GOVERNMENT AND THE MARKET

Introduction
Why government interventions?
Types of market failure
Externalities
Market power
Government failures

INTRODUCTION
In a free market economic system, scarce resources are allocated through the price
mechanism where the preferences and spending decisions of consumers and the supply
decisions of businesses come together to determine equilibrium prices. The free market works
through price signals. When demand is high, the potential profit from supplying to a market
rises, leading to an expansion in supply (output) to meet rising demand from consumers. Day
to day, the free market mechanism remains a tremendously powerful device in determining
how resources are allocated among competing ends.

WHY GOVERNMENT INTERVENTION?

The government may choose to intervene in the price mechanism largely on the grounds of
wanting to change the allocation of resources and achieve what they perceive to be an
improvement in economic and social welfare.
All governments of every political persuasion intervene in the economy to influence the
allocation of scarce resources among competing uses
The main reasons for government intervention are:
To correct market failure
To achieve a more equitable distribution of income and wealth
To improve the performance of the economy
Government intervention occurs when markets are not working optimally i.e. there is a Pareto
sub-optimal allocation of resources in a market/industry. In order words, the market may not
always allocate scarce resources efficiently in a way that achieves the highest total social
welfare. And government can justify her intervention by implying its in the publics interest.

MARKET FAILURE
Introduction
Market, in equilibrium, do not always achieve efficiency. When the allocation in an
unregulated market in equilibrium is inefficient, the market is said to fail. Market failures are
numerous in the resources and environmental sector of the economy. The market fails in the

allocation of many environmental and natural resources, making the overall allocation of
resources inefficient.
A market failure is something that is inherent to the market that causes the market
equilibrium allocation to be inefficient.
Definition of Market Failure
This occurs when there is an inefficient allocation of resources in a free market. Market
failure can occur due to a variety of reasons, such as monopoly (higher prices and less
output), negative externalities (over-consumed) and public goods (usually not provided in a
free market). Basically, market failure arises when markets do not bring about economic
efficiency.
It is an economic term that encompasses a situation where, in any given market, the quantity
of a product demanded by consumers does not equate to the quantity supplied by suppliers.
This is a result of a lack of certain economically ideal factors, which prevent equilibrium.

Types of market failure

1.

Externalities This is a situation where the social optimum output or level of

consumption diverges from the private optimum. It occurs when one person's actions affect
another person's well-being and the relevant costs and benefits are not reflected in market
prices. Goods / services which give benefit/impose cost to a third party, e.g. less congestion
from cycling or cancer from passive smoking.
The main problem is the absence of clearly defined property rights for those agents
operating in the market and when negotiation is costly. When property rights are not clearly
defined, market failure is likely because producers & consumers may not be held to account.
The justification for government intervention here is when the goods are under consumed
(social benefit is less than private benefit positive externalities) or over consumed (social
cost is greater than private cost negative externalities).

2.

Merit Goods are those goods and services that the government feels that people left
to themselves will under-consume and which therefore ought to be subsidised or provided
free at the point of use. Demerit Goods are those goods and services that the government
feels that people left to themselves will over-consume and which therefore ought to
be heavily taxed.
Both the public and private sector of the economy can provide merit goods & services.
Consumption of merit goods is thought to generate positive externality effects where
the social benefit from consumption exceeds the private benefit. While consumption of
demerit goods is thought to generate negative externality effects where the social cost from
consumption exceeds the private cost.

Examples: Health services, Education, Work Training, Public Libraries, Citizen's Advice,
Inoculations.

Justification for the Government intervention:

Merit goods: Government intervenes to encourage consumption so that positive

externalities of merit goods can be achieved. Free inoculation against infectious
diseases prevents the spread of such diseases.
Demerit goods: government must step in to stop this over-consumption. In the case of
alcohol and cigarettes, the government imposes quite heavy taxes and duties. This
means that their price rises significantly in the hope that this will deter people from
consumption.

3.

Public Goods These are goods not provided by the free market because of their two
main characteristics (non-rivalry and non-excludable) e.g. police, national defence.
Non-excludability where it is not possible to provide a good or service to one person
without it thereby being available for others to enjoy.
Non-rivalry where the consumption of a good or service by one person will not
prevent others from enjoying it.
Because of their nature, the private sector is unlikely to be willing and able to provide public
goods for collective consumption. Then, the government therefore provides them
for collective consumption and finances them through general taxation

4.

Monopoly/Market power when a firm controls the market and can set higher
prices.
Few modern markets meet the stringent conditions required for a perfectly competitive
market. The existence of monopoly power is often thought to create the potential for market
failure and a need for intervention to correct for some of the welfare consequences of
monopoly power.
Justification for government intervention:
Price is higher and output is lower under monopoly than in a competitive market. This
causes a net economic welfare loss of both consumer and producer surplus. Price >
marginal cost - leading to allocative inefficiency and a Pareto sub-optimal
equilibrium.
Rent seeking behaviour by the monopolist might add to the standard costs of
monopoly. This includes high (possibly excessive) amounts of spending on persuasive
advertising and marketing.
Libenstein's X-inefficiency may also result if the monopolist allows cost efficiency to
drop. An upward drift in costs because of a lack of effective competition in the

market-place can lead to consumers facing higher prices and a reduction in their real
standard of living
5.
Inequality unfair distribution of resources in free market
Market failure can also be caused by the existence of inequality throughout the economy.
Wide differences in income and wealth between groups within our economy leads to a wide
gap in living standards between the rich and the poor. Society may come to the view that too
much inequality is unacceptable. Government may decide to intervene to reduce inequality
through changes in the tax and benefits system and also specific policies such as the national
minimum wage.
Overcoming Market Failure

Tax on negative externalities e.g. Petrol tax

Carbon Tax e.g. tax on CO2 emissions
Subsidy on positive externalities why government may subsidies public transport
Laws and Regulation Simple and effective ways to regulate demerit goods, like ban on
smoking advertising.
Buffer stocks aim to stabilise prices
Direct provision of public goods

GOVERNMENT FAILURE
This refers to substantial imperfection in government performance. Such imperfections are
comprised of inadequate actions and unreasonable inactions. The scope of the
imperfection is related to the level of a disregarded risk, inadequacy of cost-benefit analysis,
deviation from popular normative expectations, and magnitude of misallocated resources.
This is a situation where government intervention may not always improve the situation.

CAUSES OF GOVERNMENT FAILURE

Short-sighted regulation.

Significant implementation costs due to regulation.

Application of inappropriate and costly technology.

Overspending due to fiscal indiscipline.

Low productivity in the civil service

Lack of incentive for technology efficiency.