Market Failure and the Role of Government

An outcome is socially efficient when output is at the quantity where marginal social benefit equals marginal social cost, which makes total surplus as large as possible. Producing more or less than that creates deadweight loss. Markets can miss the efficient quantity because of market power, externalities, public goods, or asymmetric information (when one side of a deal knows more than the other).

An externality is a cost or benefit that lands on people outside a deal. With a negative externality like pollution, marginal social cost is above marginal private cost, so the market produces too much. With a positive externality like vaccination, marginal social benefit is above marginal private benefit, so it produces too little. On a graph with price on the vertical axis and quantity on the horizontal, the deadweight loss is the triangle between the MSC and MSB curves, from the market quantity to the socially optimal quantity. A per-unit (Pigouvian) tax equal to the external cost per unit, or a per-unit subsidy equal to the external benefit per unit, moves the market to the efficient quantity; regulation and clearer property rights can also help.

Goods are sorted by two questions: is it rival (does one person's use leave less for others?) and is it excludable (can people who don't pay be kept out?). Private goods are both. Public goods like national defense are neither, so free riders can enjoy them without paying and markets under-provide them. Common (open-access) resources like ocean fish are rival but not excludable, so they tend to be overused, which is called the tragedy of the commons.

A per-unit tax or subsidy changes a firm's marginal cost, so it changes how much the firm produces. A lump-sum tax or subsidy changes only fixed cost, so in the short run it changes profit but not output or price. Regulators can cap a monopoly's price at the socially optimal level (where demand meets marginal cost) or the fair-return level (where demand meets average total cost), and a natural monopoly needs a lump-sum subsidy to stay open at the socially optimal price. A minimum wage set in the right range can raise both pay and employment in a monopsony, and antitrust laws block mergers and collusion that reduce competition.

A Lorenz curve plots the cumulative share of households, from poorest to richest, on the horizontal axis against the cumulative share of income they earn on the vertical axis. The farther it sags below the 45-degree line of perfect equality, the more unequal incomes are, and the Gini coefficient sums this up as a number from 0 (perfect equality) to 1 (one household gets everything). On the exam you compare given Lorenz curves or Gini coefficients; you won't draw one or calculate one. Inequality comes from differences in skills and education (human capital), inherited wealth, discrimination and more. A progressive tax takes a larger share of income from people with higher incomes, a regressive tax takes a larger share from people with lower incomes, and a proportional tax takes the same share from everyone. Transfer payments, like unemployment benefits or food assistance, move income to lower-income households and reduce inequality.