Market Failure Types

Why This Matters

Market failures represent the core justification for government intervention in the economy—and that's exactly what Unit 6 of AP Microeconomics tests you on. When markets fail to achieve allocative efficiency (where $MSB = MSC$), society loses potential welfare, creating deadweight loss. You're being tested on your ability to identify why markets fail, how each failure type distorts outcomes, and what policy tools can restore efficiency.

The key insight connecting all market failures is this: prices only coordinate behavior efficiently when they reflect all costs and benefits. When private incentives diverge from social incentives—whether through externalities, information gaps, or market power—the invisible hand breaks down. Don't just memorize the eight failure types; know which mechanism each one illustrates and how to diagram the welfare loss on a graph.

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Failures from Diverging Private and Social Costs

When the costs or benefits that individuals face differ from what society experiences, markets produce the wrong quantity. These failures occur because decision-makers don't account for effects on third parties.

Externalities (Positive and Negative)

• Third-party effects not reflected in market prices—negative externalities (like pollution) impose costs on others, while positive externalities (like education) create benefits others can't capture
• Market produces wrong quantity: too much output with negative externalities ($MPC < MSC$), too little with positive externalities ($MPB < MSB$)
• Pigouvian taxes and subsidies internalize external costs/benefits by shifting private curves to align with social curves, restoring efficiency at $MSB = MSC$

Common Pool Resources

• Rivalrous but non-excludable goods—one person's use diminishes availability for others, but no one can be prevented from accessing the resource
• Tragedy of the commons occurs when individual incentives to exploit conflict with collective interest in preservation, leading to overuse and depletion
• Solutions include property rights, quotas, and community management—these align private incentives with sustainable use levels

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Failures from Information Problems

Markets assume buyers and sellers have the information needed to make efficient decisions. When one party knows more than the other, transactions break down or produce inefficient outcomes.

Asymmetric Information

• One party has superior knowledge—this information imbalance prevents markets from reaching efficient equilibria because prices can't accurately reflect quality or risk
• Creates two distinct problems: adverse selection (pre-transaction) and moral hazard (post-transaction), both of which can cause markets to unravel
• Policy responses include disclosure requirements, warranties, and licensing—these mechanisms help equalize information between parties

Adverse Selection

• Hidden information before a transaction—the party with less information cannot distinguish high-quality from low-quality options, so they offer terms that attract the worst risks
• "Lemons problem" in markets: in used cars or insurance, good risks exit while bad risks remain, potentially collapsing the market entirely
• Screening and signaling reduce adverse selection—insurers use risk assessment, employers use credentials, and sellers offer warranties to reveal hidden quality

Moral Hazard

• Hidden actions after a transaction—when one party is insulated from consequences (through insurance or guarantees), they may take excessive risks
• Changes behavior, not information: unlike adverse selection, the problem isn't what you know but what you do once protected from downside risk
• Deductibles, co-pays, and monitoring realign incentives by ensuring parties bear some consequences of their actions

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Failures from Market Power

When firms can influence prices rather than taking them as given, they restrict output to maximize profit—creating deadweight loss even without externalities or information problems.

Monopoly Power

• Single firm dominates, setting $P > MC$—unlike perfect competition where $P = MC$, monopolists restrict quantity to the point where $MR = MC$, then charge a higher price
• Deadweight loss triangle appears between the monopoly quantity ($Q_m$) and competitive quantity ($Q_c$), representing lost consumer and producer surplus
• Barriers to entry sustain market power—patents, exclusive resources, high fixed costs, and government franchises prevent competition from eroding monopoly profits

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Failures from Non-Excludability

Some goods cannot efficiently be provided by markets because non-payers cannot be excluded from benefits. This breaks the price mechanism entirely.

Public Goods

• Non-excludable and non-rivalrous—once provided, no one can be prevented from consuming (national defense, street lighting), and one person's use doesn't diminish another's
• Free-rider problem causes underprovision: since individuals can benefit without paying, private markets have no incentive to supply the socially optimal quantity
• Government provision or funding required—because $MSB$ far exceeds what any individual would pay, public goods must typically be financed through taxation

Incomplete Markets

• Some beneficial transactions simply don't occur—high transaction costs, inability to exclude, or coordination failures prevent markets from forming
• Gaps in insurance and credit markets leave high-risk individuals or uncertain ventures without coverage, even when provision would be socially beneficial
• Government can create or complete markets—through subsidies, guarantees, or direct provision where private markets fail to emerge

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Quick Reference Table

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Self-Check Questions

1. Both negative externalities and common pool resources involve costs imposed on others. What distinguishes the mechanism of market failure in each case, and how would the policy response differ?

2. A health insurance company finds that after offering comprehensive coverage, policyholders visit the doctor more frequently for minor issues. Which market failure does this illustrate—adverse selection or moral hazard? Explain your reasoning.

3. Compare public goods and common pool resources: both are non-excludable, yet one leads to underprovision and the other to overuse. What characteristic explains this difference?

4. An FRQ shows a monopolist's demand, MR, MC, and ATC curves and asks you to identify the deadweight loss. What two quantities must you compare, and where on the graph would you shade the DWL triangle?

5. Rank the following in terms of how directly a Pigouvian tax could address the market failure: (a) moral hazard in banking, (b) pollution from a factory, (c) the free-rider problem for national defense. Explain why some failures respond better to this tool than others.