Concept of Market Failure and Functions of Government

6 months ago

Atiqur Rahman

18 minutes

Introduction

The market and the government are the two elements of an economic system. Markets are regulated by individuals who are the owners of resources and determine what to produce, how to produce and for whom to produce. It is a system that coordinates the production and consumption of goods and services through a price mechanism.

The transactions between various market participants are voluntary and are targeted to maximize individual objective function. There is little government interference, and competition among market participants regulates the economy.

The government or the state, on the other hand, is an organization that uses coercive force to coordinate people’s activities according to set rules and regulations. It takes responsibility for the provision of goods and services that cannot be provided by the markets, such as public goods, social security, etc.

The operations of these two institutions are interdependent, and the success of an economy depends on how efficiently they coordinate and utilize economic resources.

From Adam Smith to the neo-classical school, everyone recognized the importance of a free market system. Adam Smith argued that the presence of an invisible hand and a free market system would drive the economy to the achievement of total economic welfare. He advocated the removal of trade barriers to improve efficiency in resource allocation.

Neo-classical economists such as Marshall and Walras argued that price mechanisms would ensure competitive equilibrium and maximum total utility where wastes from unsold surpluses and unproductive efforts of looking for commodities in short supply will be avoided.

However, Markets are not able to achieve economic efficiency in all economic activities all the time. There is some dissatisfaction with the way markets operate. It is here where government intervention is required. The following sections will discuss the concept of market failure and the role of government in this regard.

Market Failure

The Neo-Classical school argued that markets result in microeconomic efficient outcomes. Pareto defines microeconomic efficiency/ Pareto optimality as a situation where it is impossible to make one person better off without making someone else worse off.

Market operations do not always result in microeconomic efficiency. Markets may produce too much of goods, may result in externalities such as air pollution and may result in income disparities. Markets fail to achieve an optimum allocation of resources due to the presence of ‘real life’ factors such as inertia, uncertainty, imperfect information, vagaries of aggregate demand, externalities, market power, public goods etc.

Bator (1958) defines market failure as the failure of a system of price market institutions to stop “undesirable” activities, where the desirability of activity is evaluated relative to some explicit economic welfare maximization problem.

Thus, even for the efficient operation of markets, government intervention is required.

In theory, government policy seeks to improve microeconomic efficiency by correcting a market failure. It is required to enforce property rights and contracts to ensure the proper functioning of the markets.

Before discussing the role of government in correcting market failure, it is important to understand the conditions under which markets fail to achieve microeconomic efficiency. Or in other words, there are six forms of market failure.

1. Failure of Competition:

Pareto efficiency/ microeconomic efficiency requires the presence of perfect competition- a large number of firms that cannot exert a force on prices. However, in reality, there are a large number of industries where only firms have market autonomy; that is, there is the presence of monopoly/ oligopoly or monopolistic competition.

These forms of competition violate the first welfare theorem that the competitive equilibrium is Pareto efficient. It requires that there should be perfect competition, and the firms and the households believe that they don’t have any impact on prices, that is, that they act as price takers.

Limited presence or absence of competition may be due to the presence of large firms with cost advantages compared to other firms- a case of natural monopoly, imperfect information on the part of few firms and high transportation costs making it difficult for goods to be sold at many locations. Firms also engage in strategic competition to threaten the entry of new firms. Monopoly power is also gained through government action, such as the grant of patents, copyrights, etc.

We also know that imperfectly competitive firms set their marginal cost equal to marginal revenue to arrive at an equilibrium setting, unlike under perfect competition, where prices are set to equate marginal costs.

Since under imperfect competition, marginal revenue is less than the price, equilibrium output is less than the socially desirable/ competitive output. It denies consumers the benefit of choices, impedes competition and restricts production to create artificial scarcity and higher prices. This deadweight loss is a loss to society and is a social waste.

2. Public Goods:

Public goods have two properties- non-exclusion and non-rivalry. Non-exclusion implies it is impossible to exclude others from the enjoyment/ consumption of a good or service. For example. Streetlights, defence, roads, etc. Non-rival consumption implies that the consumption of a good does not affect the consumption of it by someone else. Such goods can be consumed/ enjoyed by many at the same time at no additional cost.

Private goods completely lack these properties, and markets can achieve efficient resource allocation only to private goods as private property rights are well established.

Moreover, because of the free ridership problem involved in the provision of public goods, private producers will not find it profitable to produce them. Under free ridership, there is the absence of voluntary payment for the consumption of the goods. Individuals refrain from payment, assuming that other consumers will pay for the goods. Thus, Markets fail to efficiently supply public goods, and it provides a strong rationale for government provision of such goods.

3. Externalities:

Markets fail in the presence of externalities. Externalities occur when production or consumption by an individual/ firm affects the production or consumption of others either positively or negatively, and there is no compensation involved.

For example, a chemical plant discharges pollutants in the river stream, imposing costs for downstream users of the rivers, such as fishermen. They may have to spend considerable cost on cleaning up the water.

When such externalities are present, resource allocation by the market will not be efficient. Since producers do not take into account the full costs of negative externalities associated with their production, they tend to overproduce more than the socially optimum. In the case of positive externalities, individuals do not enjoy the full benefits of activities generating positive externalities and, thus, engage in too little of these. Thus, government intervention is required to correct such market failures.

4. Incomplete markets:

It refers to the market failure that occurs when private markets fail in the provision of goods and services even though the cost of providing them is less than what individuals are willing to pay.

Insurance and Capital Markets: The prime example of such market failure relates to markets for insurance and loans. In the insurance market, there are not many private players because of certain important risks involved. In many countries, the government has taken active participation in the insurance sector. There are three important factors due to which such markets are imperfect.

High transaction cost- costs of running the market, enforcing contracts, costs associated with the introduction of new product.
Innovations- The constant innovation of new policies, new products, and new markets.
Asymmetries of information and enforcement costs- Large gaps of information between the buyers and sellers on the qualities of a product and the risks involved.

When there are asymmetries of information and enforcement problems, markets may not exist, or the transactions may be smaller than the socially optimum. Hence, the government has to intervene in such markets to increase the quality of information to the market participants.

Complementary markets: Governments intervene when there is an absence of coordination between different market players. For example, in developing countries, large-scale coordination is required between different agencies- businesses and policymakers etc.

5. Information failures:

The welfare theorems assume that market equilibrium price reflects all the information related to the relative scarcity of resources involved in the production of the products and the relative value placed on these products by the buyers.

It is also assumed that all market participants have complete access to information. When this is the case, market prices plus the market environment reflect all the information needed to make socially optimal choices.

However, we know that information is not equally available to all market participants. For example, Consumers may not be fully aware of the relative merits of competing goods such as financial products.

The insurance market is particularly prone to such information failures. The problem of adverse selection, where it is difficult to differentiate between high-risk and low-risk borrowers, causes such market failures. Thus, government intervention is required so that information is completely disseminated.

6. Unemployment and other macroeconomic disturbances:

Relative high rates of unemployment and inflation are signs of problems with the market system. Economists such as Keynes argue that unemployment is evidence of market failure and advocate government intervention to ensure economic stability.

Moreover, it has an important role in ensuring income equality and social security because the market as a system can ensure economic efficiency but, at the same time, can lead to unequal income distribution. Public policy becomes a necessity to secure objectives of high employment, price stability and economic growth.

It is also argued that individuals may not always act in their best interest, which may result in welfare losses. For example, people who smoke are aware of the ill effects of smoking yet continue to smoke.

Thus, government intervention becomes necessary in this regard, for example, imposing heavy taxes on cigarettes. Such goods fall in the category of merit goods. It calls for the public provision of some goods and restrictions on the consumption of other goods.

Functions of Government

The above paragraphs highlight the need for government intervention in the correction of market failure. The Government is required to ensure that the market outcome is in line with the preferences of individuals and the socio-economic goals of the country. It is required to guide, correct and supplement the market, which cannot solely perform all the economic activities.

For example, in the case of public goods or goods involving externalities. It enforces laws to regulate the industry and control monopolistic behaviour. It may also choose to provide goods produced under economies of scale, such as water, railways, etc.

The major functions of the government are classified into three categories:

1. The Allocation Function:

As discussed, markets fail to supply public goods. Public goods are collectively desired, whereas the need for private goods is felt individually. The markets can efficiently and optimally provide private goods where producers are guided by consumer demands.

However, in the case of public goods, the properties of non-exclusion and non-rivalry make market exchange operations inefficient. It would be inefficient to exclude anyone from partaking in the benefits of the good. From here arises the problem of free ridership. Non-exclusion implies that people can refrain from making payments for the use of public goods, assuming others are paying for it, and thus, they can escape nonpayment.

The government, through the imposition of taxes, can easily solve the problem of the refusal of voluntary payment in the case of public goods. The government must judiciously determine the amount of supply of these goods. Individuals may refrain from revealing their true preferences, and the government may resort to the voting process.

Decision-making through voting becomes a substitute for preference revelation, and taxes become a method of collecting cost shares. Thus, an approximate efficient solution can be achieved through government provision of public goods.

2. The Distribution Function:

The study of economics deals with the efficient utilization of scarce economic resources given the distribution of income and pattern of consumer preferences. Income distribution depends on the distribution of factor endowments that, in turn, is determined by the process of factor pricing.

Under perfect competition, the factors receive the payment equal to the value of the marginal product. However, under imperfect competition, factors receive less than the value of the marginal product.

Moreover, even if factor prices are determined under a competitive setup, it does not guarantee a fair distribution of income. It is difficult to compare individual utilities derived from their income, and moreover, redistribution policies may involve efficiency costs, that is, welfare losses associated with taxation and change in consumer and producer surpluses. Thus, the question- what constitutes a fair distribution is a difficult one.

It is here where the government has to play a critical role. Redistribution is implemented through

Tax transfer scheme- Progressive taxation of high-income groups and provision of subsidies for the low-income group.
Use of progressive taxation to finance programs targeted to benefit low-income groups.
Combination of taxes on goods consumed largely by high-income groups and subsidies on goods consumed largely by low-income groups.

The policymakers, while choosing between the various instruments, must take into account the associated deadweight losses as they interfere with consumer choices. For example, an income tax may lead to a distortion of choice between income and leisure. The ultimate objective must be to minimize the efficiency costs and ensure a balance between equity and efficiency objectives.

3. The Stabilization Function:

The allocation and distribution function of the government exert significant influence on the macroeconomic variables of the country. The market functioning cannot ensure the achievement of objectives such as high employment, price stability, sound balance of payment along with social-economic welfare. The government assumes a greater role in augmenting the market for the achievement of desired macroeconomic goals.

Without proper policies, the economy of any country is subject to wide economic fluctuations such as unemployment and inflation. The great depression is one important example in this regard. It exposed the loopholes of the market system and exhibited the important role played by the governments in the revival of the global economy. In recent years, with the growth of globalization, countries have become even more vulnerable to market fluctuations.

The government can play an instrumental role in affecting aggregate demand- the key parameter affecting employment level and price levels. Aggregate demand depends upon the income of the consumers, which in turn depends on factors such as present and past income, wealth, etc.

These expenditures may be insufficient to ensure the automatic restoration of full employment. Or there may be conditions where expenditure may be more than the output, leading to inflation. In such scenarios, government action through expansionary/ restrictive measures can restore equilibrium conditions.

There are two policy instruments to deal with these problems:

● Fiscal Instruments: Public revenue, public expenditure, and public debt are three fiscal policy instruments through which the government can affect the level of aggregate demand. Tax reduction will lead to higher disposable income and thus will be instrumental in raising aggregate demand.

Similarly, an increase in public expenditure can have an expansionary impact on public and private spending. Public debt, if utilized for improving productive capacity, will be fruitful for both present and future generations. Similarly, restrictive fiscal policy will help to achieve stabilization goals during the period of increasing aggregate demand and high inflation.

● Monetary Instruments: The level of money supply in an economy has an important bearing on the level of interest rates and thus on the level of investment, aggregate demand, inflation and exchange rates and thus on overall economic stability. While an efficient market mechanism can achieve an optimum allocation of resources but it cannot regulate the money supply.

Money supply, if not properly controlled, can lead to adverse consequences. Thus, the central banks of the country are authorized to take care of monetary policy through instruments of reserve requirements, open market operations, discount rates, etc.

During periods of inflation, a tighter monetary policy can lead to a rise in interest rates and help to curb rising aggregate demand. Similarly, an expansionary monetary policy will lead to higher aggregate demand through a rise in liquidity and a consequent fall in interest rates.

Thus, government activities have an important bearing on the state of economic activity and community welfare. The problems associated with market failure can be effectively corrected through a choice of government actions. However, one must note that government policies can err and can be inefficient. Care must be taken to take such inefficiencies into account.

There are two approaches to analysing the public sector activities:

Normative approach– focusing on what the government should do.
Positive approach– focusing on the government’s actual activities and their consequences.

● Normative Analysis: From our discussion, we know that under the presence of imperfect information, incomplete markets, public goods, externalities and macroeconomic disturbance and imperfect competition, markets fail to achieve microeconomic efficiencies.

Hence, a need arises for government intervention. But one must take into account that when markets fail in the presence of incomplete or imperfect information and incur huge transaction costs. So, the government would also not remain immune to such high transaction costs.

Thus, such factors must be taken into account while formalizing a market failure correction strategy. Such intervention can bring about a Pareto improvement (making someone better off without making others worse off).

● Positive Analysis: Many times, market failure has been cited as a basis for identifying situations where the government ought to do something. Many programs are designed just to justify market failure, and there exists divergence between the program’s objective and its design. Thus, care must be taken to ensure that program design is in line with its stated objective.

Moreover, more focus should be kept on the consequences of government activities rather than on what it should do.

Concept of Market Failure and Functions of Government

Introduction

Market Failure

1. Failure of Competition:

2. Public Goods:

3. Externalities:

4. Incomplete markets:

5. Information failures:

6. Unemployment and other macroeconomic disturbances:

Functions of Government

1. The Allocation Function:

2. The Distribution Function:

3. The Stabilization Function:

Read More in: Theory of Public Finance

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Introduction

Market Failure

1. Failure of Competition:

2. Public Goods:

3. Externalities:

4. Incomplete markets:

5. Information failures:

6. Unemployment and other macroeconomic disturbances:

Functions of Government

1. The Allocation Function:

2. The Distribution Function:

3. The Stabilization Function:

Read More in: Theory of Public Finance

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