Model negative and positive externalities, welfare loss triangles, and Pigouvian taxes and subsidies. Supports Edexcel (2 types) and AQA (4 types).
Otti can see your diagram
Set up a scenario, then ask Otti to analyse it, explain the economics, or mark your exam technique — just like a real tutor would.
Qp = 50.0 (private market) vs Qs = 38.1 (socially optimal). Welfare loss ≈ 148.8 (area of triangle).
An externality is a cost or benefit that falls on a third party who is not involved in the transaction. Because buyers and sellers ignore these external effects, a free market produces too much of goods with external costs and too little of goods with external benefits. This tool shows the gap between the market outcome and the social optimum, and the size of the welfare loss.
Label the axes price/cost and quantity, label every curve (MPC, MSC, MPB, MSB), mark Qp and Qs with their prices, and shade the welfare loss triangle so that it points towards the social optimum. Then explain the diagram in words: producers ignore the external cost, so they produce where MPC = MPB rather than where MSC = MSB, overproducing by the gap between Qp and Qs, and each unit in that range costs society more than it is worth. When you add a tax, show the supply curve shifting up by the tax and output moving towards Qs. Name a real example, such as pollution from a factory or the external benefits of vaccination.
Evaluate: A Pigouvian tax only moves output to the social optimum if the government can measure the external cost accurately, which is difficult when it is spread across many people or over time. If demand is price inelastic, the tax may raise revenue but change consumption little. Taxes can be regressive and encourage evasion, and subsidies have an opportunity cost. Badly designed intervention risks government failure, so regulation, tradable pollution permits or better information may be more effective in some markets.
Revise the theory behind this tool in our Edexcel revision notes:
Practise drawing the static versions you will need in the exam:
Private cost is the cost paid by the producer or consumer making the decision, such as wages, materials and energy. Social cost is the full cost to society: private cost plus any external cost imposed on third parties, such as pollution. Marginal social cost equals marginal private cost plus marginal external cost.
It shows the net loss to society from producing at the market output instead of the social optimum. For a negative externality, each unit between Qs and Qp has a social cost greater than its social benefit, and the triangle adds up those losses. For a positive externality, it shows the benefit lost because units worth more to society than they cost are not produced.
The external cost is hard to value in money, so the tax may be set too high or too low. If demand is price inelastic, consumption may fall only a little. Firms may pass the tax on to consumers or move production abroad, and high taxes can encourage illegal markets. Any of these can lead to government failure.