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Credit Sprint's Guide to Microeconomics Unit 6: Market Failure and the Role of Government

AP® weight 8–13%CLEP® weight 8–14%

Markets fail when private decisions ignore costs or benefits to others, when goods can't exclude non-payers, or when market power or information problems distort outcomes. Corrective taxes, subsidies, regulation and public provision can move output toward the socially optimal level, and taxes and transfers change the distribution of income.

What you need to know

  • Negative externality: marginal social cost > marginal private cost, so the market overproduces. A per-unit (Pigouvian) tax equal to the external cost fixes it.
  • Positive externality: marginal social benefit > marginal private benefit, so the market underproduces. A per-unit subsidy equal to the external benefit fixes it.
  • The socially optimal quantity is where MSB = MSC. Deadweight loss is the triangle between the market quantity and the optimal quantity.
  • Public goods are nonrival and nonexcludable, so the free-rider problem means markets underprovide them.
  • Common resources are rival but nonexcludable, so they get overused (tragedy of the commons).
  • Income inequality is shown with a Lorenz curve; the Gini coefficient runs from 0 (perfect equality) to 1.
  • Progressive taxes take a larger share of income from high earners; regressive taxes take a larger share from low earners; proportional taxes take the same share.
  • Government intervention can also fail: price controls, poorly targeted subsidies and regulations can create new inefficiencies.

Formulas

Socially optimal output: MSB = MSC
Optimal per-unit tax = marginal external cost at the optimal quantity
Gini coefficient = area between equality line and Lorenz curve ÷ total area under equality line
Average tax rate = total tax ÷ income

Exam traps

Watch forNegative externality → market quantity too HIGH and price too LOW. Positive externality → quantity too LOW.
Watch forA public good isn't just anything the government provides. It must be nonrival AND nonexcludable.
Watch forA tax on a negative externality reduces deadweight loss; a tax in a market without an externality creates it.

Key terms

  • Market failure: When a free market doesn't produce the socially optimal (efficient) quantity.
  • Negative externality: A cost imposed on third parties, like pollution. The market overproduces.
  • Positive externality: A benefit to third parties, like vaccinations. The market underproduces.
  • Marginal social cost: Marginal private cost plus marginal external cost.
  • Pigouvian tax: A per-unit tax equal to the external cost, which moves output to the socially optimal level.
  • Public good: A good that is nonrival and nonexcludable, like national defense.
  • Free-rider problem: People can benefit from a good without paying, so markets underprovide it.
  • Common resource: A good that is rival but nonexcludable, like ocean fish. Tends to be overused.
  • Tragedy of the commons: Overuse of a shared resource because no one owns it or bears the full cost of using it.
  • Lorenz curve: A graph of the cumulative share of income earned by the cumulative share of households.
  • Gini coefficient: A measure of inequality from 0 (perfect equality) to 1 (one household has all income).
  • Progressive tax: A tax that takes a larger percentage of income as income rises.
  • Regressive tax: A tax that takes a larger percentage of income from low earners, like a sales tax.
  • Asymmetric information: When one side of a transaction knows more than the other, as with used cars or insurance.

Practice questions

Five of the 39 Unit 6 questions in Credit Sprint. Every choice is explained in the app.

1. A negative externality exists when
  1. a buyer pays too much for a good
  2. a firm earns an economic loss
  3. a transaction imposes a cost on people who are not part of it
  4. the government taxes a good
  5. a good is used up by consumers
Show answer

a transaction imposes a cost on people who are not part of it. Like pollution from a factory.

2. The free-rider problem means that
  1. people can enjoy a good without paying, so private firms underprovide it
  2. the government overprovides public goods
  3. people buy too much of a good
  4. goods become rival
  5. firms charge too little
Show answer

people can enjoy a good without paying, so private firms underprovide it. Non-payers can't be excluded.

3. Which of the following is an example of government failure?
  1. A firm earning monopoly profit
  2. Farm subsidies that lead to large surpluses of crops nobody buys
  3. A factory polluting a river
  4. Underprovision of national defense by markets
  5. Overfishing in open waters
Show answer

Farm subsidies that lead to large surpluses of crops nobody buys. Intervention creates new inefficiency.

4. A factory's marginal private cost is $30 per unit and its pollution imposes $8 per unit on neighbors. The marginal social cost is
  1. $38
  2. $22
  3. $30
  4. $8
  5. $240
Show answer

$38. $30 + $8.

5. The Coase theorem suggests that private bargaining can solve an externality when
  1. property rights are clear and transaction costs are low
  2. property rights are unclear
  3. the government taxes the polluter
  4. many parties are involved
  5. the externality is positive only
Show answer

property rights are clear and transaction costs are low. The parties can negotiate to the efficient outcome.