Class Notes - 10/7/25
ECON 301: Intermediate Microeconomics
Topic: Market Failures & Externalities
Started class with Prof Ramirez asking why markets don't always lead to
efficient outcomes, which seems like it goes against everything from the first
half of semester. Apparently the "invisible hand" has some pretty significant
limitations.
What Even Is Market Failure?
Market failure = when free markets fail to allocate resources efficiently.
Meaning we don't reach Pareto optimality (the state where you can't make
someone better off without making someone else worse off).
This doesn't mean markets are "bad" or whatever, just that sometimes they
need intervention to reach socially optimal outcomes. The key is figuring out
WHEN intervention helps vs makes things worse.
Types of Market Failures
We're focusing on externalities today but Prof listed the main categories:
• Externalities (positive & negative)
• Public goods
• Common resources / tragedy of the commons
• Information asymmetries
• Market power (monopolies, oligopolies)
• Income inequality (though there's debate if this counts as "failure")
Externalities - The Main Event
Definition: When a transaction affects third parties who aren't directly
involved in the transaction. The effect isn't reflected in market prices, so
people making decisions don't account for these costs/benefits.
Negative Externalities - impose costs on others
Classic example = pollution. Factory produces widgets, emits pollution. The
factory considers its private costs (labor, materials, equipment) but NOT the
cost imposed on society (health problems, environmental damage, reduced
property values nearby). Since they don't bear these costs, they overproduce
relative to what's socially optimal.
Other examples:
• Traffic congestion (your decision to drive affects everyone else's commute
time)
• Secondhand smoke
• Noise pollution from airports/concerts/construction
• Antibiotic overuse (contributes to resistance which affects everyone)
The market equilibrium has MORE production than the social optimum
because marginal social cost > marginal private cost.
Positive Externalities - create benefits for others
Education is the go-to example. When you get educated, you benefit (higher
income, better opportunities) BUT society also benefits (more informed
voters, less crime, innovation spillovers, higher tax revenue). Since you only
consider your private benefits, there's UNDER-consumption of education
relative to social optimum.
Other examples:
• Vaccination (you protect others through herd immunity)
• R&D and innovation (other firms can build on discoveries)
• Home renovations (increases neighbor property values)
• Beekeeping near farms (pollination services)
Here marginal social benefit > marginal private benefit, leading to under-
provision.
The Graph Stuff (trying to get this straight)
For negative externalities:
• Supply curve = marginal private cost (MPC)
• Need to add: marginal external cost (MEC)
• Marginal social cost (MSC) = MPC + MEC
• MSC curve sits above the supply curve
• Market equilibrium: where D intersects S (private optimum)
• Social optimum: where D intersects MSC
• Result: Q market > Q social optimal
• Creates deadweight loss (the triangle between the curves)