Government Interventions in Market Failures: An Analysis

Governments can sometimes improve market outcomes. Discuss this statement in detail giving examples of situations in microeconomics where Governments should intervene in the markets. Governments can sometimes improve market outcomes. There are two broad reasons why a government may choose to intervene - to promote efficiency and to promote equity. Thus a government may intervene when efficiency and equity are absent, ie. in the case of a market failure. A market failure is when a market on its own fails to produce an efficient allocation of resources. Markets ensure those who can pay for goods get them; there is no equitable distribution of economic well being; for example, income support, welfare housing, public goods etc. This essay will discuss price controls; taxes and subsidies; positive and negative externalities; common resources and public goods; income redistribution; imperfect information and imperfect market structures as examples of situations where governments should intervene in markets. Governments sometimes intervene in the market to set a maximum or minimum price. A price ceiling is a legal maximum on the price at which a good can be sold. For example, in 1973-4 during the OPEC oil embargo, supply shortages in the USA should have rise to 1.50 USD per gallon, however, congress imposed a price ceiling of 0.57 USD. This ceiling had a binding constraint on the market, as the ceiling was below the equilibrium price of 1.50 USD, the market price was 0.57 USD. In the case of a binding limit of price, incentives change. The 1973-4 embargo lead to shortages as buyers were prepared to buy more at a lower price, whereas sellers, in the case of a price ceiling, may cut back production or exit as the market is no longer profitable. The result of price controls as a type of government interference in largely negative; a price ceiling that is not binding - ie. it is above the equilibrium - has no effect on the price or quantity sold. A binding price ceiling leads to shortages which cause negative market outcomes, such as alternative methods of rationing scarce goods among large numbers of potential buyers. The methods include long queues which have an opportunity cost of time, personal bias rationing which is unfair etc. Thus not everyone will benefit even though a ceiling is intended to help buyers by preventing rising prices. In comparison, the rationing mechanism in a free, competitive market is both efficient and impersonal as it rations goods with prices. A price floor is a legal minimum on the price at which a good can be sold. Government often set a minimum wage, which is an important example of a price floor. Like in the case of price ceiling, a price floor that is not binding because it is below the equilibrium price will have no effect. However, when a price floor is above the equilibrium price, this will lead to large surpluses. This can lead to undesirable rationing mechanisms as some sellers are unable to sell all they want at the market price. In a free market, the price serves as the rationing mechanism, and sellers can sell all they want at the equilibrium price. In the labour market, workers determine the supply of labour and firms determine the demand. If the government doesn’t intervene then the wage will adjust to balance labour supply and labour demand. However, if minimum wage is above the equilibrium, the quantity of labour supplied exceeds demand, leading to unemployment. Thus the minimum wage raises the income of those in jobs, but lowers the income of those in the ‘surplus’ who are unable to find a jobs at the market price. Thus these examples of price controls show how market interventions by the government do not always improve outcomes. Taxes and subsidies are another example of market intervention. Governments use taxes to raise revenue for public projects. A tax paid for by the seller will mean that the quantity demanded at any given price stays the same so the demand curve doesn’t change, but the business is less profitable at any given price, raising the cost of producing and selling a good, thus reducing the quantity supplied at any giving price and causing a shift in the supply curve to the left. A tax on a good places a wedge between the price paid by buyers and the price received by sellers. When the market moves to the new equilibrium, buyers pay more for the good and sellers receive less. Thus the government intervention has negative consequences, however, these are largely necessary for the government to raise revenue. Subsidies, in contrast, are a payment to buyers and sellers to supplement income or lower costs, encouraging consumption or providing an advantage to the recipient. For example; EMA Education Maintenance Allowance - is to encourage the consumption of education which has a largely positive outcome for individuals and society as a whole. Free markets allocate the supply of goods to buyers who value them most highly; and the demand for goods to sellers who can produce them at the least cost. Thus free markets produce the quantity of goods that maximises the sum of consumer and producer surplus. Buyers and sellers are led by an invisible hand to an equilibrium that maximises the total benefits to all. The invisible hand means that individuals or groups make decisions which are designed to maximise their individual or group welfare, without taking into account the cost or benefit to society (simply private costs and benefits). However, the free market provides too much of activities which result in negative externalities and too little of activities providing positive benefits. An externality is an unintended third party consequence of production and consumption. Thus because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the equilibrium is not efficient when there are externalities as it fails to maximise the total benefit to society as a whole. The government may respond by trying to influence this behaviour to protect the interests of bystanders. When an externality causes the market to reach an inefficient allocation of resources, the government can respond with command and control policies, which regulate behaviour directly, or market based policies, which provide incentives that private decision makers will choose to solve the problem on their own. This usually considers who is generating the externality producers or consumers. Regulation, legal rules and procedures are examples of methods, making certain behaviours required or forbidden; for example, the smoking ban in public places aims to reduce the negative externality of passive smoking and is applied to consumers. Government may also set legal limits, for example to reduce pollution, that can not be exceeded or a firm will have to cease production for the year; this is an incentive to clean up the production process. However, it can be difficult for government to understand and set targets which are not too lenient or harsh, Whilst this is a command and control policy, taxes and subsidies are market based policies to align private incentives with social efficiency. In the presence of a negative externality, such a pollution, the social cost of the good exceeds the private cost and thus the decision maker must somehow be forced to take into consideration the social costs of the decisions - this is referred to as internalising externalities. For example, a tax on the producer would shift the supply curve upwards by the size of the tax; if the tax accurately reflected the social cost of pollution, the new supply curve would coincide with the social cost curve. Thus in the new market equilibrium, producer would produce the socially optimal quantity. The government must alter incentives so that people take account of the external effects of their actions. For example, in the 2010 budget, the government set the Carbon tax at 15 euros per tonne and raised this to 20 euros in 2012, in an attempt to set a tax equal to marginal damage - ie. the damage caused by each extra tonne of CO2. A tax is enacted to correct the effects of a negative externality and provides an economic incentive to reduce pollution. Thus whilst a government may tax a negative externality, it may seek to subsidise a positive externality. For example, immunisation programmes, greener homes scheme, renewable energy scheme and the bike to work scheme. Tradable permits are also used by the government to improve market outcomes by created a new scarce resource. For example, the EU emissions trading scheme. Pollution permits set the quantity of pollution, which with the demand curve, determines the price. In contrast, a tax sets the price of pollution, which with the demand curve, determines the quantity. However, in the contrast to the idea that governments can sometimes improve market outcomes, the coase theorem suggest that private parties can solve the problem of externalities on their own. For example, the private solutions to externalities may involve private charities and agreements which aim to share the goal of moving resources closer to the social optimum, The private market can reach the efficient outcome without any interference, making everyone better off. Though there are difficulties in reaching agreement, issues of asymmetric information and the assumption of rational behaviour which suggest that the private market may not be up for the job, providing the government with a role to intervene and improve market outcomes. The government may improve market outcomes and choose to intervene in the case of common resources and public goods. The Tragedy of the Commons exemplifies how people are inclined to act in their own interests and contrary to the long term best interest of society as a whole by draining common resources. This is because our social and private incentives differ; no individual has much incentive to cut back on their private use of a common resource; this is called the ‘drop in the ocean’ theory. Thus government has a role in protecting common resources because these are rival goods, yet not excludable. Governments may regulate, tax, impose fees or turn a common resource into a private good to help address the problem of overuse. For example, the depletion of a forest is a common resource which a government may which to protect for economic and environmental reasons; thus it may impose regulations on deforestation to help conserve the forest. The private market has no incentive to produce public goods, thus governments should intervene and decide which goods to provide. This involves a process of cost-benefit analysis. Public goods have collective and social benefits, such as a street-light making a street safer, or a traffic signal reducing car accidents. Other public goods may include libraries for education purposes and a leisure centre for health and fitness. The benefits to a society are great, so a government may choose to intervene (and raise money through taxes) in order to provide non-market goods. Governments may also act to encourage the consumption of merit good, which are usually underconsumed if left to the market as people are unaware of their benefits; for example, education and healthcare. This is often a case of intertemporal choice, when current decisions will affect the future, for example, pensions. The government will often intervene with subsidies or to provide the service free in order to prevent underconsumption and raise public well-being. In addition to this, the government may intervene to help in the case of asymmetric situation and adverse selection to improve market efficiency. Adverse selection occurs where sellers have information that buyers do not - or vice versa about some aspect of product quality. For example, health insurance has the highest take up amongst unhealthy and so the healthy find it difficult to demonstrate their quality, forcing them out of the market. The government can prevent this by providing universal health insurance, medical checks, consumer rights etc. The government may also intervene in market outcomes to prevent the over-consumption of de-merit goods, which often generate social and private costs, for example, to health or by using resourcing like policing. Examples of de-merit goods are the over-consumption of alcohol; alcohol has health costs for the individual, which in turn have impacts on society through perhaps use of hospital beds and resources, and in addition to this, alcohol is often associated with anti-social behaviour like graffiti which may use up policing resources. Thus a government may introduce a tax or minimum pricing on alcohol to discourage consumption. The ‘invisible hand’ acts to allocate resources efficiently but not fairly. Utilitarians, like J.S. Mill, believe that the government should choose policies to maximise the total utility of everyone in society. For example, through Robin Hood taxes which take from the rich and give to the poor. This is because of diminishing marginal utility, meaning that a euro means more to a poor person than a rich person - as income rises, the extra well-being derived from a euro falls. Liberalism, as argued by John Rawls, would determine income distribution as if we were behind ‘a veil of ignorance’ which prevented us knowing our stations in life. Liberals believe in the maximin criteria, that we would choose to have a government which maximises the well being of the worst off person in society. Libertarians, like Robert Nozick, would argue against government intervention in income distribution. The government should enforce individual rights to ensure a fair process - i.e. against stealing - but that is all. Thus equality of opportunity is more important than outcome. The free market is fair; labour and capital are rewarded according to productivity. Minimum wage laws, social security, in kind transfers are all examples of government intervention which aim to help the poor and improve market outcomes. But they can have unintended side effects; such as taxes reducing risk taking of the rich or discouraging work and investment. However, in Ireland, government interventions have helped reduce poverty. For example, income outcomes are relatively unequal in Ireland and social protection improves this. Without social welfare, the numbers in poverty in Ireland would be much larger. Thus government has role to improve market outcomes with regards to income distribution and poverty. The government may also intervene where imperfect market structures exist, for example; regulators, like the Competition Authority in Ireland, are appointed by the government to set rules, behaviours, prices etc. that firms must adopt in order to mimic perfect competition. They seek to prevent the abuses of monopoly power and protect public interests by ensuring prices are not excessive, standards of customer service are upheld and there is an open market with no barriers to entry. Monopolies fail to allocate resources efficiently, they produce less than the socially desirable quantity and charge prices above marginal cost. Consumers have no choice or variety. Most countries have a process to prohibit mergers that are not in public interest, for example, Anti-trust laws exist in most countries. Thus government will usually regulate, legislate, or remove barriers to entry to break up monopolies or restrict their behaviour. In conclusion, the government should get involved in markets when there is an inefficient allocation of resources; for example, in the case of external costs and benefits; the existence of public goods/common resources; and where there is imperfect information and imperfect market structures.