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.
Sample Flashcards
Q1: Summarise the economic rationale for government intervention in markets.
Government intervention is justified when markets fail to achieve allocatively efficient outcomes. Types of market failure: (1) externalities — social costs/benefits differ from private costs/benefits, (2) public goods — non-rival, non-excludable, free-rider problem, (3) merit/demerit goods — information failure leads to over/underconsumption, (4) market power — monopoly/oligopoly leads to P > MC, (5) information asymmetry — adverse selection and moral hazard, (6) income inequality — market distribution may be inequitable. However, government intervention can also fail (government failure).
Sample Quiz Questions
Q1: Information asymmetry is a type of market failure that can justify government intervention.
Answer: TRUE
Information asymmetry (one party has more information than the other) leads to adverse selection and moral hazard, causing markets to function inefficiently. Government can intervene through disclosure requirements, consumer protection laws, and regulation.
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.
Related Concepts
Last updated: March 2026 · 1 flashcards · 1 quiz questions