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)
For positive externalities:

• Demand curve = marginal private benefit (MPB)

• Need to add: marginal external benefit (MEB)
• Marginal social benefit (MSB) = MPB + MEB
• MSB curve sits above demand curve
• Market equilibrium: where S intersects D
• Social optimum: where S intersects MSB
• Result: Q market < Q social optimal
• Also creates deadweight loss
The size of the deadweight loss depends on how elastic supply/demand are
and the magnitude of the externality.

Coase Theorem (this part got kinda philosophical)

Ronald Coase argued that if property rights are well-defined and transaction
costs are low, private parties can negotiate to solve externality problems
without government intervention.

Example: Factory polluting a river that fishermen use. If property rights are
clear (either factory has right to pollute OR fishermen have right to clean
water), they can negotiate a solution. Maybe fishermen pay factory to reduce
pollution, or factory compensates fishermen for damage. Either way, they
reach the efficient outcome through bargaining.

Key assumptions:

• Property rights are clearly defined

• Transaction costs are low (easy/cheap to negotiate)
• Small number of parties involved
• Perfect information
In reality these conditions often DON'T hold, especially for large-scale
externalities like climate change (millions of parties, huge transaction costs,
property rights unclear). So Coase Theorem is more theoretical than practical
for most cases.

Still interesting though - shows that sometimes less regulation is better if you
can get the property rights structure correct.

Policy Solutions for Externalities

For Negative Externalities:

Pigouvian Taxes - tax equal to the marginal external cost. Internalizes the
externality by making producers pay for the damage they cause. Shifts
supply curve up to match MSC. Carbon tax is the big current example.

Advantages: creates continuous incentive to reduce pollution, raises revenue

Disadvantages: hard to measure the right tax level, politically unpopular

Cap and Trade - set total allowable pollution, issue permits, let them be
traded. Achieves quantity control but lets market find lowest-cost way to
reduce pollution.
 Advantages: guarantees pollution limit, cost-effective Disadvantages: need
to set the right cap, can be volatile, potential for market manipulation

Regulation/Standards - just mandate maximum pollution levels or required

technologies. Command-and-control approach.

Advantages: simple, clear Disadvantages: doesn't account for different costs

across firms, no incentive to do better than standard, can stifle innovation

Liability Rules - make polluters liable for damages. They'll reduce pollution to
avoid lawsuits.

Advantages: no need to measure externality precisely Disadvantages: legal

costs, hard to prove causation sometimes

For Positive Externalities:

Subsidies - payment equal to marginal external benefit. Like the opposite of

a Pigouvian tax.

Education subsidies, R&D tax credits, vaccination programs all work this way.

Government Provision - just provide the good directly. Public schools, basic
research funding, public parks.

Vouchers - give people purchasing power for specific goods. School vouchers
let them choose while still ensuring consumption.

Which Solution Is Best?

Depends on:

• How well you can measure the externality

• Administrative costs
• Political feasibility
• Distributional concerns (who bears the costs?)
• Whether you want quantity control or price control
• Dynamic incentives (encouraging innovation)
Prof's take: economists generally prefer price mechanisms (taxes/subsidies)
over quantity controls because they're more efficient. But politically, people
hate taxes so regulations often win out even if they're less efficient.

Cap and trade is kind of a compromise - quantity control but market-based.

Real World Examples We Discussed

 Sulfur Dioxide Trading Program - cap and trade for acid rain in US
(1990s). Considered super successful, reduced SO2 emissions by like 50% at
way lower cost than predicted. This is the model everyone points to for why
cap and trade works.

Carbon Taxes - Several countries have them (Sweden, Canada, etc). Mixed
results. Work better when revenue is returned to citizens or used to reduce
other taxes. Political backlash is real though (yellow vest protests in France).

Cigarette Taxes - classic Pigouvian tax for negative health externalities.

Seems to work - higher taxes correlate with lower smoking rates, especially
among young people. But also regressive (hits poor people harder).

Vaccination Requirements - addressing positive externality through

mandates rather than pure subsidies. Gets you to higher vaccination rates
but obviously controversial re: personal freedom.

Critiques and Complications

Someone asked about whether governments actually implement these

policies correctly or if they get captured by special interests. Prof
acknowledged this is a real problem - the "government failure" vs "market
failure" debate. Sometimes the cure is worse than the disease if regulations
are poorly designed or captured.

Also the problem of measuring externalities accurately. Like how do you put
a dollar value on environmental damage or health effects? Different studies
give wildly different estimates. This makes setting the "right" Pigouvian tax
really difficult in practice.

And then there's the equity dimension - a lot of these policies are regressive.
Carbon taxes hurt poor people more as a % of income. Even if they're
efficient, are they fair? Tricky question.

Things I'm Still Unclear On

• How exactly do you calculate the optimal carbon tax? Like what's the actual
methodology?
• Why don't more countries use cap and trade if the SO2 program worked so
well?
• Can you have externalities that go in both directions at once? (Example:
driving creates pollution (negative) but also provides ambulance services
(positive)?)
• The relationship between externalities and property rights - need to think
through more examples
For the Exam
 Definitely need to be able to:

• Draw and label the externality graphs (both types)

• Identify deadweight loss
• Compare policy solutions
• Apply Coase Theorem and know its limitations
• Real world examples for each type of solution
Problem set due Friday covers this so that should help solidify everything.

Also need to start thinking about paper topic - maybe something on

environmental policy? Or the economics of public health interventions?