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Intermediate Microeconomics Unit 10: Market Failures: Externalities, Public Goods, Information

Markets fail to reach efficiency when some costs or benefits are unpriced or when one side knows more than the other; this unit covers how to measure those failures and the policies that fix them.

Covers: Negative and positive externalities, Pigouvian taxes and subsidies, Coase theorem and tradable permits, Public goods and free riding, Common resources, Adverse selection, Moral hazard and signaling

Study guide

An externality is a cost or benefit that falls on people outside a transaction. With a negative externality such as pollution, marginal social cost equals marginal private cost plus marginal external cost, MSC = MPC + MEC. Firms ignore the external part, so the market produces where demand meets MPC, which is more than the efficient quantity where demand meets MSC. The deadweight loss is the triangle between MSC and demand over the extra units. A Pigouvian tax equal to marginal external cost at the efficient output makes firms internalize the damage. Positive externalities, such as vaccination, lead to too little output, and a subsidy equal to the marginal external benefit corrects them.

Government is not the only possible solution. The Coase theorem says that if property rights are well defined and bargaining is cheap, the affected parties will negotiate to the efficient outcome no matter who holds the rights; the assignment of rights only decides who pays whom. When transaction costs are high, rights matter for efficiency. Tradable pollution permits set the total quantity of emissions and let firms trade; firms with low abatement costs cut more and sell permits, so the target is met at least cost. An emissions tax does the same by making every firm abate until its marginal abatement cost equals the tax.

Goods can be classified by rivalry and excludability. A pure public good is nonrival and nonexcludable, like national defense. Because people cannot be excluded, each has an incentive to free ride on others' contributions, so private provision falls short of the efficient level. The efficient quantity satisfies the Samuelson condition: the sum of individual marginal benefits equals marginal cost, so demand curves are added vertically. Lindahl pricing charges each person her own marginal benefit at that quantity. Common resources, which are rival but nonexcludable, suffer the opposite problem: overuse, the tragedy of the commons.

Asymmetric information arises when one side of a market knows more. Adverse selection is hidden information before a deal: in Akerlof's lemons model, buyers who cannot judge quality pay only an average price, so owners of good cars withdraw and the market can unravel. Insurance markets face the same risk when low-risk customers leave the pool. Moral hazard is a hidden action after a deal, such as taking less care once insured; deductibles, co-payments and performance pay reduce it. Signaling and screening help: in Spence's model, education can separate high- and low-ability workers if it is cheaper for the high-ability type, even if it adds no productivity.

Key ideas

• Negative externalities cause overproduction; positive externalities cause underproduction.
• A Pigouvian tax or subsidy equals the marginal external cost or benefit at the efficient quantity.
• Coase: with clear rights and low bargaining costs, private deals reach efficiency regardless of who holds the rights.
• Taxes and tradable permits meet abatement targets at least cost by equalizing marginal abatement costs.
• Public goods are underprovided because of free riding; efficiency requires ΣMB = MC.
• Adverse selection (hidden type) can unravel markets; moral hazard (hidden action) weakens incentives.
• Signals work when they are more costly for low types than for high types.

Formulas and rules

Common mistakes

• Setting a Pigouvian tax equal to total damage instead of marginal damage.
• Adding public-good demand curves horizontally instead of vertically.
• Thinking the Coase theorem means the harmed party is always compensated.
• Mixing up adverse selection (hidden type before the deal) and moral hazard (hidden action after).
• Calling any good provided by the government a public good.

Before the test, make sure you can

• Calculate market and efficient output and the deadweight loss with an externality.
• Set Pigouvian taxes and subsidies, including when marginal damage varies with output.
• Apply the Coase theorem and explain the role of transaction costs.
• Find least-cost abatement under a tax or tradable permits.
• Find the efficient level of a public good and Lindahl prices; explain free riding.
• Analyze adverse selection in used-car and insurance markets.
• Identify moral hazard and design signaling or incentive solutions.

Words to know

Externality

A cost or benefit of an activity that falls on people who are not part of the transaction.

Marginal social cost

Marginal private cost plus marginal external cost.

Pigouvian tax

A per-unit tax equal to marginal external cost at the efficient output, which internalizes an externality.

Coase theorem

With clear property rights and low transaction costs, bargaining leads to an efficient outcome regardless of who holds the rights.

Transaction costs

The costs of negotiating and enforcing agreements, which can block Coasian bargains.

Tradable permits

Rights to emit a set amount of pollution that firms can buy and sell.

Marginal abatement cost

The cost of reducing pollution by one more unit.

Public good

A good that is nonrival and nonexcludable.

Nonrival

One person's consumption does not reduce the amount available to others.

Nonexcludable

People cannot practically be prevented from using the good.

Free rider problem

The incentive to enjoy a good's benefits without paying for it.

Samuelson condition

Efficient provision of a public good requires the sum of marginal benefits to equal marginal cost.

Lindahl price

A personal price for a public good equal to that person's marginal benefit at the efficient quantity.

Tragedy of the commons

Overuse of a rival, nonexcludable resource because users ignore the costs they impose on others.

Adverse selection

Hidden information before a deal causes an unfavorable mix of participants.

Moral hazard

A party changes its behavior after a contract because its actions are not observed.

Signaling

An informed party takes a costly action to reveal its type.

Screening

An uninformed party designs choices that lead informed parties to reveal their type.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.