Government Microeconomic Intervention: Market Failure, Externalities and Policy
Domain 4 tests whether you can identify the precise source of market failure, show the welfare loss, and choose a policy whose size and target match the failure.
Core rules
- Market failure: externalities, public goods, merit and demerit goods, information failure, monopoly power, factor immobility, inequality.
- A negative externality of production means marginal social cost exceeds marginal private cost (MSC > MPC). The free market over-produces relative to the social optimum, creating a deadweight loss triangle.
- Public goods are non-rival and non-excludable; the free rider problem causes under-provision, so tax finance is needed.
- Policies: Pigouvian tax equal to marginal external cost at the optimum; subsidy for positive externalities; tradable permits cap quantity rather than price; regulation; education to correct information failure; property rights (Coase theorem) where transaction costs are low.
- Government failure: imperfect information, administration costs, unintended consequences, regulatory capture.
Worked example
Demand: P = 100 − Q. MPC = 20 + Q and each unit causes 10 of external cost, so MSC = 30 + Q. Free market: 100 − Q = 20 + Q → Q = 40, P = 60. Social optimum: 100 − Q = 30 + Q → Q = 35, P = 65. The Pigouvian tax is 10 per unit and output falls by 5, removing the deadweight loss.
Traps
Taxing consumers for a production externality; claiming public goods are under-provided because they are expensive (the reason is non-excludability); ignoring elasticity when judging how far a tax cuts output; forgetting a producer subsidy may be passed on to consumers.