Question

Discuss the role of government in a market economy to address market failure. Provide an examples.

Answer 1

The government plays a very important role to address market failure. The market does not always function properly to address all allocation problems. The government can play the role of an independent observer to observe the failures happening in the market and take appropriate steps to address the same. For example, recessions or depressions are examples of market failure. The market cannot itself always come out of recessions or depressions on its own. The government can play an active role in dealing with recessions and depressions. For example, the government can increases spending or cut taxes or both to stimulate demand and help the economy recover. On the contrary, the government can increases taxes or cut spending or do both to deal with an inflationary situation.

Positive or negative externalities are other examples of market failures. The government comes with subsidies to deal with positive externalities and taxes to deal with negative externalities.