Question

This week we shift our focus to the role of the government and some difficult cases where the markets might fail. Can you discuss what can cause this kind of market failure and how the Government intervenes?

Answer 1

Market failure is a situation when the price mechanism fails such that the socially optimum output is not provided.

Some of the reasons for market failure are:

(i) Positive and negative externalities

Externalities in the market i.e. third party actions have spillover effects on consumption and production. This can be either positive (for example, an educated population having a positive impact on the whole society) or negative (for example, pollution). Such failures lead to the movement away from the socially optimum.

(ii) Lack of public goods

Public goods are goods that are non-excludable and non-rival and can thus be used by the entire public. The market fails when some people try to free-ride on other people and not pay for the provision of the public good.

(iii) Monopoly power

In an attempt to maximize profits, imperfect markets restrict output and charge high prices.

When a market fails, the government intervenes in order to correct such failures. Some of the ways of government intervention include:

(i) Taxation and subsidies

By placing a tax on certain goods, the government tries to discourage use and internalize external costs. Similarly, by reducing the price of a good i.e. providing subsidies, the government tries to encourage behaviour that leads to positive externalities.

(ii) Tradeable permits

The government allots tradeable permits to the firms, such that these firms can trade permits with other firms to increase or decrease production. These permits are based on the cap-and-trade system.

(iii) Direct provision of public goods

Sometimes, the government controls the supply of the public good themselves. For example. Public parks, national defence etc. This is done in order to avoid the problem of free riding.