market failures flashcards

Externality

A cost or benefit that affects a third party not involved in the transaction.

Market Failure

Occurs when resources are misallocated or inefficiently allocated.

Causes

• Imperfect competition

• Imperfect/asymmetric information

• Externalities

• Public goods & common resources

• Moral hazards

Positive Externality

Benefits others (e.g., education, vaccines).

Negative Externality

Harms others (e.g., pollution, noise)

Spillover effects

another name for externalities

Marginal Private Cost

Cost to producer

Marginal Social Cost

MPC + external cost

Marginal Private Benefit

Benefit to customer

Marginal Social Benefit

MPB + external benefit

MPC Graph Relation

Supply Curve

MSC Graph Relation

Above supply (for negative externalities)

MPB Graph Relation

Demand curve

MSB Graph Relation

Above demand (for positive externalities)

Negative Externalities

Over production

Positive Externalities

Underproduction

Government solutions

Regulation	Laws limiting/mandating behavior	Car emissions, compulsory schooling
Taxes (Pigovian tax)	Internalizes negative externalities	$0.50 per roll → reduces output to 80k rolls
Subsidies	Internalizes positive externalities	$8,000 per student subsidy increases enrollment

Subsidy Cost: $8,000 × 2,000 = $16M → may exceed DWL benefit ($2M).

Efficient fix: Targeted (need- or merit-based aid).

Coase Theorem

If property rights are clear and transaction costs are low, private bargaining can reach efficient outcomes.

• Example: Spot the dog
  

  • If barking costs neighbor $800 and benefit to owner is $500 → owner should remove Spot (Jane pays David $600).

  • Efficient outcome reached regardless of who initially holds the rights.