Microeconomics: government intervention and market failure
What this domain tests
This domain examines market failure and government responses: externalities, public goods, common access resources, price controls, indirect taxes and subsidies. You must diagram welfare losses, evaluate policies and identify winners and losers.
Core rules
- Negative externality of production: MSC > MPC; market overproduces. Positive externality: MSB > MPB; market underproduces.
- Public goods are non-rivalrous and non-excludable, so private markets underprovide them (free-rider problem). Common access resources are rivalrous but non-excludable and tend to be overused.
- A price ceiling below equilibrium creates shortage; a price floor above equilibrium creates surplus.
- An indirect tax raises costs, shifts supply left; incidence depends on PED/PES. A subsidy shifts supply right and lowers price.
Worked example
Demand: P = 40 - Q. Private supply: MPC = 10 + Q. Each unit imposes a $4 external cost, so MSC = 14 + Q. Free market: 40 - Q = 10 + Q, Q = 15, P = 25. Social optimum: 40 - Q = 14 + Q, Q = 13, P = 27. Overproduction is 2 units. Welfare loss = ½ × external cost × quantity gap = ½ × 4 × 2 = 4. A Pigouvian tax of $4 per unit would shift MPC to MSC and remove the loss.
Traps
Do not assume the tax is fully passed to consumers; incidence depends on elasticity. A price ceiling is not always below equilibrium-if set above, it is non-binding. Public goods are not the same as merit goods. Subsidies can correct positive externalities but may cause overproduction if too large.