1. Externalities
A Market Failure occurs when the free market fails to allocate resources efficiently. The most common cause is an Externality: a side effect on a third party.
Allocative Efficiency occurs where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).
(The market only cares about Private Benefit = Private Cost. This gap creates failure.)
Negative Externality (Pollution)
Market overproduces.
Fix: Per-unit Tax.
Positive Externality (Vaccines)
Market underproduces.
Fix: Per-unit Subsidy.
2. Public Goods & Common Resources
Markets work well for private goods (like pizza). They fail for public goods (like national defense) because of the Free Rider Problem.
Types of Goods Matrix
(Can you stop people?)
(Free for everyone)
(Does use reduce supply?)
(Pizza, Clothes)
Most goods are here.
(Fish in Ocean, Pasture)
Problem: Tragedy of the Commons.
(Cable TV, Netflix)
Artificially scarce.
(Defense, Lighthouse)
Problem: Free Riders.
3. Income Inequality & Taxes
The Lorenz Curve
The "Banana" Gap = Inequality
The Lorenz Curve visualizes income distribution. The closer the curve is to the straight "Line of Equality," the more equal the society.
Gini Coefficient: A number between 0 (Perfect Equality) and 1 (Perfect Inequality). It measures the size of the "banana" gap in the graph.
Tax Systems
| Type | Definition | Example |
|---|---|---|
| Progressive | % of tax increases as income increases. | US Income Tax. |
| Proportional (Flat) | % of tax stays the same regardless of income. | Corporate Tax. |
| Regressive | % of tax decreases as income increases. | Sales Tax. |
End of Unit 6 Study Guide. You made it!