Government interventions for common causes of market failure

Market failure refers to situations when a market fails to deliver an efficient or equitable outcome. 

Efficiency occurs when Social Marginal Cost equals Social Marginal Benefit. 

Equity occurs if a situation or outcome is considered to be fair.

Analysis is no longer restricted to just markets for private goods and services and instead real world examples, where the market impacts on third parties (spillover effects), are now also considered. 

Common causes of market failure in this context relate to:

• consumption externalities
• production externalities
• public goods
• imperfect information
• inequitable income distribution.

Government remedies refer to interventions in a market by central or local government. For example, these may include, for each market failure, a selection from:

• subsidies, taxes, regulations, property rights and government provision (consumption externalities)
• subsidies, taxes, regulations, property rights and government provision (production externalities)
• government provision (public goods)
• regulation (imperfect information)
• progressive taxes, welfare benefits, collective provision and minimum wage (inequitable income distribution).

Teaching and learning for a topic involving market failures from the list above would typically require a minimum of two different market failures to be studied in depth.

Key concept indicators

The indicators below apply to all causes of market failure being studied but to aid understanding examples from negative production externalities have been included.

• Illustrates on an economic model:
  • the market failure. For example, the market graph shows Q_social (that is, where SMC=SMB) to the left of Q_market (as PMC doesn’t include negative spillover effects so is right of SMC)
  • government interventions to remedy the market failure in terms of efficiency and/or equity. Examples could include:
    • a sales tax (which raises the market price to P_tax and lowers the price received by the producer to P_prod causing Qd + Qs to decrease to Q_social and so increase efficiency. Note: Higher market price will reduce vertical equity
    • creating a sellable property right for the externalites which shifts PMC to SMC and so increases efficiency.

Note: Higher market price will reduce vertical equity but it improves horizontal equity as the producer is now paying the full cost of their production.

• Provides detailed explanations ¹ of:
  • the market failure
  • each of the government interventions that could be used to correct the market failure in terms of efficiency or equity.

Note: Detailed explanations should be supported by evidence from the relevant economic model.

• Makes a justified recommendation, in terms of it being more efficient or more equitable, about which government intervention to use to remedy the market failure.

Note: Evidence from economic model(s) illustrating the effect of the government interventions will need to be integrated into the justified recommendation.

For example, when explaining in detail why emission trading is more likely than regulation to be more efficient, the explanation should focus on the incentives of each. Regulation tends to generate an avoidance mentality, like employing lawyers to find ways to avoid the regulation, so producers continue to operate (until caught or the court case goes against them) in ways that pollute since this is their least cost method. On the other hand, reducing pollution is the least cost method when emission trading is introduced (as producers wont have to buy emission units) recognisng the larger shift in Q towards Q_social that occurs with emission trading would be the evidence that should be integrated in the detailed explanation.

1 – detailed explanations to economic questions typically have three parts. For example, What is the answer, Why is this the answer, How do you know?

For example  

Why does an unregulated market with negative externalities of production fail to deliver an allocatively efficient result?

Answer

In an unregulated market producers act in their own self-interest so take account only of their private costs and benefits (so produce at Q_market where PMC + MB intersect). Negative spillover cost resulting from the production (represented by the gap between SMC and PMC up to Q_market ) are born by third parties. Because the total spillover costs are not covered by producer and consumer surplus in the market a deadweight loss occurs (represented by area ABC) and means the market is not allocatively efficient.

Note: Hypothetical evidence has been added to show how an economic model could be used to support a detailed explanation.

Last updated May 10, 2013

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