ECON10004 · Introductory Microeconomics
Market Efficiency and Failures
This chapter is ECON10004's market-failure toolkit: it covers every way the competitive equilibrium — which maximises total surplus — can be pushed off the efficient point, and the policies that respond. Two families sit here together. Government controls and taxes (price ceilings, price floors, per-unit taxes, subsidies, incidence) drive a wedge into an otherwise efficient market, almost always destroying surplus as deadweight loss. Externalities and public goods are the deeper failures — spillovers onto third parties, free-riding and asymmetric information — where the market quantity is wrong from the start and a Pigouvian tax or subsidy, Coasian bargaining or public provision restores efficiency. The exam returns again and again to one calculation chain: solve equilibrium, find the efficient quantity, shade the deadweight-loss triangle, and set the corrective policy equal to the marginal external cost or benefit. It builds directly on consumer and producer surplus (Ch 4) and on supply, demand and elasticity.
What this chapter covers
- 01Two kinds of intervention: price controls vs taxes & subsidies
- 02Price ceilings and floors (binding vs non-binding; short side of the market)
- 03Per-unit taxes: the wedge, revenue and deadweight loss
- 04Tax incidence: statutory vs economic, split by relative elasticity
- 05The signature chain: equilibrium → elasticity → surplus → tax → DWL
- 06Minimum wage as a labour-market price floor; subsidies as reverse taxes
- 07Negative & positive externalities; the Pigouvian tax/subsidy fix
- 08Coase theorem, public goods & the free-rider problem, asymmetric information
Steel — negative externality and the deadweight-loss triangle
- +2Unregulated market sets PMB = PMC: 110 − Q = 10 + Q ⇒ 2Q = 100 ⇒ Qm = 50, price P = 60. The private market ignores the spillover and over-produces.
- +2Efficient quantity sets MB = SMC: 110 − Q = 50 + Q ⇒ 2Q = 60 ⇒ Q* = 30, P* = 80.
- +3Deadweight loss. Between Q* = 30 and Qm = 50, SMC exceeds MB. The triangle has base ΔQ = 50 − 30 = 20 and height = the external-cost gap = 40, so DWL = ½ × 20 × 40 = 400.
- +1Optimal Pigouvian tax = the marginal external cost = SMC − PMC = $40 per unit; it lifts PMC up to SMC, moving the market to Q* = 30 and erasing the DWL.
Key terms
- Deadweight loss (DWL)
- The total surplus destroyed when a market trades away from the efficient quantity. Geometrically the triangle of lost mutually-beneficial trades; for a per-unit tax DWL = ½ × t × ΔQ, where ΔQ is the fall in quantity, not the price level.
- Tax incidence
- How the economic burden of a tax is actually split between buyers and sellers, regardless of who legally (statutorily) pays it. The less-elastic — steeper — side cannot escape and so bears the larger share of the tax.
- Externality
- A cost or benefit of a transaction falling on a third party who is neither buyer nor seller — a spillover the decision-maker ignores. Negative externalities (pollution) push SMC above PMC and cause over-production; positive externalities (education) push SMB above PMB and cause under-production.
- Pigouvian tax / subsidy
- A corrective policy set equal to the marginal external cost (tax, for a negative externality) or marginal external benefit (subsidy, for a positive one). It shifts the private curve onto the social curve, making the decision-maker internalise the spillover and moving output to the efficient Q*.
- Public good
- A good that is both non-rival (one person's use does not diminish another's) and non-excludable (non-payers cannot be stopped from using it), such as national defence. Non-excludability breeds free-riding, so the market under-provides and government typically funds it through taxation.
Market Efficiency and Failures FAQ
Does a price ceiling always cause a shortage?
No — only a binding control changes anything. A ceiling bites only when it is set below equilibrium (creating a shortage); a ceiling set above P* is non-binding and the market just settles at P* as before. Symmetrically, a floor only binds when set above equilibrium (creating a surplus). Always check which side of P* the control sits on before drawing a shortage or surplus — examiners love a non-binding trap option where the correct answer is “no effect.”
If the tax is legally “on sellers,” don't sellers bear it?
No. The statutory payer — whoever writes the cheque — tells you nothing about who really pays. The economic burden is split by relative elasticity: the less-elastic (steeper) side absorbs more of the tax because it can least escape the price move. A sugar-tax or tobacco-tax MCQ usually hinges on exactly this — the answer is decided by which side is less elastic, not by who hands money to the tax office.
How do I compute the deadweight loss — do I multiply by the price?
Use the lost quantity, not the price level. For a tax, DWL = ½ × t × ΔQ, where ΔQ = Q* − Q_t: the base of the triangle is the lost quantity and the height is the tax (or, for an externality, the marginal external cost). Multiplying by the price instead of the wedge is a classic dropped mark.
Which quantity comes from which curves in an externality problem?
The market quantity always comes from the private curves: PMB = PMC. The efficient quantity uses the social curve on whichever side the externality lands — MB = SMC for a production (cost-side) externality, or SMB = PMC for a consumption (benefit-side) one. Also match the policy to the sign: a negative externality needs a tax (cut output), a positive one a subsidy (raise output) — taxing a positive externality makes the under-provision worse.
Exam move
Marks here are won by drilling the universal policy chain and lost on three traps. The chain: (1) solve P*, Q* from Qd = Qs; (2) get the efficient quantity from the social curve (MB = SMC or SMB = PMC); (3) shade and size the deadweight-loss triangle — DWL = ½ × wedge × ΔQ, using the change in quantity and the external cost/tax as the height, never the price level; (4) set the corrective policy equal to the marginal external cost (tax) or benefit (subsidy). The three trap-losses: drawing a shortage or surplus for a non-binding control; confusing statutory with economic incidence (it is the less-elastic side that bears more); and mixing up which curve gives the market vs the efficient quantity, or the wrong policy sign. Graph-drawing — correctly labelling PMC/SMC and shading the DWL — is almost always required, so practise the diagram, not just the algebra.
