Chapter – 3 Government intervention in the price system

Market failure occurs due to inefficiency in the allocation of goods and services. A price
mechanism fails to account for all of the costs and benefits involved when providing or
consuming a specific good. When this happens, the market will not produce the supply of the
good that is socially optimal – it will be over or under produced.

Types of market failure

 Productive and allocative inefficiency.
 Monopoly power.
 Missing markets.
 Incomplete markets.
 De-merit goods.
 Negative externalities.

PUBLIC GOODS AND MARKET FAILURE

Public goods cause market failure due to the problem of missing markets – the main
characteristics of public goods are –
1. Non excludability – Benefits derived from pure public goods can’t be confined solely to those
who have paid for it. Non- payers can enjoy the benefits of consumption at no financial cost to
themselves.
2. Non- rival consumption – Each party’s enjoyment of the goods or services does not diminish
other’s enjoyment- In other words the marginal cost of supplying a public goods to an extra
person is zero. If a public good is supplied to one person, it is available to all.
3. Non- rejectable – The collective supply of a pure public good for all means that it can’t be
rejected by people, an example is a national nuclear defence system or major flood defence
projects.
Non rival here means - Everyone has access to use them, and their use does not reduce their
availability for future use. that are consumed by people, but whose supply is not affected by
people's consumption
Some other example of public goods are –
 Freely available knowledge (Example free online courses)
 Public service broad casting
 Reduce risk from disease from Vaccinations
Health care does not belong to public goods because health care has the characteristics of a
private good because it is rival and excludable in consumption and non-paying individuals (for
health insurance, healthy food, etc.) may not be able to achieve good health.

QUASI PUBLIC GOODS

A quasi pubic good is a near-public good. It has some of the characteristics of a public good. The
are –
 Semi non-rival – Up to a point, more consumers using a park, beach or road do not
reduce the space available for others. But eventually beaches become crowded as do
parks facilities. Open access Wi-fi network become croweded.
 Semi non – excludable: It is possible but difficult or costly to exclude non-paying
consumers. Example fencing a park or beach and charging and entrance fee, or building
toll booths on congested road routes.

With public goods private sector markets may fail to supply in part or in whole the optimum
quantity of public goods.
  Pure public goods are not normally provided by the private sector because they would be
unable to supply the for a profit.
 It is up to the government to decide what output of public goods/funding of public goods
is appropriate for society.

FREE RIDER PROBLEM AND MARKET FAILURE

 “The free rider problem is a market failure that occurs when people take advantage of
being able to use a common resource, or collective good, without paying for it, as is the
case when citizens of a country utilize public goods without paying their fair share in
taxes”.
It does not apply to ‘private goods for the reason that private goods can be valued by each
person individually, whereas common goods have the same value to everyone.

 Key points

A free rider is someone who wants others to pay for a public good but plans to use the
good themselves; if many people act as free riders, the public good may never be
provided.

Markets often have a difficult time producing public goods because free riders attempt to
use the public good without paying for it.

How the above problem can be solved?

One solution is to treat all beneficiaries as one consumer and then divide the cost equally. For
example, if we have a public good like national defense, we can get everyone to pay for it by
using tax revenue to pay for the national defense budget.
The free rider problem can be overcome through measures that ensure the users of a public good
pay for it. Such measures include government actions, social pressures, and collecting payments
—in specific situations where markets have discovered a way to do so.

Social pressures and personal appeals

In some cases, social pressures and personal appeals can be used—instead of the force of law—
to reduce the number of free riders and to collect resources for the public good.

Why do people choose to be free riders?

Imagine that two people are thinking about contributing to a public good: P and Q. When either
of them contributes to a public good—such as a local fire department—their personal cost of
doing so is $ 4 and the social benefit of that person’s contribution is $ 6.
Because society’s benefit of $ 6 is greater than the cost of $ 4, the investment is a good idea for
society as a whole.The problem is that—while P and Q pay for the entire cost of their
contribution to the public good—they receive only half of the benefit because the benefit of the
public good is divided equally among the members of society.

Key market failure concepts to revise

1. Economic welfare
Self- interested behaviour
Rational behaviour
Consumer and producer surplus
Private benefit and private cost

2. Social welfare
Social benefit and social cost

3. Economic efficiency
 Allocative
Productive
Dynamic

4. Income inequality and wealth inequality, inequitable outcomes

5. Public goods, free ride problems
6. Imperfect competition in markets, barrier to entry

Externalities
Meaning – An externality is said to arise if a third party ( someone not directly involved)
is affected by the decision and actions of others. For example if someone is smoking in
the same room where you are, it will cause you also health problem and on the same
way if someone is playing loud music in your residential area then others not involved in
making that decision are affected by the noise that is being made.

Private cost and Social cost

Social cost of any action are all of the related costs associated with that action.
Private costs are those costs involved in an action that accrue to the decision maker.

External cost = Social cost – private cost

Social cost = Private cost + External cost

Negative externalities
Negative externalities occur when production or consumption of goods and services
impose external costs on third parties outside of the market for which no appropriate
compensation is paid. This causes social costs to exceed private costs.
Example - Negative externalities from production
1. Smokers ignore the harmful impact of toxic 'passive smoking' on non-smokers
2. Air pollution from road use and traffic congestion and the impact of road fumes on
lungs
3. The external cost of food waste
4. The external costs of cleaning up from litter and the dropping of chewing gum
5. The external costs of the miles that food travels from producer to the final consumer
6. The externalities linked to the oil sands project in the Canadian wilderness

Positive externalities
There are many occasions when the production and/or consumption of a good or a
service creates external benefits which boost social welfare.
For example – 1. External benefits from development of renewable energy sources
such as wind power
2. External benefits from other new production technologies
3. External benefits from vaccination / immunisation programmes
4. Social benefits from the maintenance of a post-office network

Government failure:
This occurs when government intervention in the economy causes an inefficient
allocation of resources and a decline in economic welfare.
Often government failure arises from an attempt to solve market failure but creates a
different set of problems.

Reasons for government failure

Lack of incentives: In the public sector, there is limited or no profit motive. Because
workers and managers lack incentives to improve services and cut costs it can lead to
inefficiency. For example, the public sector may be more prone to over-staffing. The
government may be reluctant to make people redundant because of the political costs
associated with unemployment.
Poor information, politicians may have poor information about the type of service to
provide. Politicians may not be experts in their department but concentrate on their
political ideology.
Political interference Decisions made for short-term political gain – rather than sound
economics, e.g. keep on unproductive workers. e.g. politicians may take the short-term
view rather than considering the long-term effects
No consistency. Change of government often leads to change of approach and new
political initiatives
Moral hazard. The government may offer a guarantee to all bank deposits to protect the
financial system, but this could encourage banks to take risks – because they know they
can be bailed out by the government.
Regulatory capture – When government agencies become too friendly with
business/groups they are trying to regulate
Unintended consequences. Policies to reduce relative poverty ‘means-tested benefits’ can
create ‘welfare dependency.’ For those on means-tested benefits, moving from benefits
to work could lead to very little extra income because of lost benefits and higher taxes.
Benefits can then solve one problem of relative poverty but create new problems of
higher spending and lower levels of labour market participation .

Examples of government failure

Prohibition strengthened the mafia - When the government banned alcohol in the US, it
caused the mafia to supply alcohol, leading to a rise in organised crime.
There are various things the government can try and do to overcome government failure

 Give performance targets/profit incentives

 Competitive tendering – where public sector bodies face competition from the
private sector for the right to run a public service.
 Employing outside private sector consultants to make decisions about how to cut
costs.
 Delegating certain decisions to non-political bodies. For example, setting interest
rates was given to the Bank of England as politicians often set interest rates for
political reasons.

Self-assessment questions

(a) Explain why environmental pollution is regarded as a source of market failure?

(b)  Evaluate two different policies which a government might implement to reduce
pollution.

Monopoly and market failure

One important way in which markets can be seen to fail is when a market is dominated
by a single supplier a monopoly.
A monopoly technically exists where there is just one firm in the industry. However an
insudustry can be deemed to be a monopoly when it is dominated by one firm.
Reasons for monopoly to develop –
1. Economies of scale – where there are significant economies of scale present in
an industry, firms will have to be very large in order to effectively exploit those
economies
2. Profit Motive – It is assumed in economies that firm aims to maximizing profits is
to destroy competitors. Given this a free market may move towards a
monopolistic market.
Steps taken by government to correct market failure
1. Maximum prices - If price seems to be too high, then the government might
impose a maximum price.
A maximum price could be imposed on a monopoly market in order to moderate
the price. This is a policy used in some countries by regulatory bodies.
A maximum price might also be used if there were concerns that consumers
could not afford an important product such as housing.
The effect of a maximum price could be to create shortages as it could lead to
demand exceeding supply.

2. Price stabilisation – Some markets are susceptible to undesirable swings in the

market price of the products. This is particularly true of the agricultural market.
Prices may be stabilized by the government to protect the real incomes of both
consumers and producers.

3. Taxes and Subsidies – Taxes cab be used to discourage the production of a

product. Subsidies encourage production.
Taxes may be placed on product that generates negative externalities and would
normally tend to be overproduced.

4. Advertising – encourages or discourages consumption.

Objectives of government microeconomic policy

Q – Explain why traffic congestion is a classic example of market failure? How

government should deal with the problem of traffic congestion?

Q – Apart from regulation discuss the ways in which government can intervene in the
market to prevent over fishing.