Cambridge IGCSE · 0455

Economics

Market failure and externalities — Syllabus topic 2.10

Name: ____________________Date: October 22, 2026

1.
Which of the following is an example of a negative externality of production? A A firm's profits fall after a tax increase B Factory pollution damages the health of nearby residents C A firm's costs rise due to higher wages D Consumers switch to a cheaper substitute product
[1 mark] · no calculator
Worked explanation
1. Choose B: factory pollution harms residents outside the firm's sale transaction.
2. Higher wages or taxes affect the firm's own expenses, while a resident's pollution-related health damage is an uncompensated third-party production cost.
Common mistake: A private business loss is not automatically an externality.
Marking points
- Selects B: pollution imposes a cost on a third party (nearby residents) who were not part of the original transaction.
Examiner tip: A negative externality is a spillover cost that falls on someone outside the transaction between buyer and seller.
2.
Which good is best described as a public good, in the economic sense of being non-excludable and non-rivalrous? A Ice cream B A private car C A national street-lighting system D A haircut
[1 mark] · no calculator
Worked explanation
1. Choose C, street lighting: a passer-by benefits even without paying, illustrating non-excludability.
2. Another passer-by can use the same light without diminishing it, illustrating non-rivalry. The classification follows these properties, not simply public ownership.
Common mistake: Government provision alone does not make something a public good.
Marking points
- Selects C: street lighting, since one person benefiting from it does not stop another from also benefiting (non-rivalrous), and no one can easily be excluded from a lit street (non-excludable).
Examiner tip: Ice cream, a car and a haircut are all private goods: consuming them excludes others and is rivalrous (using one unit means less is available for someone else).
3.
A factory produces goods but also releases pollution that harms nearby residents. Analyse two ways a government could reduce this negative externality.
[4 marks] · no calculator
Worked explanation
1. An emissions charge makes each unit of discharge costly, encouraging the factory to abate where prevention is cheaper than paying.
2. An enforceable discharge limit instead restricts permitted pollution directly. Both need monitoring; a paper limit without detection and consequences may leave residents exposed.
Common mistake: Explain how each instrument changes incentives or feasible actions.
Marking points
- Identifies one valid intervention, such as an emissions tax, permit scheme, enforceable pollution limit or support for cleaner technology.
- Analyses how the first intervention reduces the pollution incentive or feasible emissions.
- Identifies a second distinct valid intervention.
- Analyses its mechanism, including a relevant implementation condition if appropriate. Do not require the particular pair of a tax and direct regulation.
Examiner tip: Taxes work through incentives and prices, while regulation works through legal limits — a strong answer explains the mechanism for each.
4.
Discuss whether taxing a negative externality is likely to be more effective than banning the activity outright.
[4 marks] · no calculator
Worked explanation
1. A tax can reduce a moderately harmful activity while retaining valuable production, but requires a rate and monitoring that induce a meaningful response.
2. A ban may better protect against unacceptable irreversible harm, yet removes beneficial output and can be evaded. I would choose according to residual-harm tolerance and enforceability, not assume revenue makes taxation effective or legislation makes harm disappear.
Common mistake: Tax pass-through does not prove failure if higher prices reduce use.
Marking points
- Explains that a tax allows the activity to continue at a reduced, more socially optimal level, preserving some of its benefits.
- Explains that an effectively enforced ban can stop the prohibited activity but also remove its benefits; evasion or weak enforcement can leave pollution continuing.
- States a valid tax limitation, such as difficulty measuring damage, weak response to the tax or monitoring costs. Passing tax into prices does not by itself make the policy ineffective if demand responds.
- Reaches a balanced judgement depending on the severity of the externality (e.g. a ban may suit a very harmful activity, a tax a moderately harmful one).
Examiner tip: Consider the scale of harm: taxation suits externalities that should be reduced, not eliminated, while a ban suits activities considered unacceptable at any level.
5.
Which of the following is best described as a merit good, likely to be under-consumed if left entirely to the free market? A Cigarettes B Education C Alcohol D A luxury car
[1 mark] · no calculator
Worked explanation
1. Choose B, education: learners may undervalue long-run benefits or ignore gains to others.
2. Those omitted benefits can leave privately chosen schooling below a socially desirable level. This is not a claim that any course at any price creates enough benefit to justify unlimited provision.
Common mistake: Merit does not mean every additional unit is beneficial.
Marking points
- Selects B: education, since consumers may undervalue its long-run personal and social benefits, leading to under-consumption.
Examiner tip: A merit good creates positive externalities or benefits consumers underestimate, so the free market tends to under-provide it.
6.
Which of the following is a demerit good, typically over-consumed if left entirely to the free market? A Vaccination B A public park C Tobacco products D Basic healthcare
[1 mark] · no calculator
Worked explanation
1. Choose C, tobacco: buyers may underestimate future harm or ignore smoke damage to others.
2. Their private purchase decision can therefore support more consumption than a fully informed social assessment would prefer. Demerit is not merely a label for an expensive product.
Common mistake: Distinguish personal underestimated harm from third-party harm.
Marking points
- Selects C: tobacco products, since consumers may underestimate the harm to themselves and others, leading to over-consumption.
Examiner tip: A demerit good creates negative externalities or harms consumers underestimate, so the free market tends to over-provide it.
7.
A buyer of a used car cannot tell whether it has hidden mechanical faults, while the seller knows its full condition. Analyse how this information failure could lead to a market failure.
[4 marks] · no calculator
Course scope: Optional enrichment
Syllabus placement evidence: Cambridge 0455 syllabus (2026); 2.10.2 guidance, p.16 (printed pages). Adverse-selection feedback exceeds the expressly bounded market-failure examples.
Worked explanation
1. Buyers unable to verify a car's condition may offer only a pooled average-quality price.
2. Good-car owners can reject that undervaluation, reducing average quality and depressing offers further. This adverse-selection feedback removes mutually beneficial good-car trades before purchase.
Common mistake: Hidden pre-sale quality is not post-contract moral hazard.
Marking points
- States that this is an example of asymmetric information between buyer and seller.
- Explains that buyers, unable to verify quality, will only be willing to pay an average price reflecting uncertain quality.
- Explains that sellers of genuinely good-quality cars may then leave the market, since the average price undervalues their car.
- Concludes that the market may end up under-supplying good-quality used cars, a misallocation of resources.
Examiner tip: This is the classic 'adverse selection' problem: when quality cannot be verified, poor-quality goods can drive good-quality goods out of the market.
8.
A city subsidises bus operators so they can lower fares. Many additional bus passengers would otherwise travel by private car. Analyse how the subsidy could reduce under-use of public transport and the external costs of car travel.
[4 marks]
Worked explanation
1. The operating subsidy can lower bus fares and encourage passengers who would otherwise drive to switch modes.
2. Fewer car trips can reduce congestion imposed on other travellers. The external gain depends on actual car displacement, not simply more bus tickets; existing pedestrians switching to buses give a different result.
Common mistake: Additional bus use is not automatically an equal reduction in car use.
Marking points
- Explains that a subsidy lowers the cost of providing the service, allowing a lower fare to be charged.
- Explains that a lower fare increases the quantity of bus journeys demanded, moving consumption closer to the socially optimal level.
- Links the additional bus journeys that replace car trips to lower congestion or emissions, benefiting other road users or residents.
- Explains that these third-party benefits are not fully reflected in the traveller's private fare decision, so lower fares can move use towards the socially preferred level.
Examiner tip: A subsidy works on the supply side, shifting supply right and lowering the market price so more of the under-consumed good is bought.
9.
An unfenced public park has many open entrances, making it impractical to exclude non-paying users. Explain how this could create a free-rider problem for a private provider relying on voluntary payments.
[2 marks] · no calculator
Worked explanation
1. Open entrances make excluding non-payers impractical, so users can enjoy the park while withholding a voluntary fee.
2. A private provider anticipating insufficient receipts may not maintain it adequately. The funding problem follows non-exclusion; crowded parks can still be rival in use, so this example need not be a pure public good.
Common mistake: Free riding does not require claiming the park can never become crowded.
Marking points
- Explains that a free-rider problem occurs when people can benefit from a good without paying for it, since they cannot be excluded.
- Explains that this means private firms have little incentive to provide the good, since they cannot force users to pay, so it tends to be under-provided by the free market.
Examiner tip: The free-rider problem is a key reason why public goods are usually provided by the government rather than private firms.
10.
Several fishing fleets share access to the same open ocean fishing ground, with no limits on how much each can catch. Explain, using this example, what is meant by the ‘tragedy of the commons’.
[2 marks] · no calculator
Syllabus placement evidence: Cambridge 0455 syllabus (2026); 2.10.2-2.10.3, p.16 (printed pages). Fish-stock depletion applies prescribed external-cost reasoning.
Worked explanation
1. Each open-access fleet gains the full revenue from an extra catch but shares the cost of depleted future stocks with others.
2. The incentive to catch now can collectively undermine reproduction and future catches. Fish are rival resources, unlike a non-rival public good; enforceable collective limits can change the incentive.
Common mistake: Open access is not the same as non-rival consumption.
Marking points
- Explains that a shared resource with open access tends to be over-exploited, since no individual user bears the full cost of depleting it.
- Applies this to the example: each fleet has an incentive to catch as many fish as possible now, which can collectively exhaust the fish stock for everyone.
Examiner tip: The tragedy of the commons happens because individually rational decisions, taken together, can lead to a collectively damaging outcome.
11.
Assume a vaccine reduces infection or onward transmission of a contagious disease. Explain how widespread vaccination can create a positive externality for people who are not vaccinated.
[2 marks] · no calculator
Worked explanation
1. Under the stated transmission-reducing assumption, vaccination gives the pathogen fewer opportunities to spread.
2. An unvaccinated neighbour then faces lower exposure without receiving the vaccine, a third-party benefit. Protection depends on coverage and effectiveness and is not complete immunity for everyone.
Common mistake: Do not promise zero infection risk from community protection.
Marking points
- Explains that as more people are vaccinated, the disease has fewer opportunities to spread through the population.
- Explains that this reduced spread (herd immunity) also protects unvaccinated individuals, who benefit without paying for or receiving the vaccine themselves.
Examiner tip: Reduced transmission can lower other people's infection risk, providing an external benefit. Community protection is not complete and depends on the disease, vaccine effectiveness and coverage.
12.
Explain one positive externality that an educated workforce can provide to the wider economy, beyond the higher wages the educated individuals themselves earn.
[2 marks] · no calculator
Worked explanation
1. An educated worker may share a useful technique with colleagues who did not pay for that worker's education.
2. Those colleagues become more productive, generating a benefit outside the learner's private wage return. Merely naming the learner's higher earnings would not establish an externality.
Common mistake: The student's own wage gain is a private benefit.
Marking points
- Identifies a valid wider benefit, such as higher overall productivity, more innovation, or lower crime rates associated with a more educated population.
- Explains how this benefit spreads beyond the individual who received the education, benefiting the economy or society as a whole.
Examiner tip: Education's private benefit is the individual's higher future earnings; its external benefit is the wider gain to society and the economy.
13.
Explain the purpose of a congestion charge on vehicles entering a busy city centre during peak hours.
[2 marks] · no calculator
Worked explanation
1. An additional peak-hour driver delays others and can add pollution without fully paying for those effects.
2. A congestion charge makes marginal journeys more costly, encouraging some drivers to change time, route or mode. Its effect depends on alternatives and enforcement, not just on revenue collected.
Common mistake: Revenue raised is not itself evidence that congestion fell.
Marking points
- Explains that driving in the city centre creates a negative externality (congestion, pollution) that drivers do not pay for directly.
- Explains that the charge makes drivers pay closer to the true social cost of their journey, discouraging some unnecessary car trips and reducing congestion.
Examiner tip: A congestion charge is a Pigouvian tax: a price on an externality designed to bring private behaviour closer to the socially optimal level.
14.
Explain how a carbon tax on fossil fuels is intended to reduce a country's greenhouse gas emissions.
[2 marks] · no calculator
Worked explanation
1. A carbon charge raises the relative cost of fossil-fuel use, making efficiency and lower-emission alternatives more attractive.
2. Firms may change equipment and households change consumption, reducing emissions if they can respond. A nominally positive tax can be too small or poorly enforced to achieve the intended reduction.
Common mistake: Do not assume every taxed user can switch technology immediately.
Marking points
- Explains that the tax raises the cost of using fossil fuels, which previously did not reflect their environmental damage.
- Explains that this higher cost gives firms and consumers a financial incentive to use less fossil fuel or switch to cleaner alternatives, reducing emissions.
Examiner tip: A carbon tax internalises the external cost of emissions by building it directly into the price of fossil fuels.
15.
Explain how a cap-and-trade (tradeable permit) scheme could be used to reduce total pollution from a group of factories.
[2 marks] · no calculator
Course scope: Optional enrichment
Syllabus placement evidence: Cambridge 0455 (2026), complete 2.11.2 intervention guidance, p.16. Regulation is prescribed. Tradeable permits add a market for emission rights and a trading incentive mechanism beyond that general requirement; the specific scheme is conservatively assigned to enrichment, not required scheme recall. Editorial placement judgment from the course guidance, not an exam-board ruling.
Worked explanation
1. Set a group emissions cap and require a surrendered permit for each authorised unit; reducing permit availability lowers allowed total pollution.
2. Factories with cheap abatement can cut more and sell spare permits to expensive abaters. Trading reallocates who emits, not the total authorised amount, and enforcement prevents unpermitted emissions.
Common mistake: Trading does not create extra permits beyond the cap.
Marking points
- Explains that the government sets a maximum total level of pollution (a cap) and issues a limited number of permits allowing it.
- Explains that factories that pollute less than their permit allows can sell their spare permits to others, giving every factory a financial incentive to cut pollution.
Examiner tip: Cap-and-trade fixes the total quantity of pollution allowed directly, then lets the market find the cheapest way to achieve the reduction.
16.
Explain what is meant by moral hazard, using a person with comprehensive car insurance as an example.
[2 marks] · no calculator
Course scope: Optional enrichment
Syllabus placement evidence: Cambridge 0455 syllabus (2026); 2.10.2 guidance, p.16 (printed pages). Insurance moral hazard exceeds the expressly bounded market-failure examples.
Worked explanation
1. After comprehensive insurance, a driver may take less care if the insurer bears more of the financial consequences.
2. That incentive change is moral hazard, not a claim every insured driver becomes careless. Deductibles and monitoring can preserve some private cost of risk-taking.
Common mistake: Moral hazard concerns behaviour after cover, not hidden pre-existing risk.
Marking points
- Explains that moral hazard occurs when being protected from a risk changes a person's behaviour, making them take on more risk than they otherwise would.
- Applies this to the example: knowing that insurance will cover most of the cost of an accident, the driver might take less care than if they bore the full cost themselves.
Examiner tip: Moral hazard arises after an agreement is made, when one party's incentives to behave carefully are reduced because someone else bears the risk.
17.
Explain, using an example, what is meant by government failure in the context of correcting a market failure.
[2 marks] · no calculator
Syllabus placement evidence: Cambridge 0455 syllabus (2026); 2.11.2 final guidance, p.16 (printed pages). Evaluates intervention effectiveness against its alternative.
Worked explanation
1. Government failure means an intervention leaves net welfare below the relevant alternative, not simply that administration costs money.
2. For illustration, a badly targeted subsidy might fund many unnecessary purchases while crowding out a more valuable service. Compare additional benefits with fiscal and distortion costs before concluding failure.
Common mistake: Some waste does not prove total costs exceed benefits.
Marking points
- Explains that government failure occurs when intervention reduces net economic welfare relative to the relevant alternative; the presence of some administrative costs or waste alone does not establish that total costs exceed benefits.
- Gives a plausible example, such as a subsidy that is poorly targeted and mostly benefits people who did not need it, or a regulation that is too costly to enforce effectively.
Examiner tip: Government intervention does not automatically fix a market failure — poorly designed policy can create new problems or waste public money.
18.
Explain the difference between the private cost and the social cost of producing a good that generates pollution.
[2 marks] · no calculator
Worked explanation
1. Private production cost includes the firm's paid inputs and relevant opportunity costs.
2. Social cost adds residents' pollution damage not borne by the producer. A factory can therefore find an extra unit privately profitable even when its total resource and external cost exceeds buyers' benefit.
Common mistake: Social cost includes private cost; it does not replace it.
Marking points
- Explains private cost as the resource costs borne by the producer, including explicit payments and relevant implicit opportunity costs.
- Explains that social cost adds the external cost imposed on third parties, such as pollution damage, which the firm does not pay for itself.
Examiner tip: Social cost = private cost + external cost; a market failure occurs whenever these two costs diverge and the firm ignores the external part.
19.
Explain the purpose of a government subsidy for households installing solar panels on their roofs.
[2 marks] · no calculator
Worked explanation
1. A rooftop subsidy reduces the household's upfront installation burden, making more systems privately affordable.
2. If solar displaces emitting generation, other residents gain cleaner air or lower climate damage beyond the owner's bill saving. Displacement and extra uptake matter; subsidising installations that would happen anyway yields less additional benefit.
Common mistake: The household's lower electricity bill is not itself an external benefit.
Marking points
- Explains that if rooftop solar displaces fossil-fuel generation it can reduce pollution damage to third parties, a benefit not fully captured in the household's private decision.
- Explains that the subsidy lowers the upfront cost to households, encouraging more of them to install panels than the free market alone would achieve.
Examiner tip: A subsidy for a good with positive externalities aims to increase consumption of that good closer to the socially optimal level.
20.
Explain why national defence is considered a public good, referring to both non-excludability and non-rivalry.
[2 marks] · no calculator
Worked explanation
1. Defence is non-excludable when protecting the territory also protects residents who decline to pay.
2. It is non-rival in this model because another resident's protection does not use up the protection available to others. These properties explain the difficulty of voluntary individual charging.
Common mistake: Public ownership is not the defining test.
Marking points
- Explains non-excludability: once a country is defended, it is not possible to prevent any individual citizen from benefiting from that protection.
- Explains non-rivalry: one citizen benefiting from national defence does not reduce the protection available to any other citizen.
Examiner tip: National defence is a textbook pure public good because it is essentially impossible to exclude anyone or for one person's use to reduce what is left for others.
21.
A factory's pollution is seriously harming a nearby river's ecosystem. Discuss whether a strict legal ban would be more effective than a pollution tax in this specific case.
[4 marks] · no calculator
Worked explanation
1. Serious river ecosystem damage may be irreversible, making continued discharge unacceptable even if the factory pays tax. An enforced ban on that discharge directly targets it.
2. I would favour the ban where evidence shows no safe residual level, alongside feasible compliance monitoring. It could disrupt production and jobs, while a sufficiently strong tax can also induce clean technology; neither succeeds without enforcement. The case needs ecological thresholds, not revenue comparisons alone.
Common mistake: A ban's announcement is not proof harmful discharge stops.
Marking points
- Explains that a well-enforced ban could stop the prohibited discharge, which may be important for severe or irreversible harm; compliance is not guaranteed merely by legislating.
- Explains that a tax may leave residual pollution if firms prefer paying it to abatement, though a sufficiently high tax could eliminate the activity. Its effect depends on the rate, alternatives and enforcement.
- States a drawback of a ban, such as potential job losses if the factory must close a polluting process entirely.
- Reaches a judgement based on the severity and reversibility of the ecological harm described.
Examiner tip: A ban suits harm considered unacceptable at any level; a tax suits harm that is acceptable at a reduced level, in exchange for revenue and continued activity.
22.
Explain why health insurance companies often struggle to accurately price policies for customers whose true health risk they cannot fully observe.
[2 marks] · no calculator
Course scope: Optional enrichment
Syllabus placement evidence: Cambridge 0455 syllabus (2026); 2.10.2 guidance, p.16 (printed pages). Insurance adverse selection exceeds the expressly bounded market-failure examples.
Worked explanation
1. An insurer cannot fully distinguish high-risk applicants from low-risk applicants before agreeing cover.
2. At a pooled premium, those expecting expensive care may be more likely to buy, raising average claims and potentially premiums further. That selection mechanism differs from becoming less careful after insurance.
Common mistake: Adverse selection concerns who buys, not just post-policy behaviour.
Marking points
- Explains that this is a case of asymmetric information: the customer typically knows more about their own health and habits than the insurer does.
- Explains that this can lead to adverse selection, where people who expect to need more healthcare are more likely to buy insurance, raising average costs for the insurer.
Examiner tip: Adverse selection is a market failure caused by asymmetric information, where the riskiest customers are the most likely to seek insurance.
23.
Explain, in simple terms, why economists consider a market failure to involve a loss of overall economic welfare, even if the firms involved are still making a profit.
[2 marks] · no calculator
Worked explanation
1. Private profit counts a firm's revenues and costs, not necessarily harm or benefits borne by outsiders.
2. A polluting factory can earn profit while extra units cause more social damage than buyer benefit. Forgone net gains from a better allocation constitute welfare loss even though the firm remains solvent.
Common mistake: Firm survival is not evidence of socially efficient resource use.
Marking points
- Explains that market failure means resources are not allocated in the way that maximises total benefit to society as a whole.
- Explains that this creates a loss of welfare because the combined benefit to producers and consumers (and any third parties) is lower than it could be, even if individual firms remain profitable.
Examiner tip: Market failure is judged by overall social welfare, not by whether any individual firm is still profitable.
24.
Explain why a government might offer a subsidy to employers who provide technical skills training for their workers, rather than leaving training decisions entirely to individual firms.
[2 marks] · no calculator
Worked explanation
1. An employer may hesitate to fund transferable technical training if another employer can later recruit the trained worker.
2. A subsidy reduces the original firm's cost and can encourage skills investment whose benefits spread beyond it. Check that training is additional and useful rather than funding courses that would already occur.
Common mistake: Training spending alone does not prove an additional social benefit.
Marking points
- Explains that a firm may under-invest in training if it fears trained workers will leave to work for a competitor, so the firm does not capture the full benefit itself.
- Explains that a subsidy reduces the firm's cost of training, encouraging a level of investment in skills closer to what benefits the wider economy.
Examiner tip: Training is treated like a merit good here: its benefits spill over to other employers and the wider economy, so the free market alone tends to under-provide it.