Market Failure worksheet

Market Failure: answer key

1. 1. (B) The downstream fisheries bear real costs (damaged catches, contaminated water) from production they had no part in. Textbook negative externality: social cost exceeds private cost and the market overproduces. (A) is wrong because jobs go to the plant's own workers; they're a private outcome, not a spillover benefit to unrelated third parties. (C) confuses the river as a common resource with the concept of a public good, and the real issue here is the pollution cost, not how to classify the river.

2. 2. (C) With positive externalities, the social benefit exceeds what private buyers account for. Consumers only weigh their own gain, so the market underproduces relative to what society needs. The socially optimal quantity is therefore higher than the market equilibrium. (A) describes negative externalities, where overproduction is the problem. (B) would only be true if there were no externality at all.

3. 3. (C) National defense passes both tests: non-rivalrous (defending one citizen doesn't reduce defense for others) and non-excludable (you can't selectively leave certain residents unprotected). (A) fails both because pizza is rivalrous and excludable. (B) is excludable through the subscription paywall. (D) is excludable via the toll. All three are private or club goods.

4. 4. (C) Buyers can't distinguish peaches from lemons, so they offer an average price. Owners of good cars find that average insulting compared to what their car is worth and pull out. The remaining pool skews toward lemons. Buyers adjust downward, more good-car owners leave, and the spiral of adverse selection can collapse the market. (A) reverses the mechanism; the problem is buyers paying too little for good cars, not too much for bad ones. (B) is wrong because the breakdown comes from information asymmetry, not price controls.

5. 5. (B) Non-excludability kills the revenue model. If firms can't keep non-payers from consuming, rational people free-ride and let others foot the bill. Revenue dries up and the good either never gets made or gets produced at a fraction of the level society wants. (A) misidentifies the issue; even a cheap public good suffers from free-riding if exclusion is impossible. The bottleneck is revenue collection, not production cost.

6. 6. (C) The tax equals the marginal external cost per unit, which lifts the firm's private cost to match social cost. The market then naturally adjusts to the socially optimal output. (D) misunderstands the goal; it's not zero pollution but the efficient level, where the marginal social benefit of one more unit equals the marginal social cost. Some pollution is worth tolerating when the goods being produced are valuable enough. (B) frames it as moral punishment, but a Pigouvian tax is a corrective efficiency tool, not an ethical judgment.

7. 7. (B) Natural monopoly comes from cost structure: massive fixed costs and relatively low marginal costs. One firm spreading those fixed costs across the entire market achieves lower average cost than two or more firms splitting that same market ever could. Water utilities and electric grids are the go-to examples. (A) describes a legal barrier from patents, a different mechanism entirely. (D) is a government-granted monopoly. Both create monopoly, but through different channels. The distinction matters because natural monopolies are efficient at production. The problem is purely on the pricing side.

8. 8. (B) Moral hazard is changed behavior after a deal is struck because the other party can't fully observe you. Someone with insurance uses more medical care because the insurer picks up most of the tab. (A) is adverse selection, meaning hidden information before the transaction, not changed behavior after it. That adverse selection vs. moral hazard distinction is one of AP Micro's most commonly tested points in the market failure unit. (D) is the free-rider problem, related to public goods and externalities, not post-contract behavior change.

9. 9. (B) Add the external cost to get MSC: (20 + Q) + 30 = 50 + Q. Set MSC equal to demand: 50 + Q = 120 - Q, so 2Q = 70 and Q = 35. For reference, the unregulated market equilibrium would be 20 + Q = 120 - Q, giving Q = 50. The market overproduces by 15 units because pollution costs never factor into the firm's private calculation. (A) is the unregulated quantity, which is exactly the wrong answer on this type of question. (C) splits the difference incorrectly. (D) exceeds even the unregulated equilibrium.

10. 10. (B) The tax puts a price on the externality and lets each firm decide how to respond based on its own cost structure. Firms that can cut pollution cheaply do so and avoid the tax; firms where cleanup is expensive pay the tax instead. Same pollution reduction, lowest total cost to the economy. A blanket regulation that forces uniform cuts ignores the fact that abatement costs vary wildly across firms. (A) is misleading because both can eliminate the externality-related DWL; the tax's real advantage is cost-effectiveness. (C) is wrong because neither aims for zero pollution. (D) is wrong because setting the right Pigouvian tax requires knowing the marginal external cost.

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