Market Failure and The Role of Government

Market Failure and The Role of Government – An imperfect market outcome can be corrected by a change in the incentive structure or reallocation of resources. Economists often differ in their opinion about the type of market failure and the corrective measures required to resolve it.

What is a Market Failure?

It’s impossible to correct market failures concept without understanding what it exactly is and why it stays. The most common interpretation of a market failure—failing to attain the standards of “a perfect competition in the general equilibrium of economics”— is easily identifiable in most, if not all the markets. While the price equilibrium is a shifting target, consider all sellers and buyers in the market as sprinters in a race, with the exception that the finishing line keeps changing between right, left, up and down.

A better pragmatic interpretation of market failures is where the economic participants aren’t properly incentivized for pushing the markets towards more acceptable results. This is also where the most academic literature on market failure is concentrated.

A market failure has a negative effect on the economy due to the non-optimal allocation of resources. In other words, the social cost to manufacture the goods or services i.e. all the opportunity costs of input resources used in the creation, are not minimized. This also leads to the wastage of resources.

Take for instance the common argument regarding the minimum wage laws. The law sets wages above the prevalent market clearing wage to raise the market wages. Many critics argue that the higher wage cost would lead to employers hiring a lesser number of minimum wage employees than before the regulation was enacted. It led to more minimum wage laborers being unemployed, forging a social cost that led to market failure.

Market Failure

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Reasons for Market Failure

Market failures happen because of the inefficiency to correctly allocate the goods and services. The price mechanism fails to factor in all the costs and benefits involved while providing a particular goods or service. In such cases, the market won’t produce goods that are socially optimal. They will be either under or overproduced.

To fully understand concept of market failure, it’s pertinent that we recognize the reasons behind it. Because of the structure, it’s impossible for markets to be perfect. Most markets, as a result, are unsuccessful and need some kind of intervention.

Following are some of the key reasons of a market failure.

  • Positive and negative externalities: An externality is the effect on a third party which is usually caused by availing a particular good or service. Positive externality is the optimistic spillover which is gained from the goods or service. For instance, while public education may directly affect only the schools and their students, an educated population will extend positive effects on the society as a whole. A negative externality, on the other hand, is a pessimistic spillover effect on a third party. For instance, passive smoking could adversely affect people’s health, even if they don’t directly indulge in smoking.
  • Environmental concerns: Effects on environment as an important consideration along with sustainable development.
  • Lack of public goods: Public goods are those where the cost of production doesn’t increase with number of customers. For instance, a lighthouse has a fixed cost of production which remains the same throughout, regardless of whether just one ship or hundreds of ship use it. Public goods and services could be under-produced. There is little benefit, from the private sector, to erect a lighthouse because one can wait for somebody else to provide it, and then use the light, sans incurring any cost. Someone deriving the benefits of a product or service, without paying for it, is called a free rider problem.
  • Underproduction of merit goods: Merit goods are private sector products that the society believes is under-consumed. Healthcare, education, sports centers etc are considered as merit goods.
  • Over provision of demerit goods: Demerit goods are just the opposite of merit goods, in that the society believes is over-consumed, mostly with negative externalities. These include alcohol, cigarette, drugs and similar things.
  • Abuse of monopoly power: An imperfect market restricts the output in attempts to maximize profits.


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Probable corrective action for Market Failure

Using the definition of a broad perfect competition, a market failure can be usually corrected by allowing consumers and competing sellers to shove the market towards equilibrium over a period of time. Markets often tend to constantly move towards equilibrium, but never quite attaining it because of limitation to human knowledge, besides changes in global situations.

Many policy experts and economists seek possible regulations and interventions for compensating a perceived market failure. Subsidies, tariffs, punitive or redistributive taxation, trade restrictions, disclosure mandates, price ceilings and several other economic distortions were mooted to correct inefficient outcomes.

Other economic experts argue that a market is recognizably imperfect. Market failures, however, are improperly framed. Instead of asking whether market failures are related to perfect competition, they say that the question must revolve around whether a market performs better than other processes which humans may trigger.

Free market economists like Milton Friedman, FA Hayek, and others, have argued that a market is the only recognized discovery process capable to adjust correctly to all inefficiencies. They say that a regulation can interfere with the process causing inefficiencies to deteriorate than better.

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Here are some actions that can be adopted to resolve a market failure.

  • Control of monopoly:

A monopoly power in the market can be controlled by the government by passing restrictive trade practice legislation and anti-monopoly laws. These regulations are targeted to remove unfair competition in the market, prevent iniquitous price discrimination and fixing prices that equal to competitive prices.

The government may also deescalate all monopoly prices to a competitive level via taxation and price regulation. The authorities may enforce a price ceiling to bring down monopoly pricing to near or equal to a competitive price. This is usually achieved by setting up of a commission that fixes the price of a monopoly goods or service, below the monopoly price.

Taxation is another way of controlling monopoly power during a market failure. Taxes could be levied lumpsum, irrespective of the output of the monopolist. The tax could also be proportional to the output i.e. the taxable amount rising with a rise in output. In both cases, the target is to bring down the monopoly to a competitive level.

Eminent English economist, Arthur Cecil Pigou, favored nationalizing monopoly for ending monopoly power.

  • External factors:

Pigou suggested social control measures and using subsidies and taxes to achieve an optimal allocation of resources in the face of various externalities. The government can interfere, in all cases, an external diseconomy of production for removing any divergence between social and private costs and benefits. The government in that case can ask the business owner for moving out of the residential area by extending appropriate facilities to a smoke emitting workshop. He said that in case of any external diseconomy of consumption, the government could end the noise pollution by banning loudspeakers, except during a special occasion in specific hours with prior permission.

externalities market failure

Pigou also suggested the government to encourage production of goods and services with positive externalities by granting subsidies on each unit of product or service by the manufacturer. This will also help buyers to maximize their satisfaction by tax concession so that they can buy more commodities. Negative externalities often discourage sellers from production, and buyers from consumption by levying taxes, Pigou claimed.

The government, for instance, can impose a tax on every family living in an area, and thus collect the entire sum to pay the smoke emitting factory to relocate. In this way, subsidies and taxes can help bridge the gap between social and private costs and benefits.

Unitization or internalization of the externalities in production, is another commonly suggested measure. Firms engaged in oil production in the same field, for instance, could lead to over-pumping and over drilling. With the merger or unitization of the firms, oil can be extracted more efficiently sans a diseconomy of production.

  • Public goods

All public goods are non-rivaled and non-excluded and hence they are not available in the free market. Private companies can’t provide these public goods and services. They can be provided only by the public authority. Benefits of public goods and services can’t be divided. The government must make people share costs of public utilities so that each of them is better off.


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One way of paying for public goods and services is to charge each person an equal proportion of the maximum amount he/she is ready to pay, instead of forsaking the product, while fixing that proportion to cover the entire cost of production. In case of special public goods like defense materials, the government may itself produce them or buy from private firms that meet all relevant production guidelines. So far the “free rider” issue is concerned, whereby utility services like police, firefighting etc are provided free to all users. The government can provide them from tax revenues.

  • Increasing returns to scale

Opinions largely differ about the government’s role to provide solutions to market failure in case of increasing returns to scale. Many economists and policymakers have opined that a government must nationalize industries that operate under decreasing costs, leading to overproduction. But many others disapprove of this idea. They feel government control could make matters worse. Yet others suggest that the private sector must produce goods and services and the government must impose a price regulation and tax them so that private and social costs and benefits can be balanced.

  • Indivisibles:

The solution to the problem of indivisibility in case of goods and services that are jointly used by several persons, like paved roads, street lights, traffic signals etc, local authorities like the civic corporation, has to spend on its maintenance and repairs. The cost in this regard has to be collected from the residents of a particular area or those who use the service.

  • Property rights and the Coase Theorem:

Common property rights lead to external situations. “Who owns property, to what uses it can be put, the rights people have over it and how it may be transferred,” are the issues related to property rights. Everyone has a right to prevent people imposing costs on them. Public properties like parks, civic services, libraries etc can be included in this.

The second solution could be to distribute wealth from the rich to the poor. But it’s more a question of changing the property rights, instead of extending ownership rights. Such a solution, however, won’t be practical.

The third solution could be for the government to charge for damages or compensating for them. However, it involves the problem to compensate those who acquired a property a much lesser cost because of the damage.

The fourth option is to move the court for monetary damages by the party which has been harmed because of the externality. British economist and author, Ronal Coase, suggested that a market failure, because of property rights, could be eliminated via mutual bargaining among the involved parties. He pointed out that property rights must be marketable and clearly defined, with transactions costs at zero. Only then will a perfectly competitive economy allocate optimal resources even under externalities. This is called the Coase Theorem.

market failure

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  • Missing markets:

To rectify a market failure concept in the case of incomplete or missing markets, where two products are produced jointly, Nobel laureates Gerard Debreu and Kenneth Arrow suggested separate markets, where each product and service may be traded to a point where the private and social marginal benefits equal the two’s marginal costs. This will lead to the optimal allocation and utilization of resources.

Final words

Correcting the market, when it fails, is one of the most important responsibilities of the government. The private sector too has to play a part by not resorting to unfair practices. Correcting market failure is a major component of welfare economics. Falling markets have an impact on the overall economy of a country. With globalization being the norm today, a fall in one country’s market, has a ripple effect on others. So when Dow Jones takes a hit, the effects can be felt on Nikkei and other indexes.

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