ECON1001 · Introductory Microeconomics
Market Failure & International Trade
Weeks 11-13 cover where unregulated markets fail and how trade reshapes welfare. Externalities drive a wedge between private and social benefit or cost (MSB = MPB + MEB, MSC = MPC + MEC): negative externalities cause over-production, positive ones under-production, with deadweight loss in between — correctable by the Coase theorem, Pigovian taxes/subsidies or tradeable permits. The excludable × rival grid classifies private, club, common and public goods (summed vertically), which suffer the free-rider problem. Finally, international trade at the world price raises total surplus, while tariffs and quotas create two deadweight-loss triangles.
What this chapter covers
- 01Externalities: positive vs negative; MSB = MPB + MEB and MSC = MPC + MEC
- 02Over- vs under-production and the externality deadweight loss
- 03Coase theorem and its failure conditions
- 04Pigovian taxes and subsidies; quantity regulation; tradeable permits
- 05Excludable × rival taxonomy: private, club, common, public goods
- 06Public goods, the free-rider problem and vertical summation of MB
- 07Common resources and the Tragedy of the Commons
- 08International trade: autarky vs world price, exporter/importer, tariffs and quotas
Positive externality and the Pigovian subsidy
- 3 marks · market quantityMarket equates private benefit and cost: PMB = MC → 60 − Q = 2Q → 3Q = 60 → Q_market = 20.
- 3 marks · efficient quantitySocial marginal benefit MSB = PMB + MEB = (60 − Q) + 12 = 72 − Q. Efficient quantity sets MSB = MSC: 72 − Q = 2Q → 3Q = 72 → Q* = 24.
- 2 marks · deadweight lossThe market under-produces (20 < 24). DWL = ½ × (Q* − Q_market) × MEB = ½ × 4 × 12 = 24.
- 2 marks · subsidy size and effectA Pigovian subsidy equal to the externality, 12 per unit, paid to consumers or producers, shifts the market to the efficient Q* = 24 and removes the deadweight loss.
Key terms
- Externality
- A cost or benefit imposed on a third party outside a transaction; negative externalities (e.g. pollution) cause over-production, positive ones (e.g. education) cause under-production.
- Coase theorem
- The result that with well-defined property rights and negligible transaction costs, private bargaining reaches the efficient outcome regardless of who holds the rights; rights allocation then affects only distribution.
- Pigovian tax/subsidy
- A per-unit tax (negative externality) or subsidy (positive externality) set equal to the marginal external effect, which internalises the externality and eliminates its deadweight loss.
- Public good
- A good that is non-excludable and non-rival, prone to the free-rider problem and private under-provision; its efficient quantity is found by summing individual marginal benefits vertically.
- Tragedy of the Commons
- The over-exploitation of a common resource (non-excludable but rival), remedied by enforceable property rights or quotas.
- Tariff
- A tax on imports that raises the domestic price to the world price plus the tariff, increasing producer surplus and government revenue but creating two deadweight-loss triangles from over-production and under-consumption.
Market Failure & International Trade FAQ
How do I tell whether a market over- or under-produces under an externality?
Compare social and private curves. A negative externality makes social cost exceed private cost, so the market produces too much; a positive externality makes social benefit exceed private benefit, so it produces too little. The efficient point is always where MSB = MSC.
Why do public goods get under-provided?
Because they are non-excludable, each person can enjoy them without paying, so everyone has an incentive to free-ride and contribute nothing. Private markets then under-provide, which is why public goods are often funded through taxation. Their efficient quantity uses vertical summation of marginal benefits because the good is non-rival.
Do tariffs and quotas have the same effect?
They produce equivalent price, quantity and deadweight-loss outcomes, with the same two triangles from over-production and under-consumption. The difference is who captures the price-gap rent: a tariff gives it to the government as revenue, while a quota gives it to whoever holds the import licence, unless the licences are auctioned.
Exam move
These three weeks reuse one engine — compare the private outcome to the social optimum and measure the gap as deadweight loss — so group them mentally rather than memorising separately. For externalities, always write MSB and MSC explicitly and let the corrective tax or subsidy equal the external effect. For public goods, drill the vertical-summation contrast against horizontal summation, and for trade, practise the importer/exporter setup at the world price then add the tariff to get the two DWL triangles and the revenue rectangle. This is the densest exam-weighted block, so prioritise repeated timed problems here.
