Market Failure and Intervention
What this domain tests
This domain examines why free markets may fail to allocate resources efficiently and how governments intervene. CAPE Unit 1 expects externalities, public goods, merit and demerit goods, asymmetric information, market power and inequality, plus evaluation of taxes, subsidies, price controls, regulation and tradable permits.
Core rules
- Negative externality: MSC > MPC, so the free market overproduces. A Pigouvian tax equal to marginal external cost at the social optimum corrects the gap.
- Positive externality: MSB > MPB, so the free market underproduces; a subsidy can raise output toward the social optimum.
- Public goods are non-rival and non-excludable, causing free-riding and underprovision; merit goods are underconsumed because of information failure.
- A price ceiling below equilibrium creates a shortage and may require rationing; a price floor above equilibrium creates a surplus.
- Intervention has costs: administration, distortion, evasion, and government failure. Evaluate against the counterfactual, not perfection.
Worked example
Demand: P = 100 − Q. MPC = 20 + Q; production creates a $10 external cost per unit, so MSC = 30 + Q. Free market: 100 − Q = 20 + Q, Q = 40, P = 60. Social optimum: 100 − Q = 30 + Q, Q = 35, P = 65. A $10 per-unit tax shifts MPC to 30 + Q and achieves Q = 35. The free-market deadweight loss is ½(40 − 35)(70 − 60) = 25. Tax revenue = 10 × 35 = 350, but not all of that is a welfare loss.
Traps
- Taxing output but drawing the tax on the demand curve without shifting the correct curve.
- Claiming a subsidy always improves welfare; it can create overproduction if set above marginal external benefit.
- Confusing public goods with merit goods; public goods fail because of non-excludability, not just underconsumption.
- Ignoring that price ceilings may create black markets and quality deterioration.
- Treating government failure as a reason no intervention is ever justified.
Distribution Theory
What this domain tests
Distribution theory explains factor incomes: wages, rent, interest and profit. CAPE Unit 1 tests derived demand, marginal revenue product, labour supply, competitive versus monopsonistic wage determination, unions, and inequality measures such as the Lorenz curve and Gini coefficient.
Core rules
- Labour demand is derived from demand for output and equals MRP = MPL × MR under profit maximisation.
- A competitive firm hires until MRP = wage; the wage is set by market demand and supply. Labour supply reflects substitution and income effects, skills and mobility.
- Monopsony faces an upward-sloping labour supply; marginal cost of labour exceeds the wage, so employment and wages are below the competitive benchmark.
- Economic rent is payment above transfer earnings; the Lorenz curve plots cumulative income shares; the Gini coefficient rises with inequality.
- Unions can raise wages by restricting supply, bargaining or increasing productivity; effects on employment depend on elasticity.
Worked example
A competitive firm sells output at $5. MPL = 12 − L, so MRP = 5(12 − L) = 60 − 5L. If the wage is $25, set 60 − 5L = 25, so L = 7. At L = 7, MRP = 25, matching the wage. If the output price rises to $6, MRP = 72 − 6L; the firm hires until 72 − 6L = 25, L = 7.83, so labour demand rises. Under monopsony with labour supply w = 10 + 2L, total labour cost = 10L + 2L², MCL = 10 + 4L. Set 60 − 5L = 10 + 4L, L = 5.56 and w = 21.11 - below the competitive wage of 24.29 at L = 7.14.
Traps
- Equating MPL with MRP and ignoring output price.
- Treating labour supply as derived demand; it is labour demand that is derived.
- Assuming a union wage rise always reduces employment; it depends on labour demand elasticity and productivity.
- Confusing the Lorenz curve with the Gini coefficient; one is a curve, the other a summary ratio.
- Calling all profit economic rent; normal profit is transfer earnings.