Market failure in six diagrams

Market failure is where a free market produces the wrong amount of something, so resources are not allocated well. Six diagrams cover most of what 9708 asks you to draw. Learn the shape of each one and the labels that go with it, and you can draw any of them in about ninety seconds.

A note for O Level students: the 2281 syllabus says demand and supply diagrams for market failure are not required, so this guide is for A Level.

Before you start: the four curves

Externality diagrams use four lines and you need to keep them straight.

• MPC, marginal private cost. What the firm itself pays to produce one more unit.
• MSC, marginal social cost. What society pays in total, private cost plus any external cost.
• MPB, marginal private benefit. What the consumer themselves gains from one more unit.
• MSB, marginal social benefit. Private benefit plus any external benefit.

The free market settles where MPB crosses MPC. Society would be best off where MSB crosses MSC. The gap between those two points is the whole story, and the triangle between them is the welfare loss.

1. A negative externality in production

Think of a factory releasing smoke. Producing the good costs society more than it costs the firm.

Draw MPC sloping up and MSC above it and parallel, because the external cost is added at every level of output. Draw one demand curve labelled MPB equals MSB, since consumption harms nobody extra here.

The market produces at Q1, where MPB meets MPC. The best outcome is Q2, where MSB meets MSC, and Q2 is smaller. Shade the triangle between MSC and MSB, from Q2 across to Q1, and label it welfare loss. The market over-produces.

2. A negative externality in consumption

Think of smoking or loud music. The harm comes from the act of consuming.

Now the supply curve is MPC equals MSC, and the two benefit curves separate: MSB sits below MPB, because society gains less than the individual does.

The market consumes Q1 where MPB meets MPC. The best level is Q2 where MSB meets MSC, and again Q2 is smaller. The welfare loss triangle sits between MPB and MSB, over the extra output. The market over-consumes.

3. A positive externality in consumption

Think of vaccination or education. Other people gain when you consume it.

MSB sits above MPB this time. Supply is MPC equals MSC.

The market gives Q1, but the best outcome Q2 is larger. The welfare loss is the triangle between MSB and MSC over the output that never happened. The market under-consumes, which is why governments subsidise these goods or provide them free.

4. An indirect tax to correct over-production

Start with an ordinary demand and supply diagram. A specific tax adds the same amount to the cost of each unit, so supply shifts up by the size of the tax, from S to S plus tax.

Mark the old price P1 and the new price paid by consumers P2. Mark the price the producer keeps, which is P2 minus the tax. The vertical gap between what the buyer pays and what the seller keeps is the tax per unit, and the rectangle across to the new quantity is the total tax revenue.

The division of that rectangle is the point of the diagram. When demand is inelastic, most of the tax is paid by consumers. When demand is elastic, the producer absorbs more of it. Say which, and say why, and you have your evaluation.

In the externality version, the ideal tax is equal to the external cost, which moves the market from Q1 to Q2. Getting that number right in the real world is very hard, and that is a fair criticism to make.

5. A subsidy to correct under-consumption

This is the mirror image. A subsidy lowers cost per unit, so supply shifts right, from S to S plus subsidy.

The price consumers pay falls to P2 and the quantity rises to Q2. The producer receives P2 plus the subsidy. The rectangle between the two prices, across to the new quantity, is the total cost to the government.

Evaluation writes itself here. The money has an opportunity cost, the benefit depends on how much of the subsidy is passed on to consumers, and that depends on elasticity again.

6. Maximum and minimum prices

A maximum price is a legal ceiling, drawn as a horizontal line below the equilibrium. At that price, quantity demanded is greater than quantity supplied, so the horizontal gap between the two curves is a shortage. Label it. Shortages lead to queues, rationing, or a black market, and that is the evaluation.

A minimum price is a legal floor, drawn as a horizontal line above the equilibrium. Now quantity supplied is greater than quantity demanded and the gap is a surplus. A national minimum wage in the labour market is the same diagram, with the wage on the vertical axis and labour on the horizontal one, and the surplus is unemployment.

How to get quick at these

Draw all six from memory on one sheet of paper, without notes, and time yourself. Then check each one for the same four things: both axes labelled, every curve labelled, Q1 and Q2 marked, and the welfare loss or the shortage shaded and named.

Do it again two days later. Most students find their weakest one is the negative externality in consumption, because the two benefit curves are easy to put the wrong way round. If that is yours, draw that one twice.