Question

Compare and contrast the causes and implications of government failure vs. market failure. An excellent place to start is the welfare implications of a well-functioning, perfectly competitive market.

Answer 1

When an industry in the private sector is not performing efficiently or effectively, there is said to be “market failure”. The recommendation by economists and others typically is then for government actions to combat such failure, such as taxes to help reduce pollution. The diagnosis of market failure may be accurate, but the call for government involvement may be naïve and inappropriate.

The reason is that actual governments do not necessarily do what economists and others want them to do because there is “government failure” as well as market failure. Before recommending government actions to correct market failures, one should consider whether actual government policies would worsen rather than improve private sector outcomes. Since many factors often make for considerable government failure, considering such failure is crucial and not just a theoretical fine point.

Consider, for example, that consumers are sometimes ignorant of the qualities and other aspects of the products they buy. However, before advocating various forms of government protection of consumers, we should recognize that voters are far more ignorant of political candidates then consumers are of what they buy. The reason is that consumers directly suffer if they make bad choices out of ignorance, while individual voters have negligible influence over political outcomes. Hence voters have little incentive to be informed about different candidates and their positions, and the consequences of the mistakes they make are largely borne by others.

The intermediate cases are the most difficult: when market failures may be significant, and yet government alternatives are not attractive. This may be decided on a case-by-case basis, but It is believed that usual rule should then be to let the market operate. This belief is based on the conclusion that, on the whole, government failure is far more pervasive, damaging, and less self-correcting, than is market failure. These are the problems that a relevant welfare analysis should focus on. Simply concluding that in particular instances markets are not working perfectly is a misleading and incorrect basis for supporting active and sizable government involvement.

An excellent place to start is the welfare implications of a well-functioning, perfectly competitive market

There are certain welfare implications of perfect competition. It may be argued that an economy consisting entirely of perfectly competitive markets leads to a maximisation of consumer satisfaction. This follows because, in long-run equilibrium, competition forces firms to produce with the least- cost technology available, at the lowest possible average per unit cost, and sell to consumers at a price that just covers this cost.

In addition, P=MC balance implies that consumers pay a price that just covers the cost of the last unit of each kind of good produced. Because of the ease of entry and exit of firms to and from industries, a perfectly competitive economy will quickly re-allocated resources to meet changing consumer preferences or reflect changing supply conditions. Hence, resources are always efficiently allocated in accordance with consumers’ tastes.