Question

6 roles of government in market failure?

Answer 1

Market Failure is a situation in which the free-market system fails to satisfy society’s wants. Private markets do not efficiently bring about the allocation of resources. Hence the government must step in to satisfy society’s wants.

The six roles of government in a market economy are: (1) provide for a stable set of institutions and rules; (2) promote effective and workable competition; (3) correct for externalities; (4) ensure economic stability and growth; (5) provide for public goods and services; and (6) adjust for undesired market results.

Here are some actions that can be adopted to resolve a market failure.

Control of monopoly:

A monopoly power in the market can be controlled by the government by passing restrictive trade practice legislation and anti-monopoly laws. These regulations are targeted to remove unfair competition in the market, prevent iniquitous price discrimination and fixing prices that equal to competitive prices.

The government may also deescalate all monopoly prices to a competitive level via taxation and price regulation. The authorities may enforce a price ceiling to bring down monopoly pricing to near or equal to a competitive price. This is usually achieved by setting up of a commission that fixes the price of a monopoly goods or service, below the monopoly price.

Taxation is another way of controlling monopoly power during a market failure. Taxes could be levied lumpsum, irrespective of the output of the monopolist. The tax could also be proportional to the output i.e. the taxable amount rising with a rise in output. In both cases, the target is to bring down the monopoly to a competitive level.

External factors:

Pigou suggested social control measures and using subsidies and taxes to achieve an optimal allocation of resources in the face of various externalities. The government can interfere, in all cases, an external diseconomy of production for removing any divergence between social and private costs and benefits. The government in that case can ask the business owner for moving out of the residential area by extending appropriate facilities to a smoke emitting workshop. He said that in case of any external diseconomy of consumption, the government could end the noise pollution by banning loudspeakers, except during a special occasion in specific hours with prior permission.

Pigou also suggested the government to encourage production of goods and services with positive externalities by granting subsidies on each unit of product or service by the manufacturer. This will also help buyers to maximize their satisfaction by tax concession so that they can buy more commodities. Negative externalities often discourage sellers from production, and buyers from consumption by levying taxes, Pigou claimed.

The government, for instance, can impose a tax on every family living in an area, and thus collect the entire sum to pay the smoke emitting factory to relocate. In this way, subsidies and taxes can help bridge the gap between social and private costs and benefits.

Unitization or internalization of the externalities in production, is another commonly suggested measure. Firms engaged in oil production in the same field, for instance, could lead to over-pumping and over drilling. With the merger or unitization of the firms, oil can be extracted more efficiently sans a diseconomy of production.

Public goods

All public goods are non-rivaled and non-excluded and hence they are not available in the free market. Private companies can’t provide these public goods and services. They can be provided only by the public authority. Benefits of public goods and services can’t be divided. The government must make people share costs of public utilities so that each of them is better off.

One way of paying for public goods and services is to charge each person an equal proportion of the maximum amount he/she is ready to pay, instead of forsaking the product, while fixing that proportion to cover the entire cost of production. In case of special public goods like defense materials, the government may itself produce them or buy from private firms that meet all relevant production guidelines. So far the “free rider” issue is concerned, whereby utility services like police, firefighting etc are provided free to all users. The government can provide them from tax revenues.

Increasing returns to scale

Opinions largely differ about the government’s role to provide solutions to market failure in case of increasing returns to scale. Many economists and policymakers have opined that a government must nationalize industries that operate under decreasing costs, leading to overproduction. But many others disapprove of this idea. They feel government control could make matters worse. Yet others suggest that the private sector must produce goods and services and the government must impose a price regulation and tax them so that private and social costs and benefits can be balanced.

Indivisibles:

The solution to the problem of indivisibility in case of goods and services that are jointly used by several persons, like paved roads, street lights, traffic signals etc, local authorities like the civic corporation, has to spend on its maintenance and repairs. The cost in this regard has to be collected from the residents of a particular area or those who use the service.

Property rights and the Coase Theorem:

Common property rights lead to external situations. “Who owns property, to what uses it can be put, the rights people have over it and how it may be transferred,” are the issues related to property rights. Everyone has a right to prevent people imposing costs on them. Public properties like parks, civic services, libraries etc can be included in this.

The second solution could be to distribute wealth from the rich to the poor. But it’s more a question of changing the property rights, instead of extending ownership rights. Such a solution, however, won’t be practical.

The third solution could be for the government to charge for damages or compensating for them. However, it involves the problem to compensate those who acquired a property a much lesser cost because of the damage.

The fourth option is to move the court for monetary damages by the party which has been harmed because of the externality. British economist and author, Ronal Coase, suggested that a market failure, because of property rights, could be eliminated via mutual bargaining among the involved parties. He pointed out that property rights must be marketable and clearly defined, with transactions costs at zero. Only then will a perfectly competitive economy allocate optimal resources even under externalities. This is called the Coase Theorem.