Part III — Markets and Welfare: When Markets Work and When They Don't

Markets are powerful, but they are not magical.

Part II built the model of how markets coordinate buyers and sellers. Part III asks: when does that model fail to produce the outcomes we want? The honest answer turns out to be: often, in predictable ways. Six categories of market failure recur across the entire field of economics — externalities, public goods, common-pool resources, information asymmetries, distributional concerns, and behavioral departures from rationality. Each gets a chapter (or part of one) here. Each comes with policy responses that work better in some conditions than others. Each has a contested research literature that this textbook tries to summarize honestly.

By the end of Part III, you should be able to look at a real market — health insurance, climate policy, the local fishery, the secondary market for college textbooks, the labor market for adjunct professors — and identify which kind of market failure (if any) is operating, what the empirical evidence says, and what kinds of remedies might or might not help. You should also be able to evaluate a proposed policy without falling into either of the two easy traps: "the government should do something" without thinking about the unintended consequences, or "the market will sort it out" without thinking about the conditions the market needs to do that.

Chapter 11 — Externalities introduces the simplest market failure: when my choices affect you and you didn't choose. Negative externalities (the Walden Creek pollution case in Millbrook) and positive externalities (the value of Millbrook State graduates to the region's economy). Four solutions: Pigouvian taxes, cap-and-trade, regulation, and the Coase theorem — each with tradeoffs.

Chapter 12 — Public Goods and Common Resources introduces the rivalry-and-excludability matrix and the four categories it generates. The free-rider problem and the tragedy of the commons. Then Elinor Ostrom — Nobel laureate, political scientist — and her demonstration that commons can sometimes be managed without privatization or government, but only under specific conditions. The proposed Millbrook downtown parking garage is the running example.

Chapter 13 — The Economics of Inequality is the longest chapter in Part III. Inequality has risen in most rich countries since 1980, the explanations are contested, the philosophical frameworks for evaluating it are multiple, and the policy responses each have tradeoffs. The MSU adjunct wage gap is the running example — it is the inequality the reader can see in their own classroom.

Chapter 14 — The Economics of Healthcare explains why healthcare doesn't behave like a normal market: information asymmetry, moral hazard, and adverse selection make it the market failure Americans experience most personally. The chapter compares four healthcare systems — US mixed, UK single-payer, Canada, Singapore — without prescribing one.

Chapter 15 — The Economics of the Environment and Climate Change treats climate change as the largest externality in human history. The chapter walks through the Stern-Nordhaus debate about discount rates, the consensus on carbon pricing, the political-economy challenge of just transition, and the green industrial policy bet of the Inflation Reduction Act.

Chapter 16 — Information Asymmetry and Insurance Markets is a chapter Mankiw treats only in passing. Akerlof's lemons model. Adverse selection vs. moral hazard. How markets find partial workarounds (warranties, signals, reputation systems). And then 2008 as the anchor: mortgage-backed securities and AIG's credit default swap positions illustrated information failures so severe they took down the global financial system.

When you finish Part III, you understand that markets are necessary and not sufficient. Part IV will go inside the firm to show how the entities that participate in markets actually make decisions.

Chapters in This Part