MDS 529: Public Finance

Handout 2
The Linkage Between Market Failure and Public Finance

Lecture Overview:

Market failure is a concept in economics where the free-market mechanism fails

to allocate resources efficiently, leading to suboptimal outcomes. In contrast,
public finance deals with the government's role in managing the economy and
addressing societal needs through taxation, spending, and various fiscal policies.
The connection between market failure and public finance is significant because
when markets fail, governments often intervene through public finance measures
to correct these failures and promote economic welfare. In this lecture, we will
explore the linkage between market failure and public finance, along with
examples illustrating how public finance interventions can address market failures
effectively.

2.1 Types of Market Failure in Economics

In a perfectly functioning market, demand and supply interact to determine prices

and allocate resources efficiently. However, in reality, markets can fail to achieve
optimal outcomes due to various factors. When markets fail to allocate resources
efficiently, we refer to this as "market failure." Market failure occurs when the
competitive market equilibrium does not lead to the most efficient allocation of
goods and services, resulting in either over-allocation or under-allocation of
resources. In this lecture, we will explore some common types of market failure
and provide examples for each type.

2.1.1. Externalities:

Externalities occur when the actions of one party in a transaction have an impact
on a third party who is not directly involved in the transaction. Externalities can
be positive (beneficial) or negative (detrimental), depending on whether the
impact is beneficial or detrimental. In the presence of externalities, the market
fails to account for the full social cost or benefit of an activity.

Example:

A classic example of a negative externality is pollution from a factory. The factory's

production processes emit harmful pollutants into the air, affecting the health and
well-being of nearby residents. The cost of pollution is not borne by the factory
but rather by the people living in the area. As a result, the market may
overproduce goods at the expense of the health of the affected community.

Externalities and Public Finance:

Public finance can play a crucial role in addressing externalities through Pigouvian
Taxes/Subsidies. Pigou suggested that governments can solve the problem of
externalities by imposing taxes on goods with negative externalities (e.g., carbon
taxes on polluting industries) and providing subsidies to goods with positive

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externalities (e.g., subsidies on renewable energy). By internalizing external costs
or benefits, these fiscal measures encourage firms and individuals to consider the
broader social impact of their actions, leading to a more efficient allocation of
resources.

For example, a government might levy a Pigouvian tax on emissions from power
plants that release harmful pollutants. This tax would make polluting more
expensive, incentivizing companies to invest in cleaner technologies and reducing
overall pollution levels.

2.1.2. Public Goods:

Public goods are non-excludable and non-rivalrous, meaning that once provided,
they are available to everyone, and one person's consumption does not diminish
its availability to others. Due to the free-rider problem, where individuals can
benefit from public goods without paying for them, the private market tends to
underproduce public goods.

Example:

A riverside walkway or a road can be considered a public good due to its non-
excludable and non-rivalrous nature. Firstly, it is non-excludable, meaning that
once the walkway or road is constructed, it is available for use by anyone in the
community without the possibility of excluding certain individuals. No barriers or
fees can be imposed to prevent people from accessing it. Secondly, it is non-
rivalrous, implying that one person's use of the walkway or road does not diminish
its availability or utility for others. Multiple individuals can enjoy the benefits of
the walkway or road simultaneously without reducing its value. As a result, these
public amenities serve the entire community, offering a shared space for leisure,
recreation, and transportation, enhancing the overall quality of life for residents
and visitors alike.

Public Goods and Public Finance:

In cases where private markets fail to produce public goods efficiently,

governments can step in to directly provide these goods, financed through taxes
or borrowing. This is known as government provision of public goods. Public
finance ensures that the cost of producing public goods is spread across the entire
society, allowing for their equitable provision.

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 Four Types of Goods based on Non-Excludable and Non-Rivalrous
Characteristics
In economics, goods are classified based on their characteristics of excludability
and rivalry in consumption. Non-excludable goods are those that individuals
cannot be easily excluded from using, while non-rivalrous goods are those
whose consumption by one individual does not diminish their availability for
others. Based on these characteristics, four types of goods emerge: public
goods, common goods, club goods, and private goods. Each type plays a crucial
role in shaping economic behavior and resource allocation. In this essay, we will
delve into each type of good and explore their unique attributes and
implications.

1. Public Goods:
Public goods possess both non-excludable and non-rivalrous characteristics.
These goods are available to all members of society, and one person's
consumption of the good does not diminish its availability to others. Public
goods are typically provided by the government or other public entities, as
private markets may fail to produce them efficiently due to the free-rider
problem.

Public goods include national defense, public parks, street lighting, and clean
air. Once these goods are provided, everyone in the community benefits from
them without paying directly for their use.

2. Common Goods:
Common goods exhibit non-excludable characteristics, meaning individuals
cannot be easily excluded from using them. However, they are rivalrous in
consumption, as one person's use of the good reduces its availability for others.
Common goods are often subject to overuse or exploitation, leading to the
"tragedy of the commons."

Fisheries, grazing lands, and natural water bodies like rivers are examples of
common goods. Overfishing or overgrazing in these resources can deplete
them, affecting their sustainability.

3. Club Goods:
Club goods are excludable, meaning access can be restricted to only those who
pay for membership or usage. However, once individuals gain access, the
consumption of club goods becomes non-rivalrous, as one person's use does
not diminish the benefit to others within the club.

Cable television, private parks, and subscription-based online services are

examples of club goods. Once individuals pay for cable TV or a streaming
service, they can enjoy the content without reducing its availability to other
subscribers.

4. Private Goods:
Private goods are both excludable and rivalrous. These goods can be restricted
from those who do not pay for them, and one person's consumption directly
reduces the amount available for others.

Most consumer goods, such as food, clothing, and electronics, are examples of
private goods. When you buy a piece of clothing or eat a meal, others cannot
use that specific item.

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2.1.3. Asymmetric Information:

Asymmetric information can lead to market failure by creating adverse selection

and moral hazard problems. Asymmetric information occurs when one party in a
transaction has more information than the other, leading to imbalances in
decision-making and market outcomes. In situations of asymmetric information,
the uninformed party may make choices that are not in their best interest, leading
to market failure.

Example of Adverse Selection:

Consider an insurance company offering health insurance plans. Due to

asymmetric information, potential policyholders have more knowledge about their
health conditions than the insurer. In this situation, individuals with high-risk
health conditions are more likely to seek insurance coverage, as they expect to
benefit from the policy's extensive coverage and financial protection. However,
healthier individuals, who are less likely to require extensive medical care, might
choose not to purchase insurance, as they perceive it as an unnecessary expense.
As a result, the insurance company is left with a pool of predominantly high-risk
policyholders, leading to higher claims and increased financial strain on the
company. This adverse selection problem can result in the company either raising
premiums for all policyholders or offering less comprehensive coverage, further
exacerbating the issue.

Example of Moral Hazard:

Let's consider an individual who has comprehensive car insurance. With the
knowledge that the insurance company will cover the cost of damages resulting
from accidents, the individual might become less cautious and drive recklessly.
This behavior stems from the reduced personal financial risk associated with
accidents since the insurance company bears most of the financial burden. The
individual's reckless driving is an example of moral hazard, where the presence of
insurance changes their behavior and leads to an increased likelihood of accidents.
Consequently, the insurance company may experience higher claim payouts due
to the insured's riskier behavior, leading to increased costs and potentially
necessitating higher premiums for all policyholders.

Asymmetric Information and Public Finance:

In situations where information is unequal between buyers and sellers, public

finance interventions can help mitigate these issues.

Addressing Adverse Selection:

Risk Pooling and Mandated Coverage: Implementing universal coverage or

mandating participation in insurance plans can help spread risk across a larger
pool of individuals. By ensuring that healthier individuals also participate, the
average risk profile of the insured population becomes more balanced, mitigating
adverse selection.

Risk Adjustment Mechanisms: Governments can implement risk adjustment

mechanisms to compensate insurance companies that cover higher-risk

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individuals. This approach helps prevent insurers from avoiding high-risk
individuals and ensures that they remain financially viable while providing
coverage to all segments of the population.

Community Rating: Enforcing community rating regulations prevents insurance

companies from setting premiums based on individual risk factors. Instead,
premiums are standardized for a particular geographic area or community,
ensuring fair and equitable pricing for all policyholders.

Information Provision: Governments can invest in educating the public about the
importance of insurance and the risks associated with not having coverage.
Increased information can lead to a more informed consumer base, encouraging
healthier individuals to participate in insurance programs.

Addressing Moral Hazard:

Deductibles and Copayments: Introducing deductibles and copayments requires

policyholders to bear a portion of the costs in case of a claim. This encourages
individuals to be more prudent in their behavior and reduces the incentive for
reckless actions.

Usage-Based Insurance: Employing usage-based insurance models, where

premiums are based on actual behavior (e.g., safe driving habits), can incentivize
individuals to adopt responsible actions to reduce insurance costs.

Risk Sharing Agreements: Governments can work with insurance companies to

establish risk-sharing agreements, where insurers and policyholders agree to
share a portion of the losses incurred due to certain behaviors. This encourages
policyholders to be more accountable for their actions.

Regulatory Enforcement: Strengthening enforcement of traffic laws and other

regulations related to insured activities can act as a deterrent to risky behavior,
thereby reducing moral hazard.

Monitoring and Incentives: Governments can implement monitoring systems to

track and reward responsible behavior. For instance, offering premium discounts
or bonuses to policyholders who maintain a good driving record encourages safer
driving habits.

Combining these measures can help governments strike a balance between

promoting fair access to insurance coverage while discouraging behaviors that
contribute to adverse selection and moral hazard.

2.1.4. Market Power:

Market power refers to the ability of a single firm or a group of firms to influence
market prices and quantity. Monopolies and oligopolies are examples of situations
where firms have significant market power. When firms have market power, they
can restrict output and raise prices, leading to inefficiencies.

Example:

Consider a pharmaceutical company with a patent on a life-saving drug. Due to

its monopoly power, the company can set prices at a level that maximizes its

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profits but may be unaffordable for some patients. This results in
underconsumption of the drug and an inefficient allocation of resources.

Or, a telecommunications company holding a monopoly on internet services may

result in higher prices and lower service quality. With no direct competitors, this
company can raise prices to maximize its profits without the fear of losing
customers. As a result, consumers are left with limited options and have to bear
the burden of higher internet service costs. In addition, economists have observed
that a lack of competition can lead to complacency, causing the monopolistic
company to provide subpar services without facing repercussions.

Market Power and Public Finance:

Public finance can address this by promoting competition and preventing

anticompetitive behavior.

For the above telecommunications example, the government could take action by
enacting and enforcing antitrust laws to foster competition and level the playing
field for multiple service providers. This might involve breaking up the monopoly
company into several entities, or facilitating the entry of new companies through
tax/financing benefits, or supporting the growth of existing smaller companies by
imposing restrictions on the growth of the monopolistic entity.

However, in the case of unaffordable prices for life-saving drugs due to

pharmaceutical companies' monopoly power, the government need to strike a
balance between incentivizing innovation in the pharmaceutical industry while
ensuring access to essential medications for patients in need. There are several
potential solutions to this problem. First, price regulation – government can
impose price controls or negotiate drug prices with pharmaceutical companies to
limit excessive pricing. By setting a reasonable price ceiling for life-saving drugs,
the government can prevent monopolistic companies from exploiting their market
power and ensure affordability for patients.

Second, government can compensate the pharmaceutical company for the

innovation and issue compulsory licenses to other pharmaceutical companies
enabling them to produce generic versions of the life-saving drug. This promotes
competition and helps reduce prices. Third, government can allocate public
funds/grants to pharmaceutical companies to support research and development
of life-saving drugs and in return the company commits to work with the
government to negotiate fair prices for life-saving medications. Finally,
government sometimes directly subsidize drug prices for vulnerable populations.
This financial assistance ensures that essential medications remain affordable for
those in need.

2.1.5. Conclusion:

The linkage between market failure and public finance is crucial in ensuring the
efficient allocation of resources and enhancing societal welfare. By utilizing
taxation, subsidies, direct provision, and regulations, governments can correct
market failures and create an environment that fosters economic growth, social
well-being, and equitable outcomes.

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In conclusion, the synergy between market failure and public finance highlights
the importance of a balanced economic system, where both the private and public
sectors collaborate to achieve optimal outcomes for society as a whole.

Note: The examples provided in this lecture are meant to illustrate the concepts
of market failure. In real-world scenarios, the situations can be more complex,
and multiple types of market failures may interact simultaneously.

Prepared by:

ABM Omor Faruque

omor.faruque@du.ac.bd
June 2023
(Please do not reproduce without permission)