Home / Courses / Microeconomics / Unit 6

Microeconomics Unit 6: Market failure and the role of government

Markets fail when externalities or public goods make private and social costs or benefits differ, which can justify government action.

Covers: Socially efficient outcomes, externalities, public and private goods, government intervention, income and wealth inequality

Study guide

A market is socially efficient when it produces where marginal social benefit equals marginal social cost (MSB = MSC). Market failure occurs when the free market doesn't reach that outcome.

Externalities are costs or benefits that fall on third parties. A negative externality, like pollution, means the marginal social cost is higher than the private cost, so the market overproduces; a per-unit (Pigouvian) tax equal to the external cost can correct it. A positive externality, like vaccinations or education, means the marginal social benefit is higher than the private benefit, so the market underproduces; a subsidy can correct it. Both cause deadweight loss until corrected. Other tools include regulations, tradable pollution permits, and, when bargaining costs are low, private negotiation (the Coase theorem).

Goods are classified by whether they're excludable (people can be kept from using them) and rival (one person's use reduces another's). Private goods are both. Public goods, like national defense, are neither, which creates the free-rider problem, so markets underprovide them and governments usually supply them. Common resources, like fisheries, are rival but not excludable and suffer from the tragedy of the commons. Club goods are excludable but not rival.

Governments also address inequality. The Lorenz curve shows the distribution of income, and the Gini coefficient measures inequality from 0 (perfect equality) to 1. Progressive taxes take a larger share from higher incomes, proportional taxes take the same share, and regressive taxes take a larger share from lower incomes. Transfer payments and the earned income tax credit redistribute income, though government intervention can also create inefficiencies (government failure).

With a negative externality, the market quantity (where MPB = MPC) is larger than the socially optimal quantity (where MSB = MSC). The deadweight loss is the triangle between MSC and MSB over those extra units. With a positive externality, the market quantity is too small, and the deadweight loss is the triangle between MSB and MSC over the missing units. The Lorenz curve plots the cumulative share of income against the cumulative share of households. The farther it bows from the 45-degree line of perfect equality, the more unequal the distribution and the higher the Gini coefficient. Taxes and transfers that move income to lower quintiles shift the curve toward the line.

A per-unit tax raises a firm's MC and reduces output, which is why it can correct a negative externality. A lump-sum tax raises only fixed cost, so it doesn't change output in the short run.

Key ideas

• Efficiency requires marginal social benefit to equal marginal social cost.
• Negative externalities cause overproduction; positive ones cause underproduction.
• Pigouvian taxes and subsidies can correct externalities.
• Public goods are nonexcludable and nonrival, so markets underprovide them.
• The Lorenz curve and Gini coefficient measure inequality.

Formulas and rules

Common mistakes

• Thinking anything the government provides is a public good; it must be nonrival and nonexcludable.
• Mixing up which externality leads to overproduction (negative) vs. underproduction (positive).

Words to know

Market failure

When a free market doesn't produce the socially efficient outcome.

Marginal social cost

Private cost plus external cost.

Marginal social benefit

Private benefit plus external benefit.

Negative externality

A cost imposed on third parties, like pollution.

Positive externality

A benefit to third parties, like vaccinations.

Pigouvian tax

A per-unit tax equal to an external cost.

Coase theorem

Private bargaining can fix externalities when transaction costs are low.

Tradable permits

Pollution rights that firms can buy and sell.

Excludable

People can be prevented from using it.

Rival

One person's use reduces what's available to others.

Public good

Nonexcludable and nonrival, like national defense.

Free-rider problem

People benefit without paying.

Common resource

Rival but nonexcludable, like ocean fish.

Tragedy of the commons

Overuse of a shared resource.

Lorenz curve

A graph of income distribution.

Gini coefficient

A measure of inequality from 0 to 1.

Progressive tax

Takes a larger share from higher incomes.

Regressive tax

Takes a larger share from lower incomes.

Transfer payment

Government payment without goods or services in return, like unemployment benefits.

Sample practice questions

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