DSE Economics | Externalities and market failure

DSE Economics | Externalities and market failure — lesson-prep guide for tutors

2026-11-02

Tutor lesson-prep guides · Secondary Economics

Students can recite market failure, then draw MPC where MSC belongs. This lesson uses one set of numbers to produce overproduction and the deadweight loss in a single pass.

Objectives — Students can: (1) build MSC from MPC plus marginal external cost and explain the three; (2) find the social optimum where demand meets MSC and explain why the market overproduces; (3) compute the gap, the deadweight loss and the tax revenue, and explain why the tax should equal MEC.

01 Prerequisites (3-minute check)

If any of these fails, fix it before the lesson starts.

Skill	Quick check	Pass mark
Demand and supply	Where does equilibrium output occur?	Where the demand and supply curves cross
Marginal	What is marginal cost?	The extra cost of producing one more unit
Surplus	Which area is consumer surplus?	The triangle below demand and above price

02 Lesson flow (60 minutes)

Time	Stage	Tutor does	Student does
0-5 min	Opening question	Ask who pays for a factory discharging waste water, and who pays the rest	Vote and name the affected party
5-15 min	Prerequisite check	Three quick items: equilibrium, marginal, surplus	Written answers, marked live
15-37 min	Three-part script	Teach MSC, both signs of externality, then tax and deadweight loss	Recap which curve moves in each part
37-49 min	Question walk-through	Model four questions, solving by algebra then checking on the diagram	Copy and recompute
49-55 min	Independent practice	Circulate; ask only which curve you moved here	Do three items and self-mark
55-60 min	Exit check	Collect answers and count misses aloud	Written, no talking

03 Teaching script (read it out)

Scene 1: Part 1: MPC, MEC and MSC

Private marginal cost is what the firm pays: materials, labour, machinery. Marginal external cost is what it does not pay but society bears: waste water, noise, congestion. Adding them gives marginal social cost. Take demand P = 100 – Q, MPC = 20 + Q and damage of 10 per unit. The market only sees MPC, so 100 – Q = 20 + Q gives Q = 40 and P = 60. Society needs 100 – Q = 30 + Q, giving Q = 35 and P = 65. The market produces 5 units too many, and that is overproduction.

Which two items add up to MSC, and why does the market ignore the second?

Scene 2: Part 2: the deadweight loss and the Pigouvian tax

Each of those extra 5 units costs society more than buyers will pay. At Q = 40 the MSC is 70 while price is only 60, so every extra unit loses 10. Summing over the range from 35 to 40 gives a triangle of half times 5 times 10, which is 25: the deadweight loss. A Pigouvian tax set equal to MEC, 10 per unit, moves MPC to 30 + Q so the firm chooses 35 by itself. Revenue is 10 times 35, which is 350, and that is a transfer, not a loss. Keep the 350 and the 25 apart.

Why does the deadweight loss carry a half? Is tax revenue a social loss?

Scene 3: Part 3: positive externalities and the limits of policy

The same tools run in reverse. Education, vaccination and building maintenance carry positive externalities: marginal social benefit exceeds marginal private benefit, so the market underproduces and the remedy is a subsidy equal to the marginal external benefit. The limits matter too. A tax requires knowing MEC, which is hard to measure, and it may push firms to relocate or close, losing units whose private cost was covered. That is why exam answers usually combine tax, regulation and clearly defined property rights rather than relying on a single rate.

With a positive externality, does the market overproduce or underproduce, and is the remedy a tax or a subsidy?

04 Question types and worked steps

Type	Example	Steps	Answer
Social optimum	Given demand, MPC and MEC.	(1) Write MSC = MPC + MEC; (2) set P = MSC; (3) solve Q and P; (4) compare with market equilibrium.	Example: Q = 35, P = 65 against market Q = 40, P = 60.
Deadweight loss	Find the welfare loss.	(1) Find the output gap; (2) find the external cost over that range; (3) half x base x height; (4) give units.	Example: half x 5 x 10 = 25.
Optimal tax	Find the Pigouvian tax.	(1) Tax equals MEC at the optimum; (2) verify that MPC plus tax crosses demand at that Q; (3) compute revenue; (4) note revenue is not a loss.	Example: tax 10, revenue 350.
Classifying an externality	Given a case, name the type and policy.	(1) Separate private from social; (2) over or under production; (3) tax, subsidy or regulation; (4) name one implementation problem.	Example: vaccine subsidy; the difficulty is measuring the external benefit.

Sanity check (teach this): Reasonableness check: market equilibrium from 100 – Q = 20 + Q is Q = 40, P = 60; the social optimum from 100 – Q = 30 + Q is Q = 35, P = 65. At Q = 40 the MSC is 20 + 40 + 10 = 70, ten above price, so each extra unit loses value. Deadweight loss is half times (40 – 35) times (70 – 60) = 25. Tax revenue is 10 times 35 = 350 and must not be confused with 25. Note the algebra: both slopes are one, so the denominator when solving is two.

05 Independent practice (3 questions)

Question	Answer	What to watch
Find the market equilibrium quantity and price.	100 – Q = 20 + Q, so Q = 40 and P = 60.	Check that both Q terms are moved to the same side.
Find the social optimum and the deadweight loss.	Q = 35, P = 65; deadweight loss is half x 5 x 10 = 25.	Check the base is 40 – 35, not 40.
What is the optimal tax, and what revenue does it raise?	10 per unit, raising 10 x 35 = 350.	Check the revenue uses 35, not the market output 40.

06 Common mistakes and what to say

Mistake	Student writes	Say this
Using MPC as MSC	Draws the social cost curve at 20 + Q.	The firm pays MPC. There is a slice it does not pay, such as waste water. Both slices make MSC.
Wrong height in the triangle	Writes half x 5 x 5.	The height is the gap between the two costs, 70 minus 60, which is 10. You have mixed up base and height.
Counting tax revenue as a loss	Says the tax costs society 350.	Revenue moves from firms to government, so society does not lose it. The real loss is the deadweight triangle of 25.
Taxing a positive externality	Writes tax whenever the word externality appears.	Ask first whether it is a cost or a benefit. A positive externality means society gains more than the buyer, so subsidise to raise output.

07 Homework (paper, section and question numbers)

Secondary Economics index: finish the three items, then compare tax incidence with the tax and subsidy chapter — Exercises 1-3 on this page

08 Exit check (last 5 minutes)

Question	Answer	Decision
Which two items add up to MSC?	MPC plus MEC	Cannot answer: reteach part 1
What are the market and optimal quantities here?	40 and 35, so the market overproduces by 5 units	Cannot answer: reteach part 1
How is the deadweight loss of 25 calculated?	Half x 5 x (70 – 60)	Cannot answer: reteach part 2

09 Tutor FAQ

Which year is this for?

S6 market failure and efficiency mainly; S5 classes that have covered demand, supply and surplus can start earlier.

Must students memorise formulas?

What they need is the relationships: MSC = MPC + MEC, tax = MEC, deadweight loss = half x base x height. Numbers come from the equations given.

Is there a matching paper?

The homework link goes to the secondary Economics index, which pairs with the tax and subsidy chapter.

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A TutorZone lesson-prep guide. Written by the TutorZone team; questions and lesson flow are original and are not taken from any school or publisher material.