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

Externalities create a gap between private incentives and social welfare. When someone’s actions affect others without compensation, private decision-makers don’t consider those spillover effects, so the market outcome can be inefficient. Government intervention can fix this by internalizing the externality—imposing a tax equal to the external cost for negative externalities or providing a subsidy for positive externalities. This shifts private marginal costs or benefits toward the social marginal cost or benefit, aligning private choices with social welfare and often raising total surplus. The other statements aren’t accurate: interventions don’t always raise total surplus, they don’t eliminate all market failures, and they don’t make private markets perfectly efficient.