Unit 6 Market Failure Flashcards
Market Failure
happens when the free market does not produce the right amount of a good or service.
Causes: externalities, public goods, market power, and lack of property rights.
Deadweight Loss
Lost efficiency due to overproduction or underproduction.
Happens with taxes, monopolies, and externalities.
Marginal Social Benefit (MSB)
Total benefit to society from one more unit (private + external benefit).
Marginal Social Cost (MSC)
Total cost to society from one more unit (private + external cost).
Efficient Output
Where MSB = MSC.
Public Goods
Non-rival and non-excludable.
Example: street lights, national defense.
Private Goods
Rival and excludable.
Example: pizza, clothes.
Free-Rider Problem
People get the benefit of public goods without paying.
Leads to underproduction.
Solutions to Free-Rider Problem
Government provides the good and uses taxes to pay for it.
Externality
An externality is a side effect of a transaction that affects someone not directly involved in the activity.
Can be positive or negative.
Negative Externality
A cost that falls on people outside the market. (ex: pollution).
Market overproduces.
Positive Externality
A benefit to third parties outside the market. (ex: vaccines).
Market underproduces.
Fixing Negative Externalities
Per-unit tax equal to external cost.
Shifts MSC up to match MSB.
Fixing Positive Externalities
Per-unit subsidy equal to external benefit.
Shifts MSB up to match MSC.
Coase Theorem
If property rights are clear and transaction costs are low, private parties can fix externalities on their own.
Example: neighbors paying each other to reduce noise or pollution.
Taxes
Create deadweight loss if they reduce mutually beneficial trades.
Can correct externalities.
Subsidies
Encourage consumption or production (used in positive externalities).
Price Controls (Ceilings/Floors)
Cause inefficiency by preventing equilibrium.
Can cause shortages or surpluses.
Quantity Controls (Quotas)
Limit output to a certain amount.
Can lead to deadweight loss.
Equity vs. Efficiency
Efficiency: max total surplus
Equity: fairness in how surplus is distributed
Progressive Tax
Higher income → higher % paid.
Increases equity.
Proportional Tax
Same % for all incomes.
Regressive Tax
Higher % burden on lower incomes.
Less equitable.
Gini Coefficient
Measures income inequality (0 = perfect equality, 1 = max inequality).
