Lecture 2

Government Intervention
Market Failure
Government Failure
Dr. John Khumalo (WSG) PADM7232: Econ & Pub. Policy February 10, 2022 1 / 25
The role of government in an economy
Four questions of public economics

1 When should the government intervene in the economy?
2 How might the government intervene?
3 What is the effect of those interventions on economic outcomes?
4 Why do governments choose to intervene in the way that they do?
When should the government intervene in the economy?
Economics generally presumes that markets deliver efficient outcomes,

so why should government do anything?
The primary motive for government intervention is therefore market
failure.
⇒ Market failure: A problem that causes the market economy to deliver
an outcome that does not maximize efficiency.
How the government might intervene?
Tax or Subsidize Private Sale or Purchase

⇒ Use the price mechanism, changing the price of a good to encourage or
discourage use.
Taxes raise the price for private sales or purchases of goods that are
overproduced.
Subsidies lower the price for private sales or purchases of goods that
are underproduced
What are the effects of government interventions?
Direct effects: The effects of government interventions that would be

predicted if individuals did not change their behaviuor in response to
their interventions.
⇒ With 50 million uninsured people, providing universal health insurance
covers 50 million people.
Indirect effects: The effects of government intervention that arise only
because individuals change their behavior in response to the
interventions.
⇒ If people drop private medical coverage, many more people may end up
covered by the public plan
Governments do not always choose efficient or socially desirable
outcomes.
Governments face enormous challenges in figuring out what the public
wants and how to choose policies that match those wants.
Political economy: The theory of how the political process produces
decisions that affect individuals and the economy
Market Failure
Market failure implies that the forces of supply and demand have not
led to the best point on the production possibilities curve.
It also establishes a basis for government intervention.
Main Sources of Market failure
There are four sources of market failure, namely

1 Public goods
2 Externalities
3 Market power
4 Inequity
Public good
A public good is a good or service whose consumption by one person

does not exclude consumption by others.
Can you think of any public goods that you know?
A free rider is an individual who reaps direct benefits from someone
else’s purchases of a public good.
Free riders of public goods upset the customary practice of paying for
what you get
Externality as source of Market Failure
Externalities arise whenever the actions of one party make another

party worse or better off, yet the first party neither bears the costs nor
receives the benefits of doing so
Externalities are costs (or benefits) of a market activity borne by a
third party.
The difference between the social and private costs (benefits) of a
market activity.
The market will underproduce goods that yield external benefits.
The market will overproduce goods that generate external costs
In trying to maximise their own satisfaction, consumers often do not
consider how their consumption affects the well-being of others
Positive Externalities
Externalities can be positive as well as negative.
A positive externality of consumption exists if the consumption of a good
or service provides spillover benefits to a third party not involved in the
marke. E.g consider the market for education.
Getting an education provides many benefits for the student, such as
better job opportunities, higher pay, an earlier retirement and better
travel opportunities
However, receiving an education also benefits society as a whole.
Positive externalities of education include:
⇒ An educated citizen will be more productive in his or her life,
contributing more to national output,
1 He or she will pay more in taxes, which go towards providing benefits
for everyone in society, even those without an education.

2 He or she is more likely to become a business owner, offering
employment opportunities to others in society which may not otherwise

have been provided
Positive production externality: When a firm’s production increases
the well-being of others but the firm is not compensated by those
others.
Positive consumption externality: When an individual’s consumption
increases the well-being of others but the individual is not
compensated by those others.
Negative Externalities
Negative production externality: When a firm’s production reduces

the well-being of others who are not compensated by the firm.
⇒ Pollution from steel production, dumped in a river, hurts fishermen.
⇒ ”The main causes of water pollution are the neutralised but highly
saline acid mine drainage effluent being pumped into the river and raw
or partially treated sewage from the often non-compliant wastewater
treatment systems of local municipalities” (Lieffrink, 2017)
Negative consumption externality: When an individual’s consumption
reduces the well-being of others who are not compensated by the
individual.
⇒ Smoking at a restaurant affects the health and enjoyment of others.
Solutions to Negative externalities
Externalities undermine efficiency because one party does not pay the
costs or get all the (net) benefits of its actions.
The solution to this, therefore, is to internalize the externality.
Internalizing the externality: When either private negotiations or
government action lead the party to fully reflect the external costs or
benefits of that party’s actions.
⇒ The fishermen could pay the steel producer to reduce production.
Public policy makers employ three types of remedies to resolve the
problems associated with negative externalities:
⇒ Corrective taxation to discourage use
⇒ Subsidies to encourage use
⇒ Regulation to directly change use
Policy Options to Externality
The goal is to discourage production and consumption activities that

impose external costs on society.
We can do this in one of two ways:
⇒ Alter market incentives.
⇒ Bypass market incentives.
Market Power as Source of Market Failure
Market power is the ability to alter the market price of a good or

service.
The response to price signals, rather than the signals themselves, may
be flawed.
Market power results from restricted supply due to:
⇒ Copyrights
⇒ Patents
⇒ Control of resources
⇒ Restrictive production agreements
⇒ Efficiencies of large-scale product
Inequity as Source of Market Failure
Inequality entails lack of equitable distribution in the market.

The government alters the distribution of income with taxes and
transfers.
Income transfers – payments to individuals for which no current
goods or services are exchanged.
Is the distribution of goods and services generated by the market
“fair”?
Government intervention may be needed to redistribute income if the
market fails to reflect our notion of fairness.
Government Failure
Government failure occurs when a policy intervention leads to a

deepening of the market failure
Government intervention might worsen, rather than improve market
outcomes
Policies may have damaging long term consequences for the economy
or society
Policies may be ineffective in meeting aims
Government failure – government intervention that fails to improve
economic outcomes.
The challenge for public policy is to decide when any government
intervention is justified, then intervene in a way that improves
outcomes in the least costly way.
Government Failure
When does government step in?

To correct shortages or surpluses
To provide when the market does not or can not
To regulate and correct where there is perceived inequality or
inefficiency
To protect individuals and groups in society and provide a safety net
for those unable to help themselves
To reduce poverty -– To influence property rights
Government Failure
How does government intervene?

Taxation – to redistribute and provide incentive or disincentive effects
Subsidies – to encourage production/consumption
Regulation – guides, codes of practice, legislation, independent
regulators
Identifying property rights – ownership of property, e.g. intellectual
property, granting of patents, etc.
Direct provision of goods and services – health, education, etc.
Government Failure
How does Government Failure manifest itself?

⇒ Distortion of markets–e.g. rent control, minimum wage, agricultural
subsidies, taxes on fuel
⇒ Welfare impact -– erosion of consumer surplus and producer surplus —
e.g. tariff support for manufactured goods and food
Disincentive Effects
⇒ High taxes hampering business expansion or enterprise
⇒ Welfare benefits reducing the incentive to find work
Short termism — solving the ‘hot topics’ of the day rather than the
long term important issues
Electoral Pressure
⇒ Desire to get elected and pass popular policies to capture votes
⇒ e.g. spending on public services at the risk of higher inflation and
future interest rates?
Government Failure
Is the real answer to road congestion building more motorways than
investing in public transport?
Figure: 1 Traffic congestion on highways

Government Failure
Government Failure
End

Lecture 2

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Government Intervention

Four questions of public economics

Economics generally presumes that markets deliver efficient outcomes,

Tax or Subsidize Private Sale or Purchase

Direct effects: The effects of government interventions that would be

There are four sources of market failure, namely

A public good is a good or service whose consumption by one person

Externalities arise whenever the actions of one party make another

for everyone in society, even those without an education.

employment opportunities to others in society which may not otherwise

Negative production externality: When a firm’s production reduces

The goal is to discourage production and consumption activities that

Market power is the ability to alter the market price of a good or

Inequality entails lack of equitable distribution in the market.

Government failure occurs when a policy intervention leads to a

When does government step in?

How does government intervene?

How does Government Failure manifest itself?

Figure: 1 Traffic congestion on highways

Figure: 2 Traffic congestion on highways

Figure: 3 Traffic congestion on highways

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