Unit 6:

Market Failure and the

Role of Government

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 Topic 6.1-
Socially Efficient and
Inefficient Market
Outcomes
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MB/MC Benefits and Costs
10 MC
9
8
7
6
5
4
3
2
1
MB
Quantity of
1 2 3 4 5 6 7 8 9 10 Pizza
MB/MC Benefits and Costs
10 MC
9
8
7
6 Not
5 Enough
4 (MB>MC)
3
2
1
MB
Quantity of
1 2 3 4 5 6 7 8 9 10 Pizza
MB/MC Benefits and Costs
10 MC
9
8
7
6 Too
5 Much
4 (MC>MB)
3
2
1
MB
Quantity of
1 2 3 4 5 6 7 8 9 10 Pizza
Price Demand and Supply
10 Supply
9
8
7
6 Supply and
demand results in
5 efficient outcomes
4 with no
3 deadweight loss
2
1
Demand
Quantity of
1 2 3 4 5 6 7 8 9 10 Pizza
 The “Invisible Hand” of Free Markets
If society wants computers and people are
willing to pay high prices then…
•Businesses have the INCENTIVE to start
making computers to earn PROFIT.
•This leads to more competition with lower
prices, better quality, and more product variety.
•To maintain profits, firms find most efficient way
to produce goods and services.
•The free market satisfies society’s wants and
needs.
The government doesn’t need to get involved
since the needs of society are automatically met.
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 Does the free market
ever FAIL to meet
society’s needs?

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 What is a market failure?
•Market Failure- A situation in which the
free-market system fails to satisfy society’s
wants.
(When the invisible hand doesn’t work.)
•Private markets do not efficiently bring
about the allocation of resources.
What’s the result…
The government might be called
upon to attempt to satisfy society’s
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wants. 9
 The Four Market Failures
We will focus on four different market
failures:
1. Public goods
2. Externalities (third person side effects)
3. Imperfect competition (monopolies)
4. Unequal distribution of income
In each of the above situations,
the government may step in to attempt to
allocate resources efficiently
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 Supply and demand is great for
determining how many pizzas to produce,
but what about goods that are not sold in
markets like aircraft carriers and parks?
We still use supply and demand
The demand is the Marginal Social Benefit
of the good and its usefulness to society.
The supply is the Marginal Social Cost of
providing each additional quantity.
Socially optimal quantity
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MSB = MSC
 Demand for a New Park
Marginal willingness to pay higher taxes
# of Parks Adam is Jill is Assume: Marginal
Society’s
willing to willing to Demand
1. Cost
There are only
pay pay for Parks
two people in
1 $4 $5 $9
society. $5
2. Each additional
2 $3 $4 $7 $5
park costs $5
3 $2 $3 $5 $5
4 $1 $2 How
$3 many parks
$5
should be made?
5 $0 $1 $1 $5
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 Demand for a New Park
Marginal willingness to pay higher taxes
# of Parks Adam is Jill is Society’s Marginal
willing to willing to Demand Cost per
pay pay (MSB) Park
1 $4 $5 $9 $5
2 $3 $4 $7 $5
3 $2 $3 $5 $5
4 $1 $2 $3 $5
5 $0 $1 $1 $5
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 Demand for a New Park
Marginal willingness to pay higher taxes
# of Parks Adam is Jill is Society’s Marginal
willing to willing to Demand Social
pay pay (MSB) Cost
1 $4 $5 $9 $5
2 $3 $4 $7 $5
3 $2 $3 $5 $5
4 $1 $2 $3 $5
5 $0 $1 $1 $5
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 Supply and Demand for Public Parks
Price
$9 The Demand is
equal to the
7 marginal benefit
to society
5

1 D=MSB

0 1 2 3 4 5
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Quantity of Parks
 Supply and Demand for Public Parks
Price
$9
What is the socially
optimal quantity of
7 parks?
MSB = MSC
5 S=MSC

The supply is the

3
public good’s
marginal cost to
1 society D=MSB

0 1 2 3 4 5
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Quantity of Parks
 Supply and Demand for Public Parks
Price
$9
Why is it inefficient
7 if only 1 park is
produced?
5 S=MSC

3
MSB > MSC
1 Society wants more D=MSB

0 1 2 3 4 5
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Quantity of Parks
 Supply and Demand for Public Parks
Price
$9
Why is it inefficient
7 if 4 parks are
produced?
5 S=MSC

3
MSB < MSC
1 Society wants less
D=MSB

0 1 2 3 4 5
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Quantity of Parks