Welcome to Market Failure and Government Intervention!
Hi there! This chapter is one of the most interesting parts of Economics. Up until now, we've mostly assumed that markets work perfectly, resulting in the ideal outcome (equilibrium). However, in the real world, things often go wrong.
In this section, we will learn why free markets sometimes fail to allocate resources efficiently – this is called market failure. Then, we will explore the different ways governments step in to try and fix these problems, and critically, what happens when government attempts to fix things actually make them worse (government failure).
Don't worry if some of the terms seem new; we'll break down every concept step-by-step!
3.1.5.1 The Meaning of Market Failure
What is Market Failure?
A free market is supposed to allocate resources to maximise welfare. Market failure occurs when the free market mechanism leads to an inefficient or undesirable allocation of resources, resulting in a loss of social welfare.
The core problem resulting from market failure is the misallocation of resources. This means that resources are not distributed in a way that maximises the overall benefits for society.
- Society produces too much of the goods that are harmful (like pollution).
- Society produces too little of the goods that are beneficial (like public education).
Did you know? When a market is working perfectly, we achieve allocative efficiency (Price = Marginal Cost), meaning resources are allocated exactly according to consumer preferences and societal needs. Market failure is a failure to achieve this efficiency.
The Main Causes of Market Failure (A Sneak Peek)
The syllabus identifies several reasons why markets fail:
- Public Goods (The market doesn't provide them at all).
- Externalities (The spillover effects on third parties).
- Merit and Demerit Goods (Information problems leading to poor consumption choices).
- Monopoly and Market Imperfections (Lack of competition).
- Inequalities in Income and Wealth (Unfair outcomes that the market produces).
Key Takeaway: Market failure means the free market leads to a misallocation of resources, reducing social welfare.
3.1.5.2 Private Goods, Public Goods and Quasi-Public Goods
One major cause of market failure is the inability of the market to provide certain types of goods.
1. Private Goods
Most goods you buy every day are private goods. They have two key characteristics:
- Rivalrous: If I consume the good, you cannot consume the exact same unit. (Example: If I eat a sandwich, you can't eat it.)
- Excludable: It is possible to stop someone from consuming the good if they haven't paid for it. (Example: The shopkeeper can stop you from taking the sandwich if you don't pay.)
2. Pure Public Goods
Pure public goods have the opposite characteristics:
- Non-Rivalrous: One person's consumption does not reduce the amount available for others. (Example: Me looking at a streetlight doesn't stop you from seeing it too.)
- Non-Excludable: Once provided, it is impossible (or very costly) to prevent anyone from benefiting, even if they haven't paid. (Example: National defence or flood barriers.)
Why Pure Public Goods Cause Market Failure: The Free-Rider Problem
Because public goods are non-excludable, people can benefit without paying. This is the free-rider problem.
Since private firms cannot charge everyone for the benefit, they cannot make a profit. Therefore, the market fails to provide pure public goods at all, resulting in underprovision (zero provision).
3. Quasi-Public Goods
A quasi-public good is a good that has some, but not all, of the characteristics of a public good.
- They are often non-rivalrous up to a point, but can become rivalrous if congestion occurs. (Example: A public road is non-rivalrous when empty, but highly rivalrous during rush hour.)
- Technological change can make previously non-excludable goods excludable. (Example: TV broadcasting used to be purely non-excludable, but now satellite and cable allow exclusion via payment.)
The Tragedy of the Commons
This theory relates to resources that are non-excludable but rivalrous (like common fishing grounds or the atmosphere).
- Since no one person owns the resource (non-excludable), individuals have an incentive to use it as much as possible for their own benefit.
- Because the resource is finite (rivalrous), this self-interested behaviour leads to the depletion or degradation of the resource for everyone.
Analogy: If a shared field is open to everyone's cows, each farmer adds more cows until the field is destroyed by overgrazing. This is a severe form of environmental market failure.
Quick Review: The market fails public goods because of non-excludability (free-rider problem), leading to zero provision.
3.1.5.3 Positive and Negative Externalities
Markets work based on private costs and private benefits. However, consumption and production often affect people not involved in the transaction. These side effects are called externalities.
Divergence between Private and Social Measures
An externality exists when there is a difference (a divergence) between the private costs/benefits and the social costs/benefits.
- Private Cost (PC): The costs paid by the producer or consumer (e.g., the cost of steel, the price of a car).
- Social Cost (SC): The total cost to society (SC = PC + External Cost).
- Private Benefit (PB): The benefits received by the consumer or producer (e.g., the joy of driving a car).
- Social Benefit (SB): The total benefit to society (SB = PB + External Benefit).
Negative Externalities (Costs to Third Parties)
These occur when production or consumption imposes costs on third parties. SC > PC.
- Negative Externality in Production: Example: A factory polluting a river. The firm’s private costs (PC) only include materials and labour; they don't include the cost of cleaning up the river (the external cost).
- Result: The market price is too low and output is too high. This leads to overproduction relative to the socially optimal level.
- Negative Externality in Consumption: Example: Smoking or driving a petrol car. The smoke/fumes affect others (passive smoking, air pollution).
Positive Externalities (Benefits to Third Parties)
These occur when production or consumption creates benefits for third parties. SB > PB.
- Positive Externality in Production: Example: A firm invests in Research & Development (R&D). Other firms might benefit from this new knowledge spreading through the industry.
- Result: The private benefit is less than the social benefit. This leads to underproduction relative to the socially optimal level.
- Positive Externality in Consumption: Example: Education or vaccination. If you get educated, society benefits from higher productivity and better citizenship.
The Role of Property Rights
Market failure often results from the absence of clearly defined property rights. If a resource (like a field, river, or air) is owned by no one, or property rights are difficult to enforce, producers and consumers treat it as free.
Example: If a factory does not own the river downstream, it has no financial incentive to care about the pollution, leading to an externality and market failure.
Key Takeaway: Negative externalities lead to overproduction; positive externalities lead to underproduction. Both result from the divergence between private and social costs/benefits.
3.1.5.4 Merit and Demerit Goods
This type of market failure is linked to externalities and, crucially, to the problem of imperfect information.
The Classification and Value Judgement
The classification of merit and demerit goods requires a value judgement—an opinion on what is good or bad for society. Economists debate this, but usually use the terms based on the consequences for individuals and society.
Merit Goods
Merit goods are goods that the government believes people underconsume because they often underestimate the private benefits or ignore the positive externalities they generate.
- Characteristics: Underprovision, positive externalities in consumption, and imperfect information (consumers don't fully realise how good they are).
- Example: Education, healthcare, vaccinations.
- Market Failure: Underprovision (too few resources allocated). The market produces \(Q_m\), but society wants \(Q_s\) (where \(Q_s > Q_m\)).
Demerit Goods
Demerit goods are goods that the government believes people overconsume because they often underestimate the private costs (especially long-term costs) or ignore the negative externalities they generate.
- Characteristics: Overprovision, negative externalities in consumption, and imperfect information (consumers don't fully realise how harmful they are).
- Example: Cigarettes, excessive alcohol, highly addictive gambling.
- Market Failure: Overprovision (too many resources allocated). The market produces \(Q_m\), but society wants \(Q_s\) (where \(Q_s < Q_m\)).
Common Mistake to Avoid: Not all products that result in positive or negative externalities are necessarily merit or demerit goods. Merit/Demerit status specifically implies that imperfect information is a central issue causing the poor consumption decision.
Key Takeaway: Merit goods are underprovided/underconsumed (often due to positive externalities and consumers underestimating benefits). Demerit goods are overprovided/overconsumed (due to negative externalities and consumers underestimating costs).
3.1.5.5 Market Imperfections
Markets can also fail when the conditions for perfect competition are not met, or when price signals are distorted.
1. Imperfect and Asymmetric Information
- Imperfect Information: When economic agents (buyers or sellers) do not have all the necessary facts to make a rational decision.
- Asymmetric Information: A specific type of imperfect information where one party has more information than the other. This prevents efficient transactions.
- Example: Buying insurance. The individual knows their own risk behaviour better than the insurance company (leading to market failure or high prices).
2. Monopoly and Monopoly Power
When a single firm (monopoly) or a few large firms (oligopoly) dominate a market, they have monopoly power.
- Monopolies tend to restrict output and charge higher prices than in a competitive market.
- Market Failure: This leads to a misallocation of resources because too little of the good is produced at too high a price, resulting in a loss of economic welfare (sometimes called deadweight loss).
3. Immobility of Factors of Production (FoPs)
If resources cannot move easily to where they are needed, market failure occurs.
- Occupational Immobility: Workers lack the skills to switch jobs (e.g., a coal miner cannot easily become a software developer).
- Geographical Immobility: Workers are unable or unwilling to move to areas where jobs are available (e.g., due to housing costs or family ties).
- Market Failure: High unemployment may coexist alongside unfilled vacancies, leading to productive inefficiency.
4. Price Instability
Markets for basic commodities (like raw materials or agricultural products) often experience sudden and dramatic price fluctuations.
- Market Failure: This instability makes it very difficult for farmers/producers to plan investment, leading to uncertainty and potentially harming long-term output.
Key Takeaway: Market imperfections like monopolies, lack of information, and resource immobility prevent markets from reaching efficient outcomes.
3.1.5.6 An Inequitable Distribution of Income and Wealth
The market mechanism often allocates resources very efficiently to those who can afford them. However, this may lead to outcomes that society deems unfair, which itself is often considered a source of market failure because it reduces overall economic welfare.
Income vs. Wealth
- Income: A flow concept. Money received over a period of time (e.g., wages, rent, interest, profits).
- Wealth: A stock concept. The value of assets owned at a point in time (e.g., property, savings, shares).
Equality vs. Equity (A crucial distinction!)
- Equality: Everyone receives the exact same amount (a mathematically equal distribution).
- Equity: The distribution is considered fair or just. This is a value judgement—what one person considers fair, another may consider unfair.
In the absence of government intervention, the free market often leads to a highly unequal and inequitable distribution of income and wealth, especially because an individual's consumption ability depends directly on their income/wealth.
Market Failure: Extreme inequality can lead to a misallocation of resources. For example, essential goods (like basic healthcare or clean water) may go unconsumed by the poor, while luxury goods are consumed excessively by the rich, even though social welfare might be maximised by a more equitable distribution.
Key Takeaway: The market creates inequality. While some inequality acts as an incentive, excessive or inequitable distribution reduces social welfare and is considered a form of market failure.
3.1.5.7 Government Intervention in Markets
Since market failure exists, there is a strong argument for government intervention to influence the allocation of resources and improve economic welfare.
Objectives of Government Intervention
Governments intervene to achieve a range of objectives, including:
- Correcting resource misallocation (fixing externalities).
- Reducing inequality (using taxes and spending).
- Ensuring economic stability.
Methods of Intervention
Governments can influence resource allocation in many ways:
1. Financial Instruments (Taxes and Subsidies)
- Indirect Taxation (e.g., Excise duties on fuel or cigarettes): Used to increase the private cost of demerit goods or goods with negative externalities, encouraging consumers to reduce consumption and internalising the external cost.
- Subsidies (e.g., grants for renewable energy): Used to lower the private cost of merit goods or goods with positive externalities, encouraging greater production and consumption.
2. Price Controls and Buffer Stocks
- Price Controls: Setting maximum (ceiling) or minimum (floor) prices.
- Buffer Stocks: Government agencies buy up commodities when prices are low and release them when prices are high, aiming to stabilise unstable markets (e.g., agricultural products).
3. Provision, Property Rights and Regulation
- State Provision: Directly providing goods and services that the market fails to supply, such as pure public goods (national defence) or key merit goods (state education/healthcare).
- Regulation: Rules and laws that control economic activity (e.g., environmental laws, minimum quality standards, minimum wage laws).
- Extension of Property Rights: Defining who owns what (e.g., pollution permits or giving communities rights over local resources) to prevent the tragedy of the commons and force polluters to pay.
Evaluating Intervention: When evaluating intervention methods, you must consider the effects on consumers, producers, and the government budget. For example, a tax raises prices for consumers but generates revenue for the government.
Key Takeaway: Government intervention aims to correct market failures using a variety of tools, including financial incentives (taxes/subsidies), provision, and regulation.
3.1.5.8 Government Failure
The existence of market failure provides an argument for intervention, but it doesn't guarantee success. Government failure occurs when government intervention leads to a worse allocation of resources and a subsequent fall in economic welfare compared to the situation before the intervention (or compared to the market failure itself).
Possible Sources of Government Failure
1. Inadequate Information
Governments often lack the necessary information to make optimal decisions.
- Example: To set the perfect pollution tax, the government must know the exact level of external cost (Social Cost), which is incredibly difficult to calculate. Setting the tax too high or too low will lead to an inefficient outcome.
2. Inappropriate or Conflicting Objectives
Governments may have multiple goals that clash with each other.
- Example: A policy to promote economic growth might conflict with an objective to protect the environment. If the objective is political gain rather than welfare, this can lead to poor policy choices.
3. Administrative Costs (Wastage)
Implementing policies costs money. If the administrative costs (the cost of designing, monitoring, and enforcing a policy) are greater than the economic welfare gained, the intervention is inefficient.
4. Corruption
In some cases, intervention can lead to corruption or lobbying, where decisions are made for private gain rather than public benefit.
Unintended Consequences
A major cause of government failure is unintended consequences, where the results of the policy are unexpected and often negative.
- Example: The government imposes a high tax on cigarettes to discourage smoking (demerit good). An unintended consequence might be the growth of illegal black markets for untaxed cigarettes, which harms legitimate business and fails to raise the intended tax revenue.
Key Takeaway: Government failure is a worsening of resource allocation due to intervention. It often arises from poor information, high costs, or unexpected negative side effects (unintended consequences).