SACE Economics — Stage 2
Market Failure — Flashcards & Quiz
Market failure occurs when the free market fails to allocate resources efficiently. For SACE Economics Stage 2 you need to explain the main causes — externalities, public goods, information asymmetry, and market power — and evaluate the government responses used to correct them. Strong responses use diagrams (externality wedge, MSB/MSC curves) and link Australian examples like carbon pricing, public health campaigns and ACCC regulation.
Key Points
- Negative externality: social cost exceeds private cost (e.g. pollution). Optimal output is where MSB = MSC, not MPB = MPC.
- Positive externality: social benefit exceeds private benefit (e.g. vaccination, education). Markets under-supply.
- Public goods are non-rival and non-excludable (defence, street lighting). Free-rider problem means private markets under-supply them.
- Information asymmetry: one party knows more (used cars, insurance). Leads to adverse selection and moral hazard.
- Government responses: taxes/subsidies, regulation, direct provision, information campaigns, tradeable permits.
- Diagram: externality wedge between MSB and MSC identifies deadweight loss and optimal intervention.
Common Mistakes to Avoid
- Confusing public goods with merit goods — merit goods are under-consumed due to imperfect info, not non-rivalry.
- Calling any monopoly a "market failure" without linking it to allocative inefficiency.
- Forgetting government failure — intervention can itself be inefficient (regulatory capture, red tape).
- Treating externalities as always negative — positive externalities also justify intervention (subsidies).
- Drawing externality diagrams without labelling the social optimum and deadweight loss.
Exam Strategy
SACE market failure questions usually ask you to identify a failure, recommend a policy and evaluate it. Method: (1) define market failure and classify it (externality, public good, asymmetry, market power), (2) draw the externality or MSB/MSC diagram, (3) propose a specific policy with a real example, (4) evaluate effectiveness, efficiency, equity and unintended consequences, (5) conclude with a reasoned judgement on whether the cure is worth the cost.
Revision Tip
Market failure vocabulary plus the externality diagram are high-yield recall — drill a Revizi deck on each failure type and sketch the diagrams from memory for exam-speed recall.
Last updated: March 2026