Market Failure & Government

What this unit covers

The topics below follow the published Micro course framework for Unit 6. This unit is worth 8–13% of the exam, so budget your time against that rather than against how long the unit takes to teach.

Lessons in this unit

• Externalities14 min · 3 objectivesDistinguish negative from positive externalities and their efficiency effects · Compare the market outcome with the socially optimal outcome · Explain how taxes and subsidies correct externalities
• Public Goods & Market Failure13 min · 3 objectivesDistinguish public goods from private goods using rivalry and excludability · Explain the free-rider problem and why markets underprovide public goods · Identify other sources of market failure, including imperfect information
• Taxes, Tax Incidence & Income Distribution14 min · 3 objectivesAnalyze how a per-unit tax affects price, quantity, and total surplus · Determine tax incidence using the relative elasticities of supply and demand · Interpret the Lorenz curve and Gini coefficient as measures of income inequality
• Marginal Social Benefit, Marginal Social Cost & the Optimum15 min · 3 objectivesDistinguish private from social marginal benefit and cost · Locate the socially optimal quantity and compare it with the market quantity · Identify the deadweight loss caused by an externality
• Correcting Externalities: Taxes, Subsidies & Their Limits14 min · 3 objectivesDetermine the corrective tax or subsidy that achieves the socially optimal quantity · Explain why the correction equals the external effect at the optimum · Compare Pigouvian taxes with tradable permits and with regulation
• Rivalry, Excludability & the Four Kinds of Good13 min · 3 objectivesClassify goods by rivalry and excludability · Explain the free-rider problem and why it prevents private provision · Explain the tragedy of the commons as a rivalry-without-excludability problem
• Measuring Inequality: Lorenz Curves & the Gini Coefficient14 min · 3 objectivesRead a Lorenz curve and relate its shape to the degree of inequality · Explain what the Gini coefficient measures and interpret its value · Distinguish income from wealth inequality and identify what the measures omit

Formulas in Unit 6

Every term in Unit 6

All 46 terms we publish for Market Failure & Government, with definitions. Reading them through is the fastest way to find the ones you cannot define — then drill those in cram mode until you can produce them without the prompt.

Negative externality

A cost imposed on third parties not reflected in the market price — pollution being the standard case. The market overproduces relative to the efficient quantity.

Market failure

A situation where an unregulated market does not allocate resources efficiently. The four cases tested are externalities, public goods, imperfect competition and imperfect information.

Positive externality

A benefit conferred on third parties not captured by the price — vaccination, education. The market underproduces relative to the efficient quantity.

Marginal private cost vs marginal social cost

MSC = MPC + marginal external cost. With a negative externality, MSC lies above MPC, and the efficient quantity is where MSB = MSC.

Marginal private benefit vs marginal social benefit

MSB = MPB + marginal external benefit. With a positive externality, MSB lies above MPB, so the market quantity is below the efficient one.

Deadweight loss from a negative externality

The triangle between MSC and MSB over the units produced beyond the efficient quantity. Those units cost society more than they are worth.

Deadweight loss from a positive externality

The triangle between MSB and MSC over the units not produced. Those units would have been worth more than they cost.

Pigouvian tax

A per-unit tax equal to the marginal external cost. It internalizes the externality by shifting the private cost curve onto the social one, moving output to the efficient quantity.

Pigouvian subsidy

A per-unit subsidy equal to the marginal external benefit, used to raise output of a good with a positive externality to the efficient level.

Coase theorem

If property rights are clear and bargaining costs are low, private parties will negotiate to the efficient outcome regardless of who holds the right. Transaction costs are what usually defeat it.

Tradable pollution permits

A cap on total emissions with permits that can be bought and sold. Achieves a given reduction at least cost, because firms with cheap abatement sell permits to firms with expensive abatement.

Public good

Non-rival and non-excludable: one person's consumption does not reduce another's, and nobody can be kept out. National defense and lighthouses are the examples.

Free-rider problem

People consume a non-excludable good without paying, so private provision falls short of the efficient quantity. The reason public goods are usually publicly funded.

Private good

Rival and excludable. Markets supply these efficiently, which is why the definition matters mainly as a contrast.

Common resource

Rival but non-excludable — fisheries, grazing land. Overused because each user bears only part of the cost, which is the tragedy of the commons.

Club good

Non-rival but excludable — cable television, a toll road below capacity. Private provision works because users can be charged.

Asymmetric information

One party to a transaction knows more than the other. Leads to adverse selection before the deal and moral hazard after it.

Adverse selection

Asymmetric information before a transaction drives good risks out of the market — the used-car and health-insurance cases.

Moral hazard

Asymmetric information after a transaction changes behavior, because one party no longer bears the full consequences. Insurance is the standard example.

Progressive tax

The average tax rate rises with income. The US federal income tax is the example, and it redistributes toward lower incomes.

Regressive tax

The average tax rate falls as income rises, because the tax takes a larger share of a smaller income. Sales taxes and excise taxes are regressive in effect.

Proportional tax

The same average rate at every income — a flat tax. Neither redistributes nor concentrates the burden.

Marginal vs average tax rate

The marginal rate applies to the next dollar earned and drives incentives. The average rate is total tax divided by total income and describes the burden.

Lorenz curve

Cumulative share of income plotted against cumulative share of households. Perfect equality is the 45-degree line; the further the curve bows away, the more unequal the distribution.

Gini coefficient

The area between the Lorenz curve and the line of equality, as a share of the total area beneath that line. Runs from 0 (perfect equality) to 1 (perfect inequality).

MSB and MSC

MSB = MPB + external benefit. MSC = MPC + external cost. With no externality the private and social curves coincide and the market is efficient.

The two quantities

The market produces where MPB = MPC. The optimum is where MSB = MSC. The gap between them IS the market failure.

Negative externality direction

MSC above MPC, so the market OVERPRODUCES. And the socially optimal quantity is almost never zero.

Positive externality direction

MSB above MPB, so the market UNDERPRODUCES. The correction is a subsidy, not a tax.

Size of the corrective tax

The marginal external COST at the socially optimal quantity — not the total damage and not the resulting price change.

Why a corrective tax reduces deadweight loss

The market was already inefficient, so moving it to the optimum removes deadweight loss while also raising revenue. The rare efficiency-improving tax.

Tradable permits

Cap the total and let firms trade, so abatement happens where it is cheapest. Same efficient outcome as a tax, with quantity fixed and price discovered.

Why command-and-control costs more

A uniform mandate ignores differences in abatement cost, so the same total reduction is achieved more expensively than under a tax or permit system.

The Coase point

With clear property rights and cheap bargaining, parties may resolve an externality themselves. Intervention is for high transaction costs and dispersed parties.

Rivalry and excludability

Rival: one person's use reduces what is available. Excludable: non-payers can be kept out. Crossing them gives the four categories of good.

The four kinds of good

Private (rival, excludable) · public (neither) · common resource (rival, non-excludable) · club good (non-rival, excludable).

"Public good" is not "government-provided"

It is a technical classification. Public schooling and public roads are largely rival and excludable — government-provided private or club goods.

The free-rider problem comes from non-excludability

If non-payers cannot be excluded, nobody pays and private provision fails. Non-rivalry alone is compatible with private provision — paywalls prove it.

Tragedy of the commons

Rival plus non-excludable gives overuse, not undersupply. Each user takes the full benefit while the depletion cost falls on everyone.

Remedies for a common resource

Quotas, tradable catch shares, or assigned property rights — all of which supply the missing excludability.

Rivalry can depend on the situation

An empty park is non-rival; the same park at capacity is rival. The classification describes conditions, not permanent properties of a good.

The Lorenz curve

Cumulative income share against cumulative population, poorest first. The 45-degree line is perfect equality; real curves bow below it.

The Gini coefficient

The area between the 45-degree line and the Lorenz curve over the area under the line. 0 is perfect equality, 1 perfect inequality. Not a percentage.

What a Gini hides

Two very different distributions can share a Gini. It establishes overall spread and says nothing about where in the distribution the difference lies.

Income versus wealth

Income is a flow over a period; wealth is a stock at a moment. Wealth is far more unequally distributed, because it accumulates and is inherited.

The equity-efficiency trade-off

Redistribution reduces measured inequality and may reduce incentives to work, save and take risks. The size of that effect is empirically contested, not settled by theory.

What examiners penalize here

• On externality graphs, draw both the private and social curves (MPC vs. MSC, or MPB vs. MSB), mark the market quantity and the optimal quantity where **MSB = MSC**, and shade the **deadweight-loss triangle** between them. State the corrective tax or subsidy as the **vertical distance** equal to the external cost or benefit.
• When a question describes a good, test it on **both** rivalry and excludability before classifying it. The **free-rider problem** stems from **non-excludability**; the **tragedy of the commons** stems from rivalry combined with non-excludability. Naming the right property earns the point.
• On tax graphs, show the tax as a **vertical wedge** between the price buyers pay and sellers receive, then identify each side’s share and the **deadweight-loss triangle**. For inequality, remember: Lorenz curve farther from the 45° line ⇒ **higher Gini ⇒ more inequality**.
• Draw and label all four relevant curves and mark both quantities — market and socially optimal. Rubrics award identifying the two quantities separately from computing the deadweight loss between them.
• State the corrective tax or subsidy as a per-unit amount and say explicitly which curve it moves and by how much. "Impose a $30 tax, shifting MPC up to coincide with MSC" earns more than "tax the pollution".
• Answer rivalry and excludability separately and explicitly before naming the category. Rubrics often award the two properties as separate points, and the classification follows automatically once both are stated.
• When a question gives cumulative shares, sketch the Lorenz curve before comparing. The comparison is visual — which curve is further from the diagonal — and attempting it from the numbers alone invites errors.

Practice Micro

Our practice bank is drawn from across the whole course rather than filtered to one unit, which is closer to how the exam asks anyway — it will not tell you which unit a question is testing.

Questions about this unit

All 6 units of AP Microeconomics

1. Unit 1 · Basic Economic Concepts
2. Unit 2 · Supply & Demand
3. Unit 3 · Production, Cost & Perfect Competition
4. Unit 4 · Imperfect Competition
5. Unit 5 · Factor Markets
6. Unit 6 · Market Failure & Government