Unit 6: Market Failure and the Role of Government

a. Define social efficiency. b. Explain (using graphs where appropriate) why resource allocation in perfectly competitive markets is socially efficient.

• The optimal quantity of a good occurs where the marginal benefit of consuming the last unit equals the marginal cost of producing that last unit, thus maximizing total economic surplus.
• The market equilibrium quantity is equal to the socially optimal quantity only when all social benefits and costs are internalized by individuals in the market. Total economic surplus is maximized at that quantity. [See also PRD-3 and POL-3.]
• Enduring understanding POL-2: Perfectly competitive markets allocate resources efficiently, but imperfect competition often results in market inefficiencies.

Explain (using graphs where appropriate) how private incentives can lead to actions by rational agents that are socially undesirable (inefficient) market outcomes.

• Rational agents can pursue private actions to exploit or exercise market characteristics known as market power.
• Rational agents make optimal decisions by equating private marginal benefits and private marginal costs that can result in market inefficiencies.
• Policymakers use cost-benefit analysis to evaluate different actions to reduce or eliminate market inefficiencies.
• Market inefficiencies can be eliminated by designing policies that equate marginal social benefit with marginal social cost.
• Enduring understanding POL-2: Perfectly competitive markets allocate resources efficiently, but imperfect competition often results in market inefficiencies.

a. Explain equilibrium allocations in imperfect markets relative to efficient allocations (using graphs where appropriate) and why these markets are inefficient. b. Calculate (using graphs where appropriate) the deadweight loss resulting from the production of a non-efficient quantity.

• Equilibrium allocations can deviate from efficient allocations due to situations such as monopoly; oligopoly; monopolistic competition; negative and positive externalities in production or consumption; asymmetric information; and insufficient production of public goods.
• Producing any non-efficient quantity results in deadweight loss.
• Enduring understanding POL-2: Perfectly competitive markets allocate resources efficiently, but imperfect competition often results in market inefficiencies.

a. Define externalities. b. Explain (using graphs where appropriate) how in the presence of externalities, private markets do not take into consideration social costs or social benefits.

• The socially optimal quantity of a good occurs where the marginal social benefit of consuming the last unit equals the marginal social cost of producing that last unit, thus maximizing total economic surplus.
• Externalities are either positive or negative and arise from lack of well-defined property rights and/or high transaction costs.
• In the presence of externalities, rational agents respond to private costs and benefits and not to external costs and benefits.
• Rational agents have the incentive to free ride when a good is non-excludable.
• Enduring understanding POL-3: Private incentives can fail to account for all socially relevant considerations.

Explain (using graphs where appropriate) how public policies address positive or negative externalities.

• Policies that address positive or negative externalities include taxes/subsidies, environmental regulation, public provision, the assignment of property rights, and the reassignment of property rights through private transactions.
• Enduring understanding POL-3: Private incentives can fail to account for all socially relevant considerations.

a. Define whether goods are rival and/or excludable. b. Explain how the nature of rival and/or excludable goods influences the behavior of individuals and groups.

• Private goods are rival and excludable, and public goods are non-rival and non-excludable.
• Due to the free rider problem, private individuals usually lack the incentive to produce public goods, leaving government as the only producer.
• Governments sometimes choose to produce private goods, such as educational services, and to allow free access to them.
• Some natural resources are, by their nature, non-excludable and rival and therefore open access. Private individuals inefficiently overconsume such resources.
• Enduring understanding POL-3: Private incentives can fail to account for all socially relevant considerations.

a. Define government policy interventions in imperfect markets. b. Explain (using graphs where appropriate) how government policies can alter market outcomes in perfectly and imperfectly competitive markets. c. Calculate (using data from a graph or table as appropriate) changes in market outcomes resulting from government policies in perfectly competitive and imperfectly competitive markets.

• Per-unit taxes and subsidies affect the total price consumers pay, net price firms receive, equilibrium quantity, consumer and producer surpluses, deadweight loss, and government revenue or cost. The impact of change depends on the price elasticity of demand and supply.
• Lump-sum taxes and lump-sum subsidies do not change either marginal cost or marginal benefit; only fixed costs will be affected.
• Binding price ceilings and floors affect prices and quantities differently depending on the market structures (perfect competition, monopoly, monopolistic competition, and monopsony) and the price elasticities of supply and demand.
• Government intervention in imperfect markets can increase efficiency if the policy correctly addresses the incentives that led to the market failure.
• Government can use price regulation to address inefficiency due to monopoly.
• A natural monopoly will require a lump-sum subsidy to produce at the allocatively efficient quantity.
• Governments use antitrust policy in an attempt to make markets more competitive. Exclusion: A graph of inefficiency and policy due to collusion is beyond the scope of the course and the AP Exam.
• Enduring understanding POL-4: In imperfect markets, well-designed government policy can reduce waste.

Define measures of economic inequality in income and wealth.

• Income levels and poverty rates vary greatly both across and within groups (e.g., age, gender, race) and countries.
• The Lorenz curve and Gini coefficient are used to represent the degree of inequality in distributions and to compare distributions across different countries, policies, or time periods. Exclusion: Drawing the Lorenz curve and calculating Gini coefficients are beyond the scope of the course and the AP Exam.
• Enduring understanding POL-5: Market outcomes can result in income inequality.

Explain sources of income and wealth inequality.

• Each factor of production receives the value of its marginal product, which can contribute to income inequality.
• Sources of income and wealth inequality include differences in tax structures (progressive and regressive tax structures), human capital, social capital, inheritance, effects of discrimination, access to financial markets, mobility, and bargaining power within economic and social units (firms, labor unions, and families).
• Enduring understanding POL-5: Market outcomes can result in income inequality.