Economics · Market failure and government intervention · 9 marks
Using an appropriate diagram, explain how a negative externality in production leads to a misallocation of resources, and assess the case for correcting it with an indirect tax. [9]
Mark scheme
- Diagram: MPC and MSC drawn with MSC above MPC, MSB = MPB, the market quantity to the right of the social optimum
- Definition: an external cost falls on a third party not involved in the transaction
- The firm bases output on private costs only, so produces where MPB = MPC
- The social optimum is where MSB = MSC, at a lower quantity
- Welfare loss identified as the triangle between the two quantities
- A tax equal to the external cost at the social optimum shifts MPC up to MSC, internalising the externality
- Evaluation: the external cost is extremely hard to value, so the tax is likely to be set at the wrong level
- Evaluation: if demand is price inelastic the quantity falls little and the main effect is revenue, not correction
- Judgement: effectiveness depends on elasticity and on how the revenue is used — hypothecation strengthens the case
Nine-mark questions want the diagram doing work, not decorating. Refer to it explicitly — "as shown at Q₁" — and spend at least a third of the answer on evaluation, ending with a supported judgement.