Market failure

50 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.

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The test

1A negative externality in consumption exists when:

A the marginal social benefit of consuming a good is below the marginal private benefit
B the marginal social cost of producing a good is above the marginal private cost
C the price of the good is above its marginal cost
D consumers under-estimate the benefit of a good to themselves

2The socially optimal level of output of a good is where:

A marginal private benefit equals marginal private cost, so that no consumer or producer wishes to change
B marginal social benefit equals marginal social cost
C marginal social cost is at its minimum
D total social benefit equals total social cost

3In a free market, a good whose production creates external costs is likely to be:

A over-produced and sold at too high a price
B produced at the socially optimal level but sold at too low a price
C under-produced and sold at too high a price
D over-produced and sold at too low a price

4Vaccination protects people other than the person vaccinated. Left to the free market, vaccination is likely to be:

A over-consumed, because marginal private benefit exceeds marginal social benefit
B under-consumed, because marginal private cost exceeds marginal social cost
C under-consumed, because marginal social benefit exceeds marginal private benefit
D consumed at the socially optimal level, because the benefits are well known

5Flood defences are a public good because they are:

A provided by the government out of general taxation rather than sold by private firms
B free at the point of use for every household that lives in the area protected
C non-rival and non-excludable
D expensive to build

6The free-rider problem means that:

A people can benefit from a good without paying for it, so private firms cannot cover the cost of providing it
B a good is consumed by more people than it was designed for
C the government provides goods that the market would have provided anyway
D some consumers pay more than others for the same good

7Someone buying a second-hand car knows less about its condition than the seller. This is an example of:

A a public good
B moral hazard, because the buyer takes less care once the car has been insured
C a negative externality in consumption that falls on other road users
D asymmetric information

8Under a tradable pollution permit scheme, a firm that can cut its emissions at low cost is likely to:

A lobby the government for more free permits
B cut its emissions and sell its spare permits to firms that find cutting more expensive
C keep its emissions unchanged, because permits are free
D buy extra permits so that it can increase its output

9To correct a negative externality in production, an indirect tax should be set equal to:

A the total external cost imposed on third parties by the whole industry over a year
B the difference between the free-market price and the socially optimal price
C the marginal external cost at the socially optimal output
D the marginal private cost at the free-market output

10A maximum price set below the equilibrium price will cause:

A the equilibrium price to fall to the new maximum
B a surplus, as quantity supplied exceeds quantity demanded at the new price
C no change, because the market price is already above the maximum
D a shortage, as quantity demanded exceeds quantity supplied

11Government failure occurs when:

A regulation is not enforced strictly enough
B intervention to correct a market failure leaves resources allocated less efficiently than before
C a government fails to intervene in a market that is failing
D a government runs a budget deficit

12A Lorenz curve that lies further from the 45-degree line shows:

A a more unequal distribution of income
B a larger population
C a higher average income across the whole population
D a more equal distribution of income across the households of the economy

13Vaping has grown fast in the UK, including among teenagers who have never smoked. Discarded single-use vapes litter streets and their lithium batteries have caused fires in bin lorries and recycling centres. The long-term health effects of vaping are not yet known. From 1 June 2025 it has been illegal to sell single-use (disposable) vapes anywhere in the UK, and from 1 October 2026 a new Vaping Products Duty of £2.20 per 10ml of vaping liquid is charged on manufacturers and importers, with VAT of 20% charged on top. Table 1 shows an estimate of the market for refillable vaping liquid. Figures are illustrative.

Table 1: Vaping liquid, UK (10ml bottles, millions a year)
Price per bottle (£)	4.00	5.00	6.00	7.00
Bottles demanded	130	110	90	70
Bottles supplied before the duty	90	110	130	150
Bottles supplied after the duty	50	70	90	110

(a)Calculate the total tax, duty and the VAT charged on it, that the new duty adds to a 10ml bottle of vaping liquid. [2]

(b)Explain two reasons why the market for vapes may be an example of market failure. [4]

(c)Using Table 1 and a diagram, explain how the duty could move the market for vaping liquid towards the socially optimal output. [6]

(d)Explain why the government chose to ban disposable vapes rather than tax them, and one problem the ban may cause. [6]

14Discuss the view that government intervention to correct market failure does more harm than good. [20]

Answers

Show the answers

AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.

	Answer	Why
1	A	The consumer's own benefit is the private benefit; when consumption harms third parties, the benefit to society as a whole is smaller.
2	B	Output should expand as long as the benefit to society of one more unit covers the full cost to society of making it.
3	D	Producers ignore the costs they impose on others, so supply (MPC) lies below MSC: output exceeds the optimum and the price does not cover the full cost.
4	C	People decide on their own benefit and ignore the protection they give others, so too few are vaccinated.
5	C	One household's protection does not reduce another's, and nobody behind the wall can be excluded; who provides them or how they are paid for is not the test.
6	A	If nobody can be excluded, nobody has a reason to pay, so the market under-provides or does not provide at all: a missing market.
7	D	One party to the transaction holds information the other lacks, so the buyer may pay too much or avoid buying at all.
8	B	Permits have a market price, so the firm earns revenue by abating cheaply and selling; pollution is cut where it costs least.
9	C	A tax equal to the external cost per unit makes the producer's cost equal to the social cost, so the market settles at the optimum: the externality is internalised.
10	D	At the lower price consumers want more and producers offer less; the gap is excess demand, often followed by queues, rationing or a black market.
11	B	The test is the outcome: intervention that costs more than it gains, through poor information, unintended consequences or administrative cost, is a government failure.
12	A	The 45-degree line is perfect equality; the bigger the bow away from it, the larger the share of income held by the richest and the higher the Gini coefficient.

13 (a) Calculate the total tax, duty and the VAT charged on it, that the new duty adds to a 10ml bottle of vaping liquid. [2: AO2 2]

AO2 (1) £2.20 × 1.20
AO2 (1) £2.64

13 (b) Explain two reasons why the market for vapes may be an example of market failure. [4: AO1 2, AO2 2]

AO1+AO2 (2) Negative externalities: litter and battery fires impose costs on councils, waste firms and the public that neither the buyer nor the seller pays, so the marginal social cost exceeds the marginal private cost and too many are produced and consumed
AO1+AO2 (2) Information gaps: the long-term health effects are unknown and young consumers in particular may under-estimate the harm to themselves, so private benefit is over-estimated and the good is over-consumed (a demerit good)
AO1+AO2 (2) Or: addiction means consumption is not the result of rational choice at the margin; or external costs fall on the NHS if health harms emerge

Maximum 4: two reasons, each explained and applied to vaping.

13 (c) Using Table 1 and a diagram, explain how the duty could move the market for vaping liquid towards the socially optimal output. [6: AO1 2, AO2 2, AO3 2]

AO1 (2) Diagram: marginal private cost (supply) below marginal social cost, demand as MPB = MSB; free-market output Q1 where MPC = MPB, socially optimal output Q* where MSC = MSB, with the welfare loss triangle between them; a tax shifts MPC up towards MSC
AO2 (1) From Table 1, before the duty the market clears at £5.00 and 110 million bottles; after the duty, supply at each price is 40 million bottles lower and the market clears at £6.00 and 90 million bottles
AO3 (1) The duty raises producers' costs by the tax per bottle, so supply shifts up; the price rises and quantity demanded falls
AO3 (1) If the duty is close to the external cost per bottle, the new equilibrium is near Q*, where the price reflects the full cost to society and the welfare loss is removed
AO2 (1) Application: the duty of £2.64 including VAT raised the market price by £1.00 in the table, so consumers bear part and producers part; the government also gains revenue (90 million × £2.20 = £198 million) that can fund enforcement and health campaigns

Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct externality diagram with the tax shift; 5 to 6 for the full chain linked to the figures in Table 1 and the idea of internalising the external cost.

13 (d) Explain why the government chose to ban disposable vapes rather than tax them, and one problem the ban may cause. [6: AO1 2, AO2 2, AO3 2]

AO1+AO3 (2) A ban is regulation: it removes the product rather than raising its price. It is chosen when the external cost is judged so high, or demand so price inelastic, that a tax would leave consumption too high: litter and battery fires are tied to the single-use design itself, so no level of use is acceptable to the government
AO2 (1) Application: disposables were the product most used by teenagers, whose demand responds weakly to price and who the government most wants to protect; a ban is also simple to understand and enforce at the point of sale
AO1+AO3 (2) Problem: unintended consequences. Demand does not disappear, so sales shift to refillable devices that are near-identical, or to an illegal market in disposables where product quality is unregulated and tax is not paid; enforcement costs fall on Trading Standards
AO2 (1) Or: adult smokers who used disposables to quit lose a cheap substitute for cigarettes, which may raise smoking; or legitimate retailers lose revenue while illegal sellers gain

Maximum 6: the reason for a ban explained and applied (3) and one problem explained and applied (3).

14 Discuss the view that government intervention to correct market failure does more harm than good. [20: AO1 6, AO3 6, AO4 8]

Knowledge and analysis (AO1 to AO3)

Define market failure (the free market allocates resources inefficiently or inequitably: externalities, public goods, information gaps, monopoly power, inequality) and government failure (intervention that leaves welfare lower than it would otherwise have been).
The case that intervention helps: a tax equal to the marginal external cost internalises an externality and moves output to the social optimum (diagram); public goods such as flood defences and street lighting would not be provided at all without the state; information provision and regulation correct information gaps (food labelling, age limits); the UK's falls in smoking, the sugar levy's reformulation and the landfill tax are examples of intervention that worked.
The case that intervention harms: information failure in government (the external cost of carbon or sugar cannot be measured precisely, so taxes are set too high or too low); administrative and enforcement costs; unintended consequences (the plastic bag charge raising bin-liner sales, bans creating illegal markets, rent controls reducing the supply of housing); regulatory capture and political motives (policies chosen for votes or lobbying rather than welfare); distortion of price signals, for example agricultural subsidies producing surpluses.
Price controls as a worked example: a maximum price below equilibrium creates a shortage and black markets; a minimum price (guaranteed farm prices) creates surpluses the state must buy; in each case the intervention replaces one inefficiency with another.
Subsidies: can correct under-consumption of merit goods but cost taxpayers, may be captured by producers, and are hard to remove once given.
Comparison of tools: market-based interventions (taxes, permits) leave choices with firms and consumers and tend to have lower welfare costs than command-and-control regulation, but all depend on the quality of the information the government has.

Evaluation (AO4)

It depends on the size of the market failure: where the external cost is large and obvious (lead in petrol, CFCs, raw sewage) even a crude intervention improves welfare; where it is small or uncertain, the costs of intervention can exceed the gain.
It depends on the quality of design: taxes tied to measured harm, permits with a falling cap and sunset clauses on subsidies reduce the risk of government failure.
It depends on the time horizon: regulation that looks costly at first may change behaviour and technology over time (the landfill tax, vehicle emissions standards).
Harm to whom: intervention usually creates losers (taxpayers, producers, consumers of the taxed good) and winners (third parties no longer harmed); 'more harm than good' needs a judgement about whose welfare counts.
The counterfactual matters: the comparison is with the failing market, not with a perfect one; a policy can be imperfect and still better than nothing.
Some failures, such as public goods and gross inequality, have no market solution at all, so the choice is between imperfect intervention and no provision.

Judgement

A supported judgement might conclude that government failure is a real and common risk, so intervention does more harm than good when the market failure is small or poorly measured and the policy is badly designed; but for large externalities, public goods and serious information gaps, well-designed intervention, preferably market-based, clearly does more good than harm. The view holds for some interventions, not for intervention as such.

Marking

Bands, out of 20 (AO1 knowledge 6, AO3 analysis 6, AO4 evaluation 8, as WJEC marks a 20-mark question). Top band (16 to 20): a range of points developed in full chains of reasoning, supported by an accurate diagram and real examples, with evaluation that weighs the arguments and reaches a judgement that depends on stated conditions. Middle band (9 to 15): some developed chains, a relevant diagram, evaluation present but one-sided or asserted. Bottom band (1 to 8): points listed or described, little use of theory or examples, judgement missing or unsupported.