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

Kelvin HongExam Skills & Techniques, IB Economics, JC Economics (A-Level)

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:

The Two Rules That Work for Every Externality Diagram

If you just want 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.

Framework A vs Framework B: Which One Does Your Syllabus Use?

Framework A: Market (Dd/SS)

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

Best for: IB Economics focus mostly on A.

Framework B: Cost-Benefit

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.

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

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.

Negative Externality: the Same Rule in Both Frameworks

Rule 2 says MSC > MPC. Look at what that one instruction does in each framework. The geometry is almost identical — what changes is what the axes and the curves mean.

Framework A · Market (Dd/SS) Negative externality in the market framework Marginal social cost lies above marginal private cost, so the market equilibrium quantity Qe exceeds the socially optimal quantity Qs and a welfare loss triangle opens up between them. Price, Costs & Benefits ($) Quantity MSC MPC = S MPB = MSB = D Qs Qe Pe Welfare loss
Qe = market equilibrium output, Qs = socially optimal output. Because MSC lies above MPC, the market over-produces by Qe − Qs. The shaded triangle is the welfare loss.
Framework B · Cost-Benefit of a single party Negative externality in the cost-benefit framework For a single decision maker, marginal social cost lies above marginal private cost, so the privately chosen level of the activity exceeds the socially optimal level. Costs & Benefits ($) Level of activity (e.g. km driven) MSC MPC MPB = MSB Qs Qp Welfare loss
Qp = the level the individual privately chooses, Qs = the socially optimal level. Note there is no price on the vertical axis — nobody is trading anything here. The driver simply keeps driving until his own marginal benefit equals his own marginal cost.

Same rule, same shape, different story. In A the intersection is a market equilibrium set by buyers and sellers. In B the intersection is one person’s decision about how much of an activity to do. Get that distinction right and the rest of the analysis follows.

Positive Externality: the Same Rule in Both Frameworks

Now apply Rule 1 — MSB > MPB. Everything mirrors.

Framework A · Market (Dd/SS) Positive externality in the market framework Marginal social benefit lies above marginal private benefit, so the market equilibrium quantity falls short of the socially optimal quantity and the good is under-consumed. Price, Costs & Benefits ($) Quantity MPC = MSC = S MSB MPB = D Qe Qs Pe Welfare loss
Because MSB lies above MPB, the market under-produces by Qs − Qe. Notice the supply curve is unchanged: with a positive externality in consumption, only the benefit side diverges.
Framework B · Cost-Benefit of a single party Positive externality in the cost-benefit framework For a single decision maker, marginal social benefit lies above marginal private benefit, so the privately chosen level of the activity falls short of the socially optimal level. Costs & Benefits ($) Level of activity (e.g. hours of exercise) MPC = MSC MSB MPB Qp Qs Welfare loss
The runner keeps running until his own marginal benefit equals his own marginal cost, at Qp. Society would want Qs. Again, no price appears anywhere.

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

Same challenges…I share your horror…

shock

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!)

Vaping, drawn out in both frameworks

Framework A · Market (Dd/SS) Imperfect information about vaping in the market framework The perceived demand curve lies above the demand curve that would exist with perfect information, so the quantity traded exceeds the optimal quantity and vaping is over-consumed. Price, Costs & Benefits ($) Quantity of vapes MPC = MSC = S MPB (perceived) MPB (actual) Qs Qe Welfare loss
The orange curve is Dd (imperfect information). Youths under-estimate the private cost of vaping, so their perceived private benefit sits above the true one and Qe overshoots Qs.
Framework B · Cost-Benefit of a single party Imperfect information about vaping in the cost-benefit framework The perceived marginal private cost lies below the actual marginal private cost, so the individual chooses a level of vaping above the optimal level. Costs & Benefits ($) Level of activity (e.g. vapes per week) MPC (actual) MPC (perceived) MPB = MSB Qs Qp Welfare loss
Here the divergence is on the cost side, exactly as the rule above says. Compare this with the very first diagram on this page — identical geometry, completely different economics.

Health Screening is the mirror image. Take the two positive externality diagrams above and relabel MSB as MPB (actual) and MPB as MPB (perceived). Nothing else changes. This is exactly why I keep saying: learn the rule, not the picture.

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

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About The Economics Tutor

The Economics Tutor (TET) is a provider of Economics Tuition in Singapore, founded in 1998 by Kelvin Hong. A PSC scholar, he graduated as valedictorian with First Class Honours in Economics from NUS, worked as a government policymaker, and served on the secretariat of Singapore’s Economic Review Committee in 2001. He was offered Senior Tutor positions in Economics at NUS and NTU, and declined both. He has also chaired the National Economics Quiz, judged the International Youth Financial Analysis Competition, and trains other Economics tutors.

Since then, our JC Economics Tuition (A-Level) programme, with dedicated H1 and H2 Economics Tuition classes, has helped students secure As by focusing on critical thinking. We take the same practitioner-led approach in our IB Economics Tuition programme, with additional support for the Internal Assessment (IA) and Extended Essay (EE).

Kelvin writes TET’s study guides and model essays, which are used by students and teachers in Singapore and overseas. He is a regular commentator on Singapore’s economy and education system, and has contributed to or been interviewed by The Business Times, CNA, The Straits Times, Lianhe Zaobao and Money FM 89.3.