Introduction to Economics – 11175

Week 9

Government Intervention in the

market and market failure
 Week 9 Lecture
1. Understand the reasons for government
intervention in the market.

2. Explain positive and negative externalities in

production and consumption.

3. Understand market failure in the context of

common resources and public goods.

4. Evaluate government policies used to correct

for market failure.
What’s good about markets and why
does the government intervene?
• Equilibrium in a competitive market results in the
economically efficient level of output, where marginal
benefit equals marginal cost.

• Also, equilibrium in a competitive market results in the

greatest amount of economic surplus, or total net
benefit to society, from the production of a good or
service.
Competitive market equilibrium

P S

P* P=MC

Q* Q
What’s good about markets and
why does the government
intervene?
The economic bases for government intervention
• Although markets often lead to economic efficiency,
the majority of economists acknowledge the necessity
of some government intervention.
• Eg:- Market Failure - The market fails to produce the
efficient level of output - too many or too few goods
and services consumed or produced [i.e. allocative
inefficiency].
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 General government final
consumption expenditure (% of GDP)
Country 2020 (in %)

Australia 20.9

France 25.1

Germany 22.4

Italy 20.8

Japan 21.0

Sweden 26.7

Switzerland 11.9

United Kingdom 22.2

United States 14.7

Why Government?
What’s good about markets and
why does the government
intervene?
Reasons for government intervention include:
1. Legal System & Rule of Law
• The ability of a government to enforce the laws of
a country, particularly with respect to protecting
private property and enforcing contracts.
What’s good about markets and
why does the government
intervene?
Reasons for government intervention include:
2. Maintaining or enforcing competition
• A lack of competition in the market is a form of market
failure, as it leads to allocative inefficiency - too little is
produced at a price greater than marginal cost.
What’s good about markets and
why does the government
intervene?
Reasons for government intervention include:
• Measures to increase competition:
➢Deregulation
➢ACCC enforcement of the Trade Practices Act
➢Trade reform
➢ Making markets contestable: A contestable market is
one in which the potential for competition exists due to
minimal entry and exit costs.
❑Even monopoly markets may have the potential to be
competitive with government intervention.
What’s good about markets and
why does the government
intervene?
Reasons for government intervention include:
3. Regulating a natural Monopoly
• Natural Monopoly: A situation in which economies of
scale are so large that one firm can supply the entire
market at a lower average cost than can two or more
firms.
➢Regulated prices
➢Third party access
What’s good about markets and why does the
government intervene?
Reasons for government intervention include:
4. Externality: is a benefit or cost that affects someone
who is not directly involved in the production or consumption
of a good or service.
• Negative Externality: occurs when a production or
consumption activity imposes costs on others who are not
directly associated with that activity, and no compensation
is paid.
• Positive externality: occurs when a production or
consumption activity benefits others who are not directly
involved with that activity and who do not pay for it.
What’s good about markets and why does
the government intervene?
Reasons for government intervention include:
Negative externality
• Negative externality in consumption:– cigarette smoking;
Wild parties (when you are not invited) etc.
• Negative externality in production:- noise, air and water
pollution; land degradation and/or contamination; global
warming etc.
What’s good about markets and why does
the government intervene?
Reasons for government intervention include:
Positive externality
• Positive externality in consumption:– education; parents
vaccinating their children…etc.
• Positive externality in production:- research and
development (R&D); displaying beautiful gardens and freshly
painted homes; provision of public transport etc.
Externalities and efficiency
• Economic efficiency is reduced as externalities lead to a
divergence between:
➢ Private benefits and social benefits.
➢ Private costs and social costs.

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Externalities and efficiency
• Private cost: The cost borne by the producer of a good or
service.

• Social cost: The total cost of producing a good or service,

including both the private cost and any external cost.

• Private benefit: The benefit received by the consumer of a

good or service.

• Social benefit: The total benefit from consuming a good or

service, including both the private benefit and any external
benefit.

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 Negative externality in production
• Negative externality in production reduces economic efficiency.
• The social cost of the production activity is greater than the private cost of
production.
• Production occurs at a level that is higher than the socially efficient level, and
price is lower than the socially efficient price.
• A deadweight loss occurs.
• Market failure.
Positive externality in production
• The social cost of the production activity is less than
the private cost of production.
• Production occurs at a level that is lower than the
socially efficient level, and price is higher than the
socially efficient price.
• Deadweight loss occurs.
• Market Failure.
 Positive externality in production
Price of
research Deadweight S1 = private cost
loss
Market S2 = social cost
equilibrium

Positive
PMARKET
externality
PEFFICIENT
Efficient
equilibrium

Demand
0 QMARKET QEFFICIENT Quantity of
research
Copyright ©2016 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781486022847/Hubbard Essentials of 19
Economics/3e
Positive externality in consumption
• The social benefit from the consumption activity is
greater than the private benefit from the activity.
• Consumption and production occurs at a level that is
lower than the socially efficient level, and price is
lower than the socially efficient price.
• Deadweight loss occurs.
• Market failure.
Positive externality in consumption
Negative externality in consumption
• The social benefit from the consumption activity
is less than the private benefit from the activity.
• Consumption occurs at a level that is higher than
the socially efficient level, and price is higher
than the socially efficient price.
• A deadweight loss occurs.
• Market failure.
 Negative externality in consumption

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What causes externalities?
• Externalities and market failure result from
incomplete property rights or from the difficulty of
enforcing property rights in certain situations.

• Property rights: The rights individuals or firms have

to the exclusive use of their property, including the
right to buy or sell it.
 Government Policies to Deal
with Externalities
• Pigovian taxes and subsidies: Government taxes and
subsidies intended to bring about an efficient level of
output in the presence of externalities.

• For a negative externality in production, a tax could be

imposed on production equal to the cost of the
externality.

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Government Policies to Deal with
Externalities
Government Policies to Deal with
Externalities
Government Policies to Deal with
Externalities
Government Policies to Deal with
Externalities
• For a negative externality in consumption, a tax
could be imposed on consumers equal to the cost
of the externality.

• In practice, it is administratively more practical to

place the tax on producers.

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Government Policies to Deal with
Externalities
• Command and control approach: Government-imposed
quantitative limits or regulations on the amount or type of
activity that firms or individuals are allowed to engage in.

• Tradeable emissions allowances: The government can issue a

fixed quantity of emission allowances, which can then be
bought and sold in the market.

➢ Rewards firms who reduce emissions, as they can sell their

allowances. Penalises firms with high emissions, as they must buy
more emission allowances.
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5. Common Resources
• Common resources are rival but non-excludable.
➢All goods differ on the basis of whether their
consumption is rival and/or excludable.

➢Rivalry: The situation that occurs when one person

consuming a unit of a good or service means no one else
can consume it.

➢Excludability: The situation in which anyone who does

not pay for a good or service cannot consume it.
Common Resources

• An extreme case of externalities where no one can

be denied access to the resource, but one person’s
use of the resource reduces the possible use by
others.
Examples:- Tuna in the ocean, public park, clean
air, wildlife.

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Common Resources
• Without government intervention, such as
regulations, people will use too much of a common
resource because:
➢ It is free to use
➢ No one pays for its upkeep
➢ There are no incentives to conserve it.

• Tragedy of the commons: The tendency for a common

resource to be overused.
• Market failure.
Government Policy towards common
resources
Is there a way out of the tragedy of the commons?

• Assigning property rights over the common resource.

• Societal norms and laws on the use of common resources.

• Legal restrictions on access to the common resource.

➢ Taxes.

➢ Licenses.

➢ Tradeable permits.
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➢ Quotas.
 6. Public goods
• A good or service which an additional consumer
does not ‘use up’ or prevent another’s use of it (i.e.
non-rival), and non can be excluded from
consuming the good or service (i.e. non-excludable).
• Examples include national defence and street
lighting.
 Public Goods
• The marginal cost of providing for one extra person is
zero.
• A price cannot be charged (non-excludable). This leads
to the problem of the free-rider. Free riding: Benefiting
from a good without paying for it.
• No incentive for the private sector to provide such
goods.
 7. Merit goods
• A good which is beneficial to society irrespective of
the preferences of consumers.
• Examples include art galleries and museums.
8. Asymmetric Information

• The situation in which one party to an economic

transaction has less information than the other party.

• Adverse selection: The situation in which one party to

a transaction takes advantage of knowing more than
the other party to the transaction.
 Asymmetric Information
Reducing adverse selection in the car market
• Buyers in the used car market fall victim to adverse
selection: the market for ‘lemons’.
• Regulations requiring minimum warranties (free repairs
on the car for a specified time period after purchase)
help to address the problem of adverse selection in the
used car market.
 Other roles for Government
• Income distribution
• Macroeconomic Stabilisation
 Lecture Revision Questions
1. Economic efficiency in a competitive market is achieved
when
A. economic surplus is equal to consumer surplus.
B. consumers and producers are satisfied.
C. the marginal benefit equals the marginal cost from the
last unit sold.
D. producer surplus equals the total amount firms receive
from consumers minus the cost of production
 Lecture Revision Questions
2. An externality is
A. a benefit realised by the purchaser of a good or service.
B. a cost paid for by the producer of a good or service.
C. a benefit or cost experienced by someone who is not a
producer or consumer of a good or service.
D. anything that is external or not relevant to the
production of a good or service
 Lecture Revision Questions
3. Which of the following activities creates a negative
externality?
A. Cleaning up the sidewalk on your block
B. Graduating from university
C. Repainting the house you live in to improve its
appearance
D. Keeping a junked car parked on your front lawn
 Lecture Revision Questions
4. When a negative externality exists, the private market
produces
A. more than the economically efficient output level.
B. less than the economically efficient output level.
C. products at a low opportunity cost.
D. products at a high opportunity cost.
 Lecture Revision Questions
5. Medical research that ends in a cure for a serious disease produces positive
externalities. What is the impact of this positive externality on economic
efficiency?
A. At equilibrium, less than the economically efficient quantity of medical
research is produced.
B. A deadweight loss occurs because, at equilibrium, the marginal social cost
of medical research is greater than the marginal social benefit.
C. At equilibrium, more than the economically efficient quantity of medical
research is produced.
D. A deadweight loss occurs because at equilibrium, the marginal social cost
equals the marginal social benefit.
 Lecture Revision Questions
6. Refer to the figure below. The efficient output is

A. Q1.
B. Q2.
C. Q3.
D. Q4.
 Lecture Revision Questions
7. Refer to the figure below. Suppose the government wants to use a
pigovian tax to bring about the efficient level of production. What should
the value of the tax be?

A. (P2- P1) per tonne of output

B. (P2- P0) per tonne of output
C. (P1- P0) per tonne of output
D. P1 per tonne of output
 Lecture Revision Questions
8. Governments can increase the consumption of a product that
creates positive externalities by
A. subsidising the production of the product so that the supply
is increased and market price is reduced.
B. taxing the production and consumption of the product.
C. convincing everyone to consume the good.
D. assigning property rights to the producers of the product.
 Lecture Revision Questions
9. The 'tragedy of the commons' refers to the phenomenon
where
A. individuals are free riders.
B. people overuse a common resource.
C. people do not internalise an externality.
D. there is rivalry in consumption.
 Lecture Revision Questions
10. Public goods are distinguished by two primary
characteristics. What are they?
A. Non-rivalry and non-excludability
B. Government intervention and low prices
C. Market failure and high prices
D. Rivalry and exclusivity
 Lecture Revision Questions
11. The term that is used to refer to a situation in
which one party to an economic transaction has less
information than the other party is
A. inefficient market hypothesis.
B. moral hazard.
C. information disparity.
D. asymmetric information.