’t care in production or consumption), make Marginal Social Benefit (MSB) > Marginal Private Benefit (MPB).
   
2. As long as it is a Negative Externality (don’t care in production or consumption), make Marginal Social Cost (MSC) > Marginal Private Cost (MPC).

So these “Rules” apply regardless of whether you are doing

A) Market (Dd/SS) framework OR

B) Cost-Benefit from a Single Party (Consumer or Producer) framework.

And I also recommend that, if you can handle, you should learn both A) and B) frameworks.

Use A most of the time because it is a natural extension of the Demand Supply theories you have already learnt.

Use B when there isn’t a market you can analyse because the context is about making decisions regarding certain activities such as how much to drive your car, how much R&D to do, how often to go for a run etc.

Diagrams in both frameworks are going to look very similar but you need to understand they represent different things. For example, in A, the MPC represents costs to the firm. But in B, if you are looking at how often to drive your car, the MPC represents costs incurred when you drive your car and this should include opportunity costs as well. You need to understand A vs B and then the rest follows logically.

IB Economics focus mostly on A.

Most JC Economics do B but there are several JCs that teach both A and B.

Still Unclear / Confused / Unsure? Let me know! Our Economics tuition is here to help!

Unlike other centres, we run dedicated JC Economics Tuition A-Level and IB Economics Tuition classes so that you do not get mixed up as to which diagrams are applicable to your specific syllabus!

What about in the case of Imperfect Information (Consumer Ignorance)?

Same challenges…I share your horror…

It depends on whether you are using A or B.

So if you are using Framework A:

Focus on the Dd side. It will either be:

Dd (Imperfect Information) / MPB (perceived) > Dd (Perfect Information) / MPB (actual) due to consumer ignorance leading to under-estimation of private costs. For example in the case of Vaping.

OR

Dd (Imperfect Information) / MPB (perceived) < Dd (Perfect Information) / MPB (actual) due to consumer ignorance leading to under-estimation of private benefits. For example in the case of Health Screening.

See the similarities and differences?

So if you are using Framework B:

It will either be:

MPC (perceived) < MPC (actual) due to consumer ignorance leading to under-estimation of private costs. For example in the case of Vaping.

OR

MPB (perceived) < MPB (actual) due to consumer ignorance leading to under-estimation of private benefits. For example in the case of Health Screening.

So over here, the “divergence” is according to whether the imperfect information is regarding costs or benefits. For example, if it is under-estimation of cost, like in the case of Vaping, then the “divergence” happens on the cost side. (By the way, vaping is really an alarming issue amongst youths! You should know right? We should apply economics to suggest better government policies!)