Microeconomics Foundations (ECON 101) · Module 8 of 9
Market Failure & Government Intervention
When markets don't produce the efficient outcome on their own, and what policy tools try to fix it.
Externalities
- A negative externality imposes a cost on third parties not involved in a transaction, like pollution; a positive externality provides a benefit to third parties, like vaccination reducing disease spread.
- Because externalities aren't reflected in market prices, markets tend to overproduce goods with negative externalities and underproduce goods with positive externalities, relative to the socially optimal level.
Why does an unregulated market tend to overproduce a good with a significant negative externality, like pollution?
Solution. The producer's private cost doesn't include the external cost imposed on third parties, so the market price is too low and quantity too high compared to what would account for the good's true total social cost.
Public Goods & the Free-Rider Problem
- A public good is both non-excludable (can't easily prevent people from using it) and non-rivalrous (one person's use doesn't reduce availability for others), like national defense or a public fireworks display.
- Because people can benefit from a public good without paying for it — the free-rider problem — private markets tend to underprovide public goods, often requiring government provision.
Why do private markets tend to underprovide public goods, like national defense?
Solution. Since public goods are non-excludable, people can benefit from them without paying (free-riding), giving private firms little incentive to produce them since they can't easily charge everyone who benefits, leading to underprovision relative to what's socially desirable.
Price Controls
- A price ceiling (maximum legal price) set below equilibrium causes a shortage, since quantity demanded exceeds quantity supplied at that price, as with rent control.
- A price floor (minimum legal price) set above equilibrium causes a surplus, since quantity supplied exceeds quantity demanded at that price, as with minimum wage.
What effect does a rent control policy — a price ceiling on rent, set below equilibrium — typically have on the housing market?
Solution. It causes a shortage of available housing, since more people want to rent at the artificially low price (higher quantity demanded) than landlords are willing to supply at that price (lower quantity supplied).
Taxes, Subsidies & Deadweight Loss
- A tax on a good typically raises the price paid by buyers, lowers the price received by sellers, and reduces the quantity traded below the efficient equilibrium level, creating a deadweight loss.
- A subsidy has the opposite effect on quantity, increasing it, but can also create deadweight loss if it pushes production above the socially efficient level.
Why does a tax on a good typically create a deadweight loss?
Solution. The tax drives a wedge between what buyers pay and what sellers receive, reducing the quantity traded below the efficient equilibrium level; this means some mutually beneficial trades no longer occur, resulting in a loss of total economic surplus.
Check yourself
2 of this module's 5 quiz questions. Pick your answers, then check them in the app, with an explanation for every question.
1. What is a negative externality?
2. What two properties define a public good?