Difficulty: Introductory | Prerequisites: Resource Allocation and Market Efficiency notes (Doc 1); Price Controls, Taxes, Subsidies, and Fairness notes (Doc 2)
This document covers three topics that frequently appear together in introductory microeconomics: the classification of goods, externalities and market failure, and the basics of consumer choice theory. The first two explain why markets sometimes fail to reach efficiency even without government intervention, and what policy tools can fix those failures. Consumer choice theory explains the demand side from first principles, showing where the demand curve comes from. You should be comfortable with surplus analysis, deadweight loss, and the efficiency-equity tradeoff before reading these notes.
Goods are classified by whether they are rival (one person's use reduces availability) and excludable (non-payers can be kept out). Public goods are underprovided by markets because of free-riding; common goods are overused because nobody owns them. Externalities (costs or benefits falling on third parties) push markets away from efficiency, and the main fixes are property rights, Pigovian taxes, cap-and-trade, and direct regulation. Consumer choice theory shows that a rational consumer maximises utility by equalising marginal utility per pound across all goods, which is the logic behind the downward-sloping demand curve.
Rival (rivalrous)
A good is rival if one person's consumption reduces the amount available for others. A sandwich is rival; a radio broadcast is not.
Excludable
A good is excludable if non-payers can be prevented from using it. A cinema ticket is excludable; a streetlight is not.
Private good
Both rival and excludable. Most everyday goods fall here: food, clothing, electronics.
Club good
Non-rival (up to a congestion point) but excludable. Streaming services, toll roads, and gyms are typical examples.
Public good
Non-rival and non-excludable. National defence, street lighting, and clean air are classic cases.
Common good (common-pool resource)
Rival but non-excludable. Fisheries, forests, and aquifers. Because nobody can be excluded, they tend to be overused.
Free-rider problem
The tendency for individuals to benefit from a public good without contributing to its cost. Because non-payers cannot be excluded, private markets underprovide public goods.
Tragedy of the commons
The degradation or depletion of a common resource because each user has an incentive to consume as much as possible before others do. Overfishing is the standard example.
Externality
A cost or benefit that falls on a third party who is not involved in the transaction. Externalities cause the market to over- or underproduce relative to the socially optimal quantity.
Negative externality
An external cost imposed on third parties (pollution, noise, congestion). The market overproduces because private costs are lower than social costs.
Positive externality
An external benefit enjoyed by third parties (education, vaccination). The market underproduces because private benefits are lower than social benefits.
Coase theorem
If property rights are well defined and transaction costs are low, private bargaining will lead to an efficient outcome regardless of who holds the initial rights.
In simple terms, if the people affected can talk cheaply and someone clearly "owns" the right, they will sort it out themselves.
Budget line
The set of all combinations of two goods a consumer can afford given their income and the prices of the two goods. It is a straight line whose slope equals the negative ratio of the two prices.
Utility
A measure of the satisfaction or happiness a consumer derives from consuming goods and services.
Marginal utility (MU)
The additional utility gained from consuming one more unit of a good.
Diminishing marginal utility
The principle that each successive unit of a good provides less additional utility than the one before it. The first slice of pizza is wonderful; the fifth is less so.
Utility maximisation rule
A consumer maximises utility when the marginal utility per pound spent is equal across all goods: MUa / Pa = MUb / Pb.
Goods are sorted into four categories using two tests: is the good rival, and is it excludable?
Excludable | Non-excludable | |
|---|---|---|
Rival | Private good (food, clothing) | Common good (fisheries, forests) |
Non-rival | Club good (streaming service, toll road) | Public good (national defence, streetlight) |
These are the standard market goods. Because they are both rival and excludable, markets handle them well. The price mechanism allocates them efficiently in competitive conditions.
Excludability means providers can charge, so private firms supply them. They are non-rival up to a point, but congestion can make them rival at high usage (a gym at 6 pm).
Public goods are non-rival and non-excludable. This combination creates the free-rider problem: since no one can be excluded, each individual has an incentive to let others pay while still enjoying the good.
Private markets will underprovide public goods because firms cannot capture enough revenue from consumers who refuse to pay. Governments typically step in, funding public goods through taxation.
Common goods are rival but non-excludable. Because no one can be excluded, each user races to consume before others do, leading to overuse and eventual depletion.
Classic examples: overfishing in open waters, overgrazing on shared land, pumping from a shared aquifer.
Solutions include assigning property rights (privatisation), government regulation (catch limits, quotas), or community-managed rules.
An externality exists when a transaction imposes costs or benefits on people who are not party to it. Because these costs or benefits are not reflected in the market price, the market produces the wrong quantity.
A negative externality means the social cost of production exceeds the private cost. The supply curve (private MC) sits below the true social cost curve (MSC).
Result: the market overproduces relative to the socially optimal quantity. Too many units are made because producers do not bear the full cost.
Examples: factory pollution, traffic congestion, noise from a construction site.
A positive externality means the social benefit of consumption exceeds the private benefit. The demand curve (private MB) sits below the true social benefit curve (MSB).
Result: the market underproduces. Too few units are consumed because consumers do not capture the full benefit.
Examples: education (spillover benefits to society), vaccination (herd immunity), research and development.
Four main policy tools:
Property rights and bargaining (Coase theorem) – if property rights are clearly assigned and transaction costs are low, the affected parties can negotiate an efficient outcome on their own. The initial assignment of rights affects who pays whom, but not the final quantity produced. This works well for small numbers of parties but breaks down when transaction costs are high or many people are involved.
Pigovian taxes – a tax equal to the marginal external cost. It shifts the private cost curve up to the social cost curve, so the market naturally settles at the efficient quantity. Used for pollution (carbon taxes, for instance).
Cap-and-trade – the government sets a total emissions cap and issues tradeable permits. Firms that can reduce emissions cheaply sell permits to those that cannot, achieving the cap at minimum cost.
Direct regulation – mandating standards or banning certain activities outright (emission limits, safety requirements). Less flexible than taxes or cap-and-trade, but sometimes simpler to enforce.
This section explains the logic behind the demand curve.
The budget line shows every combination of two goods (call them A and B) that a consumer can afford, given their income (I) and the prices of the two goods (Pa and Pb).
The equation is: Pa x Qa + Pb x Qb = I
The intercept on the A axis is I / Pa (spend all income on A).
The intercept on the B axis is I / Pb (spend all income on B).
The slope is -Pa / Pb, representing the rate at which the consumer can trade A for B in the market.
A change in income shifts the budget line in or out (parallel). A change in one price rotates the line around the other good's intercept.
Consumers rank bundles of goods by the satisfaction (utility) they provide. Total utility rises with quantity, but each additional unit adds less than the one before: this is diminishing marginal utility.
The consumer's goal is to choose the combination of goods on their budget line that maximises total utility. The optimal condition is:
MUa / Pa = MUb / Pb
In words: the last pound spent on good A should give the same marginal utility as the last pound spent on good B. If it does not, the consumer can increase total utility by shifting spending toward the good with the higher marginal utility per pound.
This rule explains the downward-sloping demand curve. When the price of good A falls, MUa / Pa rises, so the consumer buys more of A until diminishing marginal utility brings the ratio back into balance.
The free-rider problem is why national defence, public broadcasting, and basic research are typically funded by governments rather than left to private markets. No firm could charge enough voluntary subscribers to cover the cost.
Carbon taxes and cap-and-trade systems (such as the EU Emissions Trading System) are textbook Pigovian corrections applied at scale. They force firms to internalise the cost of greenhouse gas emissions, steering production toward the socially efficient level.
The utility maximisation rule is the formal logic behind everyday consumer behaviour. When a supermarket puts crisps on sale, you buy more of them (MU per pound has risen relative to other snacks) until the marginal utility of yet another bag drops enough to restore the balance.
Students often think "public good" means "provided by the government." The definition is about rivalry and excludability, not who supplies it. A lighthouse is a public good whether run by the state or a private charity.
Students often assume the Coase theorem means government intervention is never needed. The theorem requires low transaction costs and well-defined property rights, conditions that rarely hold for large-scale problems like air pollution affecting millions of people.
Students often confuse common goods with public goods. The critical difference is rivalry: a public good is non-rival (your use does not reduce mine), while a common good is rival (your fish is one fewer for me).
Students often think diminishing marginal utility means total utility is falling. Total utility still rises with each unit consumed; it just rises by a smaller increment each time.
⚠️ The 2x2 table of goods (rival/non-rival, excludable/non-excludable) appears on nearly every introductory exam. Memorise it with examples.
⚠️ Externality questions typically ask you to identify whether the externality is positive or negative, state whether the market overproduces or underproduces, and recommend a corrective policy. Have a template answer ready.
⚠️ The Coase theorem is a favourite short-answer topic. Be prepared to state the theorem, name its assumptions, and explain why it fails in practice for large-scale externalities.
⚠️ Utility maximisation questions will give you a table of MU values and prices and ask you to find the optimal bundle. Practise dividing MU by price for each good and equalising the ratios.
Fill in the blank: a good that is rival but non-excludable is called a ________ good.
Common good (common-pool resource).
True or false: positive externalities cause the market to overproduce.
False. Positive externalities cause underproduction because private benefits are lower than social benefits.
Fill in the blank: the Coase theorem requires well-defined ________ and low ________.
Property rights; transaction costs.
True or false: at the utility-maximising bundle, the marginal utility of every good is equal.
False. The marginal utility per pound (MU/P) is equal across goods, not the marginal utility itself.
Fill in the blank: the slope of the budget line equals ________.
Negative Pa / Pb (the negative ratio of the two prices).
Q: Classify each of the following as a private, club, public, or common good: (a) a fish in the ocean, (b) a Netflix subscription, (c) national defence, (d) a chocolate bar.
A: (a) Common good (rival, non-excludable). (b) Club good (non-rival, excludable). (c) Public good (non-rival, non-excludable). (d) Private good (rival, excludable).
Q: A factory emits smoke that harms nearby residents. Using the Coase theorem, explain how an efficient outcome could be reached without government intervention, and state one condition under which this would fail.
A: If property rights are clearly assigned (either the factory has the right to pollute or the residents have the right to clean air) and transaction costs are low, the two parties can bargain. The residents could pay the factory to reduce emissions, or the factory could compensate residents for the damage. Either way, they reach the quantity of pollution where the marginal benefit of production equals the marginal cost of pollution. This fails when transaction costs are high, for example if thousands of residents are affected and coordinating payment is impractical.
Q: A consumer has £20 to spend on goods A and B. Pa = £2, Pb = £5. Currently MUa = 10 and MUb = 20. Is the consumer maximising utility? If not, what should they do?
A: MUa / Pa = 10 / 2 = 5. MUb / Pb = 20 / 5 = 4. The ratios are not equal, so the consumer is not maximising utility. MUa / Pa > MUb / Pb, so the consumer should buy more of A and less of B. As they do, diminishing marginal utility will lower MUa / Pa and raise MUb / Pb until the two ratios equalise.
Q: Why do private markets underprovide public goods?
A: Public goods are non-excludable, so firms cannot prevent non-payers from benefiting. Consumers have no incentive to pay voluntarily (the free-rider problem), so firms cannot generate enough revenue to cover costs. The market produces less than the socially optimal quantity, or nothing at all.
The classification of goods and externalities build directly on the surplus and deadweight loss framework from Doc 1 and the policy tools (taxes, subsidies, regulation) from Doc 2. Consumer choice theory provides the micro-foundations for the demand curve, which you have been taking as given up to this point. Later in the course, if you cover game theory, the free-rider problem reappears as a prisoner's dilemma, and the tragedy of the commons becomes a common-pool resource game.
Rivalry, excludability, private good, club good, public good, common good, common-pool resource, free-rider problem, free riding, tragedy of the commons, externality, negative externality, positive externality, external cost, external benefit, spillover, market failure, Coase theorem, property rights, Pigovian tax, cap-and-trade, emissions trading, direct regulation, budget line, budget constraint, utility, total utility, marginal utility, diminishing marginal utility, utility maximisation, MU/P rule, consumer choice, consumer equilibrium, microeconomics, ECON 101, intro to microeconomics