AQA A-Level Economics: Market Failure and Government Intervention

Read the following extract and answer the question that follows.

The following extract was written for this exercise.

In the economy of Calderon, a cluster of factories produces zentic acid, a chemical used in fertiliser. Production discharges untreated waste into the River Mol, harming downstream fisheries and raising the cost of treating drinking water for towns along its banks. None of these costs is paid by the zentic producers, who base their output decisions only on their own private costs. The market is competitive and the firms currently produce 90,000 tonnes a year, where the price they charge just covers their private marginal cost. Calderon's environment agency estimates that every tonne of zentic acid imposes a constant external cost of 60 credits on third parties, and calculates that the socially optimal output would be only 70,000 tonnes a year. The government is under pressure to act. Industry lobbyists warn that a heavy tax would cost jobs in a region with few alternative employers, while environmental campaigners demand an outright ban. Officials are weighing an indirect tax, tighter regulation of discharges, and a scheme of tradable pollution permits.

Zentic acid market, Calderon (per year)	Value
Free-market output	90,000 tonnes
Socially optimal output	70,000 tonnes
Estimated marginal external cost	60 credits per tonne
Free-market price	200 credits per tonne

Question: Evaluate whether the government of Calderon should intervene to correct the negative externality in the zentic acid market, and assess which method of intervention would be most appropriate. [25 marks]

A coal-fired power station emits sulphur dioxide that damages the health of nearby residents, a cost the generator does not pay. The government is considering an indirect tax on the electricity it produces.

Explain how an indirect (Pigouvian) tax can correct a negative production externality of this kind, with the help of a diagram. [15 marks]

A seasonal flu vaccination protects the person who receives it and, by reducing the spread of infection, also protects others in the community. If vaccinations were sold in a free market at their full private price, fewer people would choose to buy one than would be socially desirable.

Analyse why a merit good such as flu vaccination is likely to be under-consumed in a free market, with the help of a diagram. [9 marks]

A factory produces a chemical whose manufacture creates a negative production externality. The table shows the marginal private cost (MPC) and the marginal social cost (MSC) of the chemical at the current free-market output. The marginal external cost is constant at every level of output. The government plans an indirect tax to bring output down to the socially optimal level of 12,000 units per year.

At the free-market output	Value per unit
Marginal private cost (MPC)	£30
Marginal social cost (MSC)	£45

Calculate (a) the marginal external cost per unit, (b) the size of the per-unit indirect tax needed to internalise the externality, and (c) the total tax revenue raised at the socially optimal output. (6 marks)

A sea wall would protect the low-lying coastal town of Harrowmouth from flooding. Once built, it would shield every resident, and one person being protected does not reduce the protection available to anyone else.

Explain why a public good such as the Harrowmouth sea wall would be under-provided by a free market. (5 marks)

A good with a negative production externality is over-produced in a free market. The free-market output is 20,000 units a year and the socially optimal output is 15,000 units a year. At the free-market output, the marginal social cost exceeds the marginal social benefit by £8 per unit. The deadweight welfare loss is the triangle bounded by the MSC and MSB curves between the optimal output and the free-market output.

Calculate the size of the deadweight welfare loss caused by the over-production. (4 marks)