Unit 6

Market Failure and the Role of Government: the one-page sheet

6.1 Socially Efficient and Inefficient Market Outcomes

A quantity is socially efficient where marginal social benefit equals marginal social cost: every unit worth more than it costs is made, and no other. Total surplus is largest there. A competitive market in which demand and supply reflect all benefits and costs reaches that point on its own. Taxes, subsidies, price controls and monopoly move the quantity away from it, and the lost net benefit is deadweight loss, a triangle between MSB and MSC that points toward the efficient quantity. A market outcome that is not efficient is a market failure.

Marginal social benefit (MSB) is the benefit of one more unit to everyone; marginal social cost (MSC) is its cost to everyone.
The socially efficient quantity is where MSB = MSC. There total surplus is largest.
A competitive market whose demand and supply capture every benefit and cost has D = MSB and S = MSC, so its equilibrium is efficient.
Any other quantity leaves deadweight loss, a triangle between MSB and MSC pointing toward the efficient quantity. A market failure is a market outcome that is not efficient.

making it adds to total surplus total surplus is as large as it can be: the efficient quantity units are lost (or wasted) whose benefit and cost do not match deadweight loss appears: a market failure if the market itself causes it

marginal social benefit: Marginal social benefit (MSB) is the benefit of one more unit to everyone in society; marginal social cost (MSC) is its cost to everyone. The efficient quantity is where MSB = MSC.
market failure: A market outcome that is not socially efficient: the market produces more or less than the quantity where MSB = MSC, leaving deadweight loss.

6.2 Externalities

An externality is a cost or benefit that falls on people outside a market. With a negative externality, the social cost exceeds the private cost (or the social benefit falls short of the private benefit), so the market, which uses private curves, produces more than the efficient quantity where MSB = MSC; with a positive externality it produces less. The deadweight loss is the triangle between the social and private curves from the market quantity to the efficient quantity. A per-unit tax or subsidy equal to the external cost or benefit at the efficient quantity moves the market there; a lump-sum tax does not, because it leaves marginal cost unchanged.

An externality is a cost or benefit that falls on people outside the deal. Production externalities show up on the supply side (MSC vs MPC); consumption externalities on the demand side (MSB vs MPB).
Negative externalities (MSC above MPC, or MSB below MPB) mean the market makes too much. Positive ones mean it makes too little.
Always state both quantities: the market at MPB = MPC, the efficient one at MSB = MSC. The deadweight loss triangle sits between them and points toward the efficient quantity.
A corrective (Pigouvian) tax or subsidy per unit equal to the external cost or benefit at the efficient quantity fixes it. A lump-sum tax does not change MC, price or quantity.

MSC lies above the firms' MPC (supply) the market produces where MPB = MPC, more than where MSB = MSC there is deadweight loss: a market failure supply shifts up to MSC, and the market produces the efficient quantity

externality: A cost or benefit of producing or consuming a good that falls on people outside the market. Because buyers and sellers ignore it, the market quantity is not efficient.
negative externality: An external cost. From production it puts marginal social cost above marginal private cost (MPC); from consumption it puts marginal social benefit below marginal private benefit. The market makes too much.
positive externality: An external benefit. From consumption it puts marginal social benefit above marginal private benefit (MPB); from production it puts marginal social cost below marginal private cost. The market makes too little.
corrective tax: A corrective (Pigouvian) tax or subsidy: a per-unit tax equal to the external cost, or per-unit subsidy equal to the external benefit, at the efficient quantity, which moves the market to MSB = MSC.

6.3 Public and Private Goods

Goods differ in rivalry (does one person's use leave less for others?) and excludability (can nonpayers be kept out?). Private goods are rival and excludable and markets handle them well. Public goods are nonrival and nonexcludable: people can free ride, so markets provide too little, even when the sum of everyone's benefit exceeds the cost, and governments often provide them with taxes. Common resources are rival but nonexcludable, so they are overused. Club goods are excludable but nonrival.

Rival: one person's use leaves less for others. Excludable: nonpayers can be kept out.
Private goods are rival and excludable; public goods nonrival and nonexcludable; common resources rival and nonexcludable; club goods nonrival and excludable.
Public goods suffer from the free-rider problem: markets underprovide them. A public good is worth providing when the sum of everyone's benefit is at least its cost.
Common resources are overused (the tragedy of the commons), because each user ignores the cost to others. Limits, permits or fees per unit reduce overuse.

people can enjoy it without paying each waits for others to pay: free riding a private seller cannot cover its cost, so the market provides too little or none the outcome is inefficient, and government often provides the good, paid for with taxes

rival good: A good is rival when one person's use leaves less for others (a sandwich). It is nonrival when many can use it at once without reducing each other's use (a radio broadcast).
excludable good: A good is excludable when people who do not pay can be kept from using it (a concert with a ticket gate). It is nonexcludable when they cannot (national defense).
public good: A good that is both nonrival and nonexcludable, such as national defense or a flood wall. A private good is rival and excludable.
free-rider problem: The free-rider problem: people can enjoy a nonexcludable good without paying, so few pay and a market provides too little of it.
common resource: A good that is rival but nonexcludable, such as fish in open waters. Each user ignores the cost to others, so it is overused: the tragedy of the commons.
club good: A good that is excludable but nonrival, such as a streaming service or an uncrowded toll road. Firms can sell it because nonpayers can be kept out.

6.4 The Effects of Government Intervention in Different Market Structures

The same policy can have different effects in different market structures. A price ceiling cuts output in a competitive market but can raise a monopoly's output by making its marginal revenue flat. Regulators of a natural monopoly choose between the socially optimal price (P = MC, efficient but with a loss that needs a subsidy) and the fair-return price (P = ATC, a normal profit). Lump-sum taxes and subsidies change only profit; per-unit ones change marginal cost and so output and price. A minimum wage lowers employment in a competitive labor market but can raise it in a monopsony.

A price ceiling lowers quantity in a competitive market but can raise it for a monopoly, set between the monopoly price and the price where demand meets MC.
Natural monopoly regulation: the socially optimal price (P = MC) is efficient but leaves a loss; the fair-return price (P = ATC) gives a normal profit and less deadweight loss than no regulation.
Lump-sum taxes and subsidies change profit only. Per-unit ones change MC: a tax cuts a monopoly's output and raises its price; a subsidy does the opposite.
A minimum wage lowers employment in a competitive labor market but can raise it in a monopsony.

MR is below price, so it restricts output and P > MC each unit up to demand earns the ceiling price, so MR equals the ceiling output rises toward the efficient quantity and price falls the firm makes a loss, so the regulator subsidizes it or uses the fair-return price P = ATC

regulation of market power: Regulation of market power: government policies, such as price ceilings on a monopoly and fair-return or socially optimal pricing of a natural monopoly, that move a firm with market power toward more output at a lower price.

6.5 Inequality

The Lorenz curve shows how income is shared: the cumulative percentage of income held by the cumulative percentage of households, from poorest to richest. The diagonal line of equality means equal shares, and the further the curve bows below it, the more unequal the distribution. The Gini coefficient measures that gap as a share of the area under the line. Taxes are progressive, proportional or regressive by how their share of income changes with income, and progressive taxes and transfer payments move the after-tax Lorenz curve toward equality. Inequality comes from differences in skills, wealth, discrimination, market power and luck.

The Lorenz curve plots the cumulative percentage of income against the cumulative percentage of households, poorest first. The diagonal is the line of equality; the further the curve bows below it, the more unequal.
The Gini coefficient is the area between the line of equality and the Lorenz curve as a share of the triangle under the line: 0 is perfect equality, 1 the most unequal.
Taxes are progressive, proportional or regressive as the share of income they take rises, stays the same or falls with income. Transfer payments give money with no good or service in return.
Sources of inequality include differences in skills and training, inherited wealth, discrimination, market power and luck. Income is a yearly flow; wealth is a stock of assets.

each point gives the share of income held by the lowest x percent: the Lorenz curve the curve bows further below the line of equality the Gini coefficient, that area as a share of the triangle, rises the after-tax curve moves toward the line of equality

Lorenz curve: A curve that shows the cumulative percentage of income (or wealth) held by the cumulative percentage of households, ranked from lowest to highest. The diagonal line of equality shows perfectly equal shares.
Gini coefficient: A measure of inequality: the area between the line of equality and the Lorenz curve as a share of the whole triangle under the line. It runs from 0 (perfect equality) to 1.
progressive tax: A tax that takes a larger share of income as income rises. A proportional tax takes the same share from all incomes; a regressive tax takes a larger share of lower incomes.
transfer payment: A payment from the government, such as cash aid to low-income households, for which no good or service is given in return.
income inequality: Income inequality is an unequal spread of yearly income across households; wealth inequality is an unequal spread of assets (savings, homes, businesses). Wealth earns income, so the two are linked.