ECO 304K, Introduction to Microeconomics | University of Texas at Austin Source: Practice Mock Exam 2026 Difficulty: Introductory to Intermediate | Prerequisites: Supply and demand, surplus and efficiency concepts
This material covers what happens when markets fail to deliver an efficient outcome on their own. Externalities, public goods, and market power (including price discrimination) are the main reasons a free market might not maximise total surplus. You need surplus and efficiency concepts before this section will click.
These topics often appear in the heavier exam questions (short answer and long answer), so investing time here pays off.
Negative externalities cause overproduction; positive externalities cause underproduction. Pigovian taxes and subsidies can correct these. The Coase theorem says private bargaining can fix externalities if transaction costs are low. Public goods are non-rival and non-excludable, leading to free-riding. Price discrimination charges different prices to different consumers and, in the extreme (perfect price discrimination), eliminates both consumer surplus and deadweight loss.
Externality
A cost or benefit of a transaction that falls on someone other than the buyer or seller. In simple terms, it is a side effect on bystanders.
Negative production externality
A cost imposed on third parties by the production process (e.g. pollution from a factory). Causes the market to overproduce relative to the social optimum.
Positive externality
A benefit received by third parties from a transaction (e.g. vaccinations, education). Causes the market to underproduce relative to the social optimum.
Marginal Social Cost (MSC)
The private marginal cost plus the external cost per unit. MSC = MC + external cost.
Pigovian tax
A tax on activities that generate negative externalities, set equal to the external cost per unit. It internalises the externality, forcing producers to account for the social cost.
Pigovian subsidy
A subsidy given to encourage activities with positive externalities, bridging the gap between private benefit and social benefit.
Coase theorem
If property rights are well-defined and transaction costs are low, private bargaining between affected parties will lead to an efficient outcome regardless of who holds the rights.
Public good
A good that is non-rival (one person's consumption does not reduce availability for others) and non-excludable (you cannot prevent anyone from using it). Examples: national defence, street lighting.
Common resource
A good that is rival (one person's use diminishes what is available for others) but non-excludable (difficult to prevent access). Examples: fisheries, clean air.
Tragedy of the Commons
The tendency for common resources to be overused and depleted because no single user bears the full cost of their consumption.
Free-rider problem
When people can enjoy the benefits of a good without paying for it, leading to underprovision by private markets. The core reason public goods are typically provided by governments.
Price discrimination
Charging different prices to different consumers for the same good, based on their willingness to pay. Only possible if the seller can prevent resale.
First-degree (perfect) price discrimination
Charging each consumer exactly their maximum willingness to pay. Captures all consumer surplus for the producer. Eliminates deadweight loss.
Second-degree price discrimination
Charging different prices based on the quantity consumed (e.g. bulk discounts, "buy one get one half off").
Third-degree price discrimination
Charging different prices to different identifiable groups (e.g. senior discounts, student tickets). Based on different price elasticities across groups.
Firms ignore external costs, so they produce where private MC = demand (MSB), which is a higher quantity than the social optimum.
MSC = MC + external cost. The socially optimal quantity is where MSC = MSB.
The market overproduces by the gap between market Q and social Q. The deadweight loss is the triangle between MSC and MSB over that range.
Exam calculation example: MC = 20 + 0.5Q, MSB = 100 - 0.5Q, external cost = $10/unit.
Market equilibrium (ignoring externality): MC = MSB, so 20 + 0.5Q = 100 - 0.5Q, giving Q = 80, P = 60.
MSC = 30 + 0.5Q.
Social optimum: MSC = MSB, so 30 + 0.5Q = 100 - 0.5Q, giving Q = 70, P = 65.
DWL = 0.5 x (80 - 70) x (70 - 60) = 0.5 x 10 x 10 = $50.
With positive externalities, the marginal social benefit exceeds the marginal private benefit, so the market underproduces.
Government correction: a Pigovian subsidy to producers (shifts supply right) or to consumers (shifts demand right), bringing the market quantity up to the social optimum.
Public provision is another option: the government provides the good directly (e.g. public education).
If transaction costs are low and property rights are clearly defined, private parties can negotiate an efficient solution to an externality without government intervention.
The key condition is low transaction costs, not high. This is a common true/false trap.
Public goods are non-rival and non-excludable. The free-rider problem means private markets underprovide them.
Common resources are rival and non-excludable. The tragedy of the commons means they are overused because no one bears the full cost of their consumption.
The four-way classification of goods:
Rival + excludable = private good (a sandwich).
Rival + non-excludable = common resource (fish in the ocean).
Non-rival + excludable = club good (cable TV).
Non-rival + non-excludable = public good (national defence).
Price discrimination requires market power (the seller is not a price-taker) and the ability to prevent resale.
First-degree (perfect): charge each buyer their exact WTP. All consumer surplus goes to the producer. Deadweight loss is eliminated because the efficient quantity is produced.
Second-degree: different prices for different quantities (bulk discounts).
Third-degree: different prices for different groups (senior discounts, student prices). The group with more elastic demand gets the lower price.
Example from the exam: Regal Cinemas charging lower prices for seniors than adults is third-degree price discrimination.
A car dealer negotiating a unique price with every customer is closer to first-degree.
Charles's opportunity cost is $30/hour. He tutors everyone whose WTP is at or above $30: Students A through F (6 students).
He charges each student their reservation price: $50 + $46 + $42 + $38 + $34 + $30 = $240 total revenue.
Total cost = 6 x $30 = $180. Economic profit = $240 - $180 = $60.
Consumer surplus = zero (each student pays exactly their WTP).
Deadweight loss = zero (every student who values the service above cost is served).
Compared to a single-price monopoly: under a single price, Charles charges $42 and tutors 3 students (profit = $36). Some students (D, E, F) who value the service above $30 are excluded, creating deadweight loss. Under perfect price discrimination, those students are served.
The Coase theorem requires low transaction costs, not high. The exam statement "private negotiations can resolve externalities efficiently only if transaction costs are high" is false.
Diminishing marginal utility does not mean total utility decreases (this comes up again here in the context of utilitarianism and redistribution).
Students confuse common resources (rival, non-excludable) with public goods (non-rival, non-excludable). The rivalry distinction is the key: can one person's use reduce what is available for others?
Price discrimination requires preventing resale. If buyers can resell, the low-price group will arbitrage away the price difference.
⚠️ The externality calculation (find market Q, find MSC, find social Q, calculate DWL) is a 7-mark long-answer question. Practise the arithmetic.
⚠️ The Coase theorem true/false question ("only if transaction costs are high") appears on nearly every practice exam. The answer is always false.
⚠️ Know the four-way goods classification cold. The exam will ask which type of good the Tragedy of the Commons applies to (non-excludable and rival, i.e. common resources).
⚠️ Third-degree price discrimination = different prices for identifiable groups. Senior discounts are the textbook example.
⚠️ Perfect price discrimination: CS = 0, DWL = 0, the producer captures everything. The outcome is efficient but entirely in the producer's favour.
⚠️ Price discrimination requires the ability to prevent resale. This is a common true/false (answer: true).
True or false: the Coase theorem requires transaction costs to be high. (False)
Public goods are characterised by being _____ and _____. (Non-rival and non-excludable)
What type of price discrimination is a senior citizen discount? (Third-degree)
Under perfect price discrimination, consumer surplus equals _____. (Zero)
A Pigovian tax aims to correct which market failure? (Negative externalities / overproduction)
Q: In the presence of a negative production externality (like pollution), the market equilibrium quantity is...?
A: Greater than the socially optimal quantity. Firms ignore external costs and overproduce.
Q: What is a Pigovian tax, and what specific market failure does it aim to solve?
A: A Pigovian tax is a tax on activities that generate negative externalities. It is set equal to the external cost per unit, internalising the externality and reducing output to the socially optimal level.
Q: Identify and explain one government policy used to correct a positive externality.
A: A Pigovian subsidy. Since positive externalities lead to underproduction (MPB < MSB), the government provides a financial incentive to producers or consumers, shifting the relevant curve to the right and bringing output up to the socially efficient quantity.
Q: The Tragedy of the Commons typically occurs with goods that are...?
A: Non-excludable and rival (common resources). Because access cannot be restricted, each user consumes without bearing the full cost, leading to overuse.
Q: If Charles can perfectly price discriminate, how many students will he tutor, and what is his total revenue?
A: 6 students (A through F, all with WTP at or above his $30 opportunity cost). Total revenue = $50 + $46 + $42 + $38 + $34 + $30 = $240.
Q: Calculate Charles's economic profit under perfect price discrimination.
A: Profit = TR - TC = $240 - (6 x $30) = $240 - $180 = $60.
Q: If Charles must charge a single uniform price to all students, what price maximises his economic profit?
A: At $42, he tutors 3 students (A, B, C). Profit = (42 - 30) x 3 = $36. At $38, he tutors 4 students. Profit = (38 - 30) x 4 = $32. The profit-maximising single price is $42. (Note: the exam's answer key marks $38 as correct using a marginal revenue approach, but the direct profit calculation shows $42 yields higher profit. Be prepared for both approaches.)
Q: Given MC = 20 + 0.5Q, MSB = 100 - 0.5Q, and external cost = $10/unit, find the market equilibrium, social optimum, and deadweight loss.
A: Market: Q = 80, P = 60. MSC = 30 + 0.5Q. Social optimum: Q = 70, P = 65. DWL = 0.5 x 10 x 10 = $50.
Externalities and public goods build directly on the surplus and efficiency framework: deadweight loss from externalities is calculated the same way as DWL from price controls. The Pigovian tax connects to tax incidence, since the tax shifts the supply curve up by the amount of the external cost.
Price discrimination connects to elasticity: the group with more elastic demand gets the lower price under third-degree discrimination.
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