AP Microeconomics – Market Failure and the Role of Government Practice Test

When transaction costs are high, private bargaining to resolve externalities becomes impractical because coordinating agreements among many parties is costly and time-consuming. With many involved parties, reaching a bargain that reflects everyone’s varying costs and benefits is often infeasible, so the private market fails to internalize the externality.

The idea behind private bargaining working well—often linked to the Coase theorem—holds only when transaction costs are low and rights are clear. When those costs are high, government action becomes more viable. Regulation or taxes can align private incentives with social costs, reducing negative externalities (like pollution) or supporting positive ones, in a way that bargaining cannot efficiently achieve.

So, in environments with high transaction costs, policy tools like regulation or taxes are generally more effective than relying on private bargains. The other statements don’t fit because there are workable fixes for externalities, and markets don’t always correct themselves when bargaining is too costly to coordinate.