Grade 9-12

AP Microeconomics – When Markets Fail

Updated: January 12 2017,
Author: Gary Stone

This lesson supports the Market Failure and the Role of Government section of the Advanced Placement Microeconomics curriculum. Students need to understand the conditions under which a competitive market fails to produce the socially-optimal quantity of a good or service.They also need to know what steps a government can take to correct a negative externality.

This lesson appears as Lesson 2 in Unit 5: The Role of Government in CEE's Advanced Placement Microeconomics (4th Edition).


The material discussed in this lesson appears frequently on the AP Microeconomics Exam.
Students need to understand the conditions under which a competitive market fails to produce the socially optimal quantity of a good or service. They also need to know what steps can be taken to remedy this situation. Some government intervention in the economy is designed to
remedy problems arising from third-party costs and benefits of private activities or transactions.
Students who understand third-party effects, often called externalities, can analyze the need
for and effect of such government interventions. Activity 5-2 provides an overview of the externality problem. When a government tries to correct a negative externality, it can choose to intervene in a number of ways, or the problem may be corrected by private negotiations, which is the basis for the Coase Theorem presented in Activity 5-3. When government does intervene, its objective should be to use marginal analysis so as to have the marginal social benefit of the last unit produced equal to that unit’s marginal social cost. Activity 5-4 provides
practice in doing this type of analysis as students must decide on the optimal amount of pollution cleanup.
Bell Ringer: You hear a neighbor say, "Pollution is nasty and stinks. We should do all we can to eliminate all pollution!" Do you agree with your neighbor?

Learning Objectives

  • Explain how private market activities can cause externalities.
  • Define and give examples of third-party costs (also called negative externalities or social spillover costs).
  • Define and give examples of third-party benefits (also called positive externalities or social spillover benefits).
  • Analyze why positive and negative externalities cause underproduction or overproduction of goods and services in a competitive market.
  • Analyze the effectiveness of government policies designed to remedy problems caused by positive or negative externalities.
  • Explain the Coase Theorem and use it to analyze how negotiations among private property owners can resolve market allocation problems.
  • Analyse how marginal analysis can determine the optimum amount of pollution cleanup.

Resource List


Please refer to the When Markets Fail, Teacher Lesson.


Conduct a general discussion about why markets fail and how government attempts to correct these failures.

Extension Activity

There is no extension activity for this lesson.


Please refer to the When Markets Fail, Student Resource Manual.