Market Failure and the Role of Government: every key term you need (+ practice quiz)
35 flashcard terms for AP Microeconomics Unit 6, written to match the course framework. Study them here, then drill them as interactive flashcards, or test yourself with the 20-question quiz — free, no account needed.
A situation in which a free market fails to produce the allocatively efficient quantity, so total surplus is not maximized.
Externality
A cost or benefit of a transaction that falls on a third party not involved in the exchange.
Negative Externality
An external cost imposed on bystanders, such as pollution from a factory; the market overproduces the good.
Positive Externality
An external benefit enjoyed by bystanders, such as vaccination or education; the market underproduces the good.
Marginal Social Cost (MSC)
Marginal private cost plus marginal external cost; the true cost to society of one more unit.
Marginal Social Benefit (MSB)
Marginal private benefit plus marginal external benefit; the true value to society of one more unit.
Socially Optimal Quantity
The output where marginal social benefit equals marginal social cost (MSB = MSC).
Deadweight Loss from Externalities
With a negative externality, units between the optimal and market quantities cost society more than they are worth; with a positive externality, valuable units go unproduced.
Corrective (Pigouvian) Tax
A per-unit tax equal to the marginal external cost that shifts private cost up to social cost, moving output to the optimum.
Corrective Subsidy
A per-unit payment equal to the marginal external benefit that raises private demand to the social level for goods like vaccines.
Tradable Pollution Permits
Cap-and-trade systems that fix total emissions and let firms trade rights, so abatement happens where it is cheapest.
Coase Theorem
If property rights are clear and bargaining costs are low, private parties can negotiate an efficient solution to an externality without government.
Rival in Consumption
One person's use of a good diminishes another's ability to use it, like a slice of pizza.
Excludable
Sellers can prevent people who do not pay from consuming the good.
Private Good
Rival and excludable — the ordinary goods markets handle well.
Public Good
Nonrival and nonexcludable, such as national defense or a fireworks display; markets underprovide it.
Free-Rider Problem
Because nonpayers cannot be excluded from a public good, people wait for others to pay, so private provision collapses.
Common Resource
Rival but nonexcludable, like ocean fisheries; overuse leads to the tragedy of the commons.
Individually rational overuse of a common resource that depletes it, because no user bears the full cost of their use.
Club (Artificially Scarce) Good
Excludable but nonrival, like streaming services; charging a price excludes users whose enjoyment would cost society nothing.
Government Provision
The public-goods solution: tax-financed supply at the quantity where the sum of individual marginal benefits equals marginal cost.
Antitrust Enforcement
Government correction of the market failure caused by market power, via laws against collusion and anticompetitive mergers.
Lorenz Curve
A graph plotting the cumulative share of income earned by the cumulative share of households; the farther below the 45° line, the more unequal.
Gini Coefficient
A 0-to-1 measure of income inequality derived from the Lorenz curve: 0 is perfect equality, 1 is maximal inequality.
Sources of Income Inequality
Differences in human capital, ability, inheritance and wealth, discrimination, and market power.
Progressive Tax
A tax that takes a larger percentage of income from higher-income earners, such as the U.S. federal income tax.
Regressive Tax
A tax that takes a larger percentage of income from lower-income earners, such as sales taxes.
Proportional (Flat) Tax
A tax taking the same percentage of income from all earners regardless of income.
Transfer Payments
Government payments not made in exchange for goods or services — welfare, unemployment insurance — used to redistribute income.
Equity-Efficiency Trade-off
Redistribution can reduce incentives to work and invest, so societies balance fairness goals against efficiency losses.
Marginal vs. Average Tax Rate
The marginal rate applies to the last dollar earned; the average rate is total tax divided by total income.
Overproduction Result
With external costs, the market quantity (MPB = MPC) exceeds the social optimum (MSB = MSC), creating deadweight loss.
Underproduction Result
With external benefits, the market quantity falls short of the optimum because buyers ignore benefits to others.
Per-Unit vs. Lump-Sum Tax Effects
A per-unit tax shifts MC and changes the profit-maximizing output; a lump-sum tax changes only fixed cost, leaving MR = MC output unchanged in the short run.
Nonexcludability and Markets
When exclusion is impossible, firms cannot charge users, so private markets supply little or none of the good.