Unit 2: Microeconomics Part II - Market Failure

Understanding When Markets Fail to Achieve Allocative Efficiency

Introduction: What is Market Failure?

Market failure occurs when the free market mechanism fails to allocate resources efficiently, resulting in a loss of economic welfare. In other words, the market equilibrium does not maximize social welfare.

Key concept: At market equilibrium, marginal social benefit (MSB) does not equal marginal social cost (MSC).

Allocative Efficiency Condition

Allocatively efficient outcome:

\[ MSB = MSC \]

Market failure occurs when:

\[ MSB \neq MSC \]

Where:

• MSB = Marginal Social Benefit (benefit to society)
• MSC = Marginal Social Cost (cost to society)

Types of Market Failure

Externalities: Third-party effects not reflected in market prices (positive and negative)
Common Pool Resources: Overuse of shared resources
Public Goods: Markets underprovide or don't provide at all
Asymmetric Information: Unequal information between buyers and sellers
Market Power: Monopolies and oligopolies (covered in other units)
Equity Issues: Unfair distribution of resources

1. Negative Externalities

Definition

Negative externality (external cost) occurs when the production or consumption of a good imposes costs on third parties who are not involved in the transaction.

Result: Market overproduces/overconsumes the good because private costs are less than social costs.

A. Negative Externalities of Production

Definition: Production activities impose costs on third parties.

Examples:

Air pollution: Factory emissions harm nearby residents' health
Water pollution: Chemical runoff contaminates rivers
Noise pollution: Airport noise affects surrounding neighborhoods
Deforestation: Logging destroys ecosystem services
Climate change: Carbon emissions affect global environment

Key Relationships - Negative Production Externality

Social cost exceeds private cost:

\[ MSC = MPC + MEC \]

Where:

• MSC = Marginal Social Cost
• MPC = Marginal Private Cost (what producers pay)
• MEC = Marginal External Cost (cost to third parties)

Market equilibrium condition:

\[ MPB = MPC \]

Socially optimal condition:

\[ MSB = MSC \]

Since MSB = MPB (no consumption externality):

\[ MPB = MSC = MPC + MEC \]

📊 NEGATIVE PRODUCTION EXTERNALITY

Vertical Axis: Price/Cost
Horizontal Axis: Quantity
MPB = MSB (demand curve)
MPC (supply curve - private)
MSC (supply curve shifted up by MEC)
Market equilibrium: MPB = MPC at Qmarket (overproduction)
Social optimum: MSB = MSC at Qoptimal (lower quantity)
Welfare loss triangle between MSC and MPB from Qoptimal to Qmarket

Market Failure Analysis

Free market produces: \(Q_{\text{market}}\) where MPB = MPC

Society wants: \(Q_{\text{optimal}}\) where MSB = MSC

Result: \(Q_{\text{market}} > Q_{\text{optimal}}\) → Overproduction

Welfare loss: For units between \(Q_{\text{optimal}}\) and \(Q_{\text{market}}\), MSC > MSB

Society pays more in total costs than it receives in benefits → Deadweight loss

Example 1: Steel Factory Pollution

Scenario: Steel factory pollutes river, harming fishing industry downstream

Private costs (MPC):

Labor, raw materials, energy
Factory pays these directly

External costs (MEC):

Health problems for local residents
Loss of fish population
Reduced tourism
Ecosystem damage

Social cost (MSC) = MPC + MEC:

Factory only considers MPC when deciding output
Produces too much steel from society's perspective
River pollution is "free" to the factory but costly to society

Market failure: Steel overproduced, resources overallocated to steel production

B. Negative Externalities of Consumption

Definition: Consumption activities impose costs on third parties.

Examples:

Secondhand smoke: Smokers harm non-smokers' health
Loud music: Disturbs neighbors
Alcohol consumption: Drunk driving, violence, healthcare burden
Junk food: Obesity increases healthcare costs for society
Antibiotic overuse: Creates resistant bacteria affecting everyone

Key Relationships - Negative Consumption Externality

Social benefit is less than private benefit:

\[ MSB = MPB - MEC \]

Where:

• MSB = Marginal Social Benefit
• MPB = Marginal Private Benefit (what consumers value)
• MEC = Marginal External Cost (negative impact on others)

Market equilibrium:

\[ MPB = MPC \]

Social optimum:

\[ MSB = MSC \]

Since MSC = MPC (no production externality):

\[ MSB = MPB - MEC = MPC \]

📊 NEGATIVE CONSUMPTION EXTERNALITY

MPB (demand curve - private benefit)
MSB (demand curve shifted down by MEC)
MPC = MSC (supply curve)
Market equilibrium: MPB = MPC at Qmarket (overconsumption)
Social optimum: MSB = MSC at Qoptimal (lower quantity)
Welfare loss triangle between MPC and MSB from Qoptimal to Qmarket

Example 2: Cigarette Consumption

Private benefits (MPB):

Pleasure, stress relief, social bonding (as perceived by smoker)

External costs (MEC):

Secondhand smoke harms non-smokers
Healthcare costs borne by taxpayers
Lost productivity from illness
Fire hazards
Litter and environmental damage

Social benefit (MSB) = MPB - MEC:

To society, benefit is less than private benefit
Smokers don't account for harm to others

Market failure: Cigarettes overconsumed, too many resources allocated to tobacco production

Solutions to Negative Externalities

1. Indirect Taxes (Pigouvian Tax)

How it works: Government imposes tax equal to MEC

Shifts MPC upward to equal MSC (production externality)
Or shifts MPB downward to equal MSB (consumption externality)
Internalizes the externality—forces producers/consumers to pay for external costs

Advantages:

Market-based solution, preserves choice
Generates government revenue
Reduces quantity to socially optimal level
Polluter pays principle

Disadvantages:

Difficult to measure MEC accurately
May be regressive (hurts poor disproportionately)
Politically unpopular
Firms may relocate to avoid tax

2. Regulation and Legislation

Examples:

Emission standards for factories
Bans on smoking in public places
Speed limits and traffic laws
Waste disposal regulations

Advantages:

Direct control, certain outcomes
Can completely ban harmful activities
Protects vulnerable populations

Disadvantages:

Inflexible, one-size-fits-all
High enforcement costs
Doesn't incentivize innovation
Black markets may emerge

3. Tradable Permits (Cap-and-Trade)

How it works: Government sets total pollution limit (cap), issues permits, firms can trade permits

Firms that reduce pollution cheaply can sell permits
Firms with high reduction costs buy permits
Market finds cost-efficient solution

Example: EU Emissions Trading System (ETS) for CO₂

Advantages:

Certainty about total emissions
Cost-efficient pollution reduction
Incentivizes green technology

Disadvantages:

Complex to administer
Permit price volatility
Initial allocation can be unfair
Monitoring and enforcement needed

4. Advertising and Education

How it works: Government campaigns to change behavior

Anti-smoking campaigns
Road safety advertisements
Nutritional information

Advantages:

Non-coercive, preserves freedom
Long-term behavior change
Low cost

Disadvantages:

Slow to work
Uncertain effectiveness
People may ignore messages

2. Positive Externalities

Definition

Positive externality (external benefit) occurs when the production or consumption of a good creates benefits for third parties who are not involved in the transaction.

Result: Market underproduces/underconsumes the good because private benefits are less than social benefits.

A. Positive Externalities of Production

Definition: Production activities create benefits for third parties.

Examples:

Research and development: Innovations benefit whole industry
Training programs: Skilled workers benefit other employers
Beekeeping: Bees pollinate neighboring farms
Infrastructure: Private roads/bridges benefit community

Key Relationships - Positive Production Externality

Social cost is less than private cost:

\[ MSC = MPC - MEB \]

Or equivalently:

\[ MSC < MPC \]

Where MEB = Marginal External Benefit from production

Market equilibrium: \(Q_{\text{market}}\) where MPB = MPC

Social optimum: \(Q_{\text{optimal}}\) where MSB = MSC

Result: \(Q_{\text{market}} < Q_{\text{optimal}}\) → Underproduction

B. Positive Externalities of Consumption

Definition: Consumption creates benefits for third parties. These goods are called merit goods.

Merit goods: Goods that are underprovided by the free market because individuals undervalue the benefits (positive externalities).

Examples:

Education: Educated workforce benefits society (productivity, innovation, social cohesion)
Healthcare: Vaccinations prevent disease spread (herd immunity)
Public transportation: Reduced congestion and pollution for everyone
Museums and culture: Preserved heritage benefits future generations
Exercise facilities: Healthier population reduces healthcare costs

Key Relationships - Positive Consumption Externality

Social benefit exceeds private benefit:

\[ MSB = MPB + MEB \]

Where:

• MSB = Marginal Social Benefit
• MPB = Marginal Private Benefit
• MEB = Marginal External Benefit (spillover benefits)

Market equilibrium:

\[ MPB = MPC \]

Social optimum:

\[ MSB = MSC \]

Since MSC = MPC:

\[ MSB = MPB + MEB = MPC \]

📊 POSITIVE CONSUMPTION EXTERNALITY

MPB (demand curve - private)
MSB (demand curve shifted up by MEB)
MPC = MSC (supply curve)
Market equilibrium: MPB = MPC at Qmarket (underconsumption)
Social optimum: MSB = MSC at Qoptimal (higher quantity)
Welfare loss triangle between MSB and MPC from Qmarket to Qoptimal

Example 3: Vaccination

Private benefits (MPB):

Individual protected from disease
Avoid illness costs (medicine, lost work)

External benefits (MEB):

Herd immunity: Protects unvaccinated people (babies, immunocompromised)
Reduces disease spread in community
Lower healthcare system burden
Higher workforce productivity
Prevents epidemics

Social benefit (MSB) = MPB + MEB:

Society gains more than individual
Free market → people undervaccinate
They don't consider benefits to others

Market failure: Too few vaccinations from society's perspective

Example 4: Education

Private benefits (MPB):

Higher income potential
Better job opportunities
Personal development

External benefits (MEB):

More productive workforce (economic growth)
Innovation and technological progress
Lower crime rates
More informed voters (better democracy)
Social cohesion and tolerance
Lower unemployment

Market failure: Education underprovided if left to free market

Reality: Most countries heavily subsidize or provide free education

Solutions to Positive Externalities

1. Subsidies

How it works: Government payment to reduce production/consumption costs

Shifts supply curve down (production subsidy)
Or effectively shifts demand up (consumption subsidy)
Increases quantity to socially optimal level

Examples:

Education subsidies (free public schools)
Healthcare subsidies (vaccinations)
Public transport subsidies
R&D tax credits

Advantages:

Increases consumption of merit goods
Improves equity (makes essential goods affordable)
Market-based, preserves choice

Disadvantages:

Opportunity cost (government spending)
Difficult to calculate optimal subsidy
May cause overproduction if too large

2. Direct Government Provision

How it works: Government produces and provides goods for free or at low cost

Public schools and universities
Public hospitals
Public libraries
Public parks

Advantages:

Ensures universal access
Quantity directly controlled
Promotes equity

Disadvantages:

High government expenditure
Potential inefficiency (no profit motive)
Crowding out private provision
Political interference

3. Legislation

How it works: Make consumption compulsory

Mandatory education up to certain age
Compulsory vaccinations
Mandatory insurance (car, health)

Advantages:

Ensures everyone consumes
Maximum external benefits realized

Disadvantages:

Reduces freedom of choice
Enforcement costs
May face public resistance

3. Common Pool Resources

Definition

Common pool resources (CPRs) are natural or human-made resources where:

Non-excludable: Difficult or costly to prevent people from using
Rivalrous: One person's use reduces availability for others

Examples: Fish stocks, forests, groundwater, grazing lands, atmosphere (for waste disposal)

The Tragedy of the Commons

Concept (Garrett Hardin, 1968)

The tragedy of the commons occurs when individuals, acting in their own self-interest, overuse a shared resource, leading to its depletion or degradation.

Key insight: Each individual benefits fully from exploiting the resource but shares the costs of depletion with everyone.

Result: Rational individual behavior leads to collectively irrational outcome (resource collapse)

Example 5: Overfishing

Scenario: Ocean fish stocks are common pool resources

Individual fisher's reasoning:

"If I don't catch these fish, someone else will"
"My impact on total fish population is negligible"
"I need to maximize my catch to survive"

Collective result:

All fishers overfish
Fish population depletes
Breeding stock falls below sustainable level
Fish stocks collapse (cod fisheries in Atlantic, bluefin tuna)
All fishers worse off in the long run

Market failure: Negative externality—each fisher imposes cost on others by depleting shared resource

Example 6: Amazon Rainforest Deforestation

Individual actors: Loggers, farmers, ranchers

Individual incentive:

Clear land for agriculture (private benefit)
Harvest valuable timber
Each person gets full benefit of their exploitation

Social costs (shared by everyone):

Loss of biodiversity
Climate change (CO₂ release)
Loss of oxygen production
Indigenous communities displaced
Ecosystem services destroyed

Result: Rapid deforestation, irreversible environmental damage

Why CPRs Lead to Market Failure

No property rights: Nobody owns the resource, so nobody has incentive to conserve
Free rider problem: If one person conserves, others benefit from their restraint while continuing to overexploit
Short-term thinking: Immediate gains outweigh long-term sustainability
Lack of coordination: No mechanism to limit total use
Negative externalities: Each user's exploitation harms all other users

Solutions to Common Pool Resource Problems

1. Government Regulation and Quotas

How it works: Set maximum usage limits for each user

Fishing quotas (catch limits per boat)
Logging permits
Water extraction limits
Emission caps

Advantages:

Direct control over total usage
Prevents overexploitation

Disadvantages:

Difficult to enforce (esp. internationally)
Costly monitoring
Inefficient allocation (doesn't go to highest-value users)

2. Property Rights (Privatization)

How it works: Assign ownership of resource to individuals or groups

Owner has incentive to conserve for long-term value
Can exclude overusers

Examples:

Privatized fisheries (Iceland's individual transferable quotas)
Private forests
Water rights

Advantages:

Creates incentive for sustainable use
No free rider problem
Efficient allocation through market

Disadvantages:

Ethically controversial (who gets ownership?)
Excludes poor users
Difficult for mobile resources (fish migrate)
Doesn't work for global commons (atmosphere, oceans)

3. Community Management (Ostrom's Solution)

How it works: Local communities self-govern resource use through social norms and agreements

Examples:

Swiss alpine meadows (communal grazing rules)
Japanese village forests
Lobster fishing communities (Maine, USA)

Conditions for success (Elinor Ostrom, Nobel Prize):

Clear boundaries (who can use)
Rules adapted to local conditions
Participatory decision-making
Monitoring by community members
Graduated sanctions for violators
Conflict resolution mechanisms
Recognition by higher authorities

Advantages:

Local knowledge incorporated
Low enforcement costs (peer pressure)
Equitable access

Disadvantages:

Works best for small-scale resources
Requires social cohesion
Vulnerable to outsiders

4. Taxes and Tradable Permits

How it works: Price the use of common resource

Carbon taxes
Water extraction fees
Tradable fishing quotas

Advantages:

Market-efficient
Generates revenue
Flexible

Disadvantages:

Difficult to set correct price
May favor wealthy users

4. Public Goods

Characteristics of Public Goods

Public goods have two key characteristics:

1. Non-excludable:

Once provided, cannot prevent others from using
Impossible or prohibitively expensive to exclude non-payers

2. Non-rivalrous:

One person's consumption doesn't reduce availability for others
Marginal cost of additional user is zero
\(MC = 0\) for additional consumers

Classification of Goods

	Rivalrous	Non-Rivalrous
Excludable	Private Goods (Food, clothing, cars)	Club Goods (Cable TV, private parks, toll roads)
Non-Excludable	Common Pool Resources (Fish stocks, forests, clean air)	Public Goods (National defense, streetlights, knowledge)

Examples of Public Goods

National defense: Military protects all citizens; one person's protection doesn't reduce others'
Street lighting: Everyone benefits; can't exclude non-payers; doesn't "run out"
Lighthouse: Guides all ships; can't charge individual vessels
Clean air: Everyone breathes it; one person's breathing doesn't reduce air available
Basic research: Scientific knowledge benefits everyone; sharing doesn't diminish it
Public broadcasting: Radio signals available to all
Flood control systems: Protects entire region
Fireworks displays: Everyone can watch; viewing doesn't reduce show

The Free Rider Problem

Why Markets Fail for Public Goods

Free rider problem: People can benefit from public goods without paying, so they have no incentive to contribute voluntarily.

Rational individual behavior:

"I can enjoy the benefits whether I pay or not"
"Let others pay for it"
"My contribution won't make a difference"

Result:

Everyone free rides
Nobody contributes
Public good is not provided
Market failure—socially beneficial goods underprovided or not provided at all

Example 7: Lighthouse Free Rider Problem

Lighthouse benefits all ships passing by

Private provision problem:

Ship owner A: "If I build lighthouse, all ships benefit (non-excludable)"
Ship owner B: "I'll wait for someone else to build it, then use it for free"
Ship owner C: Has same reasoning
Result: Nobody builds lighthouse, even though all would benefit

Market failure: Socially beneficial lighthouse not provided

Solution: Government builds and funds through taxes (everyone contributes)

Example 8: National Defense

Private provision impossible:

Military protection is non-excludable (can't protect some citizens and not others)
Non-rivalrous (protecting one person doesn't reduce protection for others)

Free rider problem:

Citizens: "If my neighbor pays for defense, I'm protected anyway"
Nobody volunteers to pay
Nation left undefended

Solution: Government provides through compulsory taxation

Solutions to Public Goods Underprovision

1. Government Provision Funded by Taxation

How it works: Government produces public goods, funds through compulsory taxes

Solves free rider problem (everyone must contribute)
Ensures provision at socially optimal level

Examples:

National defense
Police and fire services
Street lighting
Public parks

Advantages:

Universal access
Addresses market failure directly
Equitable (funded by all taxpayers)

Disadvantages:

Difficult to determine optimal quantity
Government inefficiency possible
Opportunity cost (resources from other uses)

2. Contracting Out

How it works: Government funds but private firms produce

Combines public funding with private efficiency
Competitive bidding for contracts

Examples:

Private security firms (in some countries)
Waste collection
Road construction

3. Subsidizing Private Provision

How it works: Government subsidizes private producers of quasi-public goods

R&D subsidies for innovation
Public broadcasting subsidies

5. Asymmetric Information

Definition

Asymmetric information occurs when one party in a transaction has more or better information than the other, creating an imbalance that can lead to market failure.

Result: Inefficient outcomes, markets may break down entirely

A. Adverse Selection

Adverse selection occurs when asymmetric information exists before the transaction, leading to the selection of "bad" products or customers.

Classic example: "Market for Lemons" (George Akerlof, Nobel Prize)

Example 9: Used Car Market (Lemons Problem)

Information asymmetry:

Sellers know car quality (whether it's a "lemon" or "peach")
Buyers cannot distinguish quality before purchase

Market breakdown:

Step 1: Buyers know some cars are lemons, so they offer average price
Step 2: Owners of good cars ("peaches") refuse to sell at average price (below their car's value)
Step 3: Only lemon owners willing to sell at average price
Step 4: Buyers realize only lemons on market, lower price further
Step 5: Market dominated by lemons; good cars exit market

Result: Market for good used cars disappears (market failure)

Example 10: Health Insurance Adverse Selection

Information asymmetry:

Individuals know their health status better than insurance companies

Problem:

Unhealthy people more likely to buy insurance (high-risk pool)
Healthy people less likely to buy (don't think they need it)
Insurance companies raise premiums to cover high-risk pool
Higher premiums drive away more healthy people
"Death spiral"—only very sick people remain, premiums skyrocket

Result: Insurance market inefficient or collapses

B. Moral Hazard

Moral hazard occurs when asymmetric information exists after the transaction, leading one party to take more risks because they don't bear the full consequences.

Key insight: Insurance or protection changes behavior in ways that increase risk

Example 11: Car Insurance Moral Hazard

Before insurance: Driver is very careful (bears full cost of accident)

After insurance:

Driver takes more risks (drives faster, less careful parking)
Reasoning: "If I crash, insurance pays"
Insurance company cannot perfectly monitor driving behavior

Result:

More accidents occur
Insurance costs rise for everyone
Inefficient outcome

Example 12: Banking Moral Hazard ("Too Big to Fail")

Problem: Large banks take excessive risks

Reasoning:

If risky investments succeed → bank profits
If risky investments fail → government bailout (too systemically important to fail)
Heads they win, tails taxpayers lose

Result: 2008 Financial Crisis

Banks made risky mortgage loans
Assumed government would rescue them
Taxpayer-funded bailouts (moral hazard realized)

Solutions to Asymmetric Information Problems

1. Government Regulation and Standards

Mandatory disclosure laws:

Food labeling (ingredients, nutrition, allergens)
Financial disclosures (company accounts)
Product safety standards
Truth in advertising laws

Licensing and certification:

Medical licenses (ensures minimum doctor quality)
Lawyer bar exams
Building inspections

2. Signaling

How it works: Informed party takes action to credibly reveal information

Education as signal: Degree signals ability/intelligence to employers
Warranties: Manufacturers of good products offer warranties (bad products won't)
Brand reputation: Established brands signal quality

3. Screening

How it works: Uninformed party designs mechanisms to reveal information

Insurance deductibles: High-risk people choose low deductibles, revealing themselves
Job interviews and tests: Employers screen candidates
Credit checks: Banks screen loan applicants

4. Co-payments and Deductibles (Moral Hazard)

How it works: Make insured party bear some cost

Health insurance co-pays discourage unnecessary doctor visits
Car insurance deductibles encourage careful driving
Reduces moral hazard by maintaining some personal cost

5. Monitoring and Enforcement

How it works: Reduce information asymmetry through oversight

Bank regulators monitor risk-taking
Insurance companies use telematics (black boxes in cars)
Audits of financial statements

6. Equity (Fairness)

Definition

Equity refers to fairness in the distribution of resources and opportunities. While markets can be efficient, they may produce outcomes that society considers unfair.

Key distinction:

Efficiency: Maximizing total welfare (size of economic pie)
Equity: Fair distribution of welfare (how pie is divided)

Trade-off: Policies promoting equity may reduce efficiency, and vice versa

Types of Equity

1. Horizontal Equity

"Equals should be treated equally"

People in similar circumstances should be treated similarly
Example: Two people with same income should pay same tax

2. Vertical Equity

"Unequals should be treated unequally"

People in different circumstances should be treated differently
Example: High-income earners should pay higher tax rates (progressive taxation)

Why Markets May Not Achieve Equity

Unequal starting points: Inherited wealth, family background, education access
Unequal abilities: Talent, intelligence, physical capabilities vary
Discrimination: Race, gender, age biases in labor markets
Market power: Monopolies extract consumer surplus
Geographic disparities: Rural vs. urban opportunities
Luck: Random factors (health, economic cycles) affect outcomes

Example 13: Healthcare Access Inequality

Market outcome:

Healthcare allocated based on willingness and ability to pay
Rich receive excellent care
Poor may receive inadequate or no care

Efficiency: Market is efficient (resources go to highest bidders)

Equity problem: Society may consider it unfair that poor cannot access life-saving treatment

Policy response: Universal healthcare, subsidies, free clinics

Trade-off: Taxes reduce efficiency but improve equity

Government Policies to Improve Equity

1. Progressive Taxation

How it works: Higher-income earners pay higher percentage in taxes

Redistributes from rich to poor
Funds social programs

Trade-off: May reduce work incentives (efficiency loss)

2. Transfer Payments

Examples:

Unemployment benefits
Food stamps (SNAP)
Housing subsidies
Child benefits
Disability payments

Trade-off: May create dependency, reduce work incentives

3. Provision of Merit Goods

Free or subsidized:

Education
Healthcare
Housing

Ensures access regardless of income

4. Price Controls

Examples:

Rent control (protect tenants)
Minimum wage (protect workers)
Maximum drug prices

Trade-off: Create shortages/surpluses (efficiency loss)

5. Anti-Discrimination Laws

Examples:

Equal employment opportunity laws
Equal pay for equal work
Fair housing laws

Efficiency-Equity Trade-off

The Fundamental Trade-off

Arthur Okun's "Leaky Bucket":

Transferring income from rich to poor is like carrying water in leaky bucket
Some "water" (resources) lost in transfer (administrative costs, reduced incentives)
Question: How much leakage is acceptable for equity gains?

Why redistribution reduces efficiency:

Disincentive to work: High taxes reduce incentive for high earners
Disincentive to work: Generous benefits reduce incentive for low earners
Administrative costs: Running welfare programs
Deadweight loss: Taxes create inefficiency

Society's choice: How much efficiency to sacrifice for equity depends on values

Summary: Types of Market Failure

Market Failure	Problem	Main Solutions
Negative Externalities	Overproduction/overconsumption (MSC > MPC or MSB < MPB)	Taxes, regulations, tradable permits
Positive Externalities	Underproduction/underconsumption (MSB > MPB or MSC < MPC)	Subsidies, direct provision, legislation
Common Pool Resources	Overexploitation (tragedy of commons)	Quotas, property rights, community management
Public Goods	Underprovision or no provision (free rider problem)	Government provision funded by taxes
Asymmetric Information	Adverse selection, moral hazard, market breakdown	Regulation, signaling, screening, monitoring
Equity	Unfair distribution of resources	Progressive taxation, transfers, merit good provision

IB Economics Exam Tips

Diagram Essentials

Externality diagrams: Always show both MPC/MPB and MSC/MSB curves
Label clearly: Market equilibrium vs. social optimum quantities
Shade welfare loss: Triangle showing deadweight loss
Direction matters: Negative externality → MSC above MPC; Positive externality → MSB above MPB

Evaluation Points

Solution effectiveness: Depends on elasticities, enforcement, information
Unintended consequences: Black markets, behavioral responses
Trade-offs: Efficiency vs. equity, costs vs. benefits
Real-world complexity: Multiple market failures often coexist
Government failure: Government intervention may worsen situation

Common Mistakes to Avoid

Wrong curve shifts: Negative externalities shift cost/benefit DOWN for society, not up
Confusing CPR and public goods: CPRs are rivalrous, public goods are not
Oversimplifying solutions: No single solution works perfectly
Ignoring magnitude: Small externalities may not justify intervention costs
Forgetting trade-offs: All policies have costs and benefits

✓ Market Failure Checkpoint

You should now understand the six major types of market failure; why each causes allocative inefficiency (MSB ≠ MSC); how to diagram negative and positive externalities showing welfare loss; the tragedy of the commons and its solutions; why public goods are underprovided and the free rider problem; how asymmetric information leads to adverse selection and moral hazard; and the equity-efficiency trade-off in policy decisions. These concepts form the foundation for understanding why government intervention in markets may be justified, which is central to IB Economics SL microeconomic analysis.