Market Failure, Externalities and Government Intervention
What the domain tests
Market failure, externalities and government intervention examines when prices fail to reflect true social costs and benefits, and evaluates taxes, subsidies, regulation, permits and public provision. Expect diagrams and policy evaluation.
Core rules
- Market failure occurs when the free market produces a socially inefficient quantity: public goods, merit and demerit goods, externalities, information failure, monopoly power and factor immobility.
- Negative externality: marginal social cost exceeds marginal private cost; output is above the social optimum. Positive externality: marginal social benefit exceeds marginal private benefit; output is below the optimum.
- Public goods are non-rival and non-excludable, so markets underprovide them (free-rider problem). Merit goods are underconsumed because of information failure; demerit goods are overconsumed.
- Corrective taxes aim to internalise external costs; subsidies internalise external benefits; regulation, tradable permits and property rights also address externalities.
- Government failure can arise from poor information, administrative costs, unintended effects and political incentives.
Worked example
A factory's marginal private cost is N$20 per unit, but pollution imposes N$5 of external cost, so marginal social cost is N$25. The free-market output is where MPB=MPC. A Pigouvian tax of N$5 shifts private cost to N$25, reducing output toward the social optimum. The tax also raises revenue, but if demand is very inelastic the output fall is small, and if the tax exceeds the external cost it creates a new deadweight loss.
Traps
A merit good is not a public good. A subsidy can worsen overproduction if misapplied. Do not assume government intervention always improves welfare; evaluate magnitude and government failure.