What is market failure? Market failure is defined as the situation where the free market fails to achieve allocative efficiency – the market fails to achieve an outcome that maximizes society’s welfare. Government intervention during market failure may in certain cases be justified, but in other cases unjustified. This essay intends to discuss if government intervention in markets that fail is justified and effective, by addressing and focusing on the economic problem of externalities, demerit goods, and the lack of provision of public goods.
Governments can utilise various methods to address externalities and demerit goods. Externalities are third party spillover effects, and can be both positive and negative, and can come from consumption or production sides. Demerit goods are goods that either cause negative externalities, or are goods that governments deem unacceptable for their citizens, for instance smoking and gambling. In the case of negative externalities and demerit goods, when goods are over-consumed as their marginal social costs exceed the marginal social benefit, the government may adapt the use of an output tax to prevent the over-consumption of the good.
[Insert a diagram on output tax showing how this policy cures the problem]
Imposing a tax per unit that is equal to the MEC shifts the MPC to the left. The new private equilibrium now coincides with the new social equilibrium Qs where MSB = MSC. Allocative efficiency is achieved as the output has been reduced to the social optimal level and therefore government intervention is justified.
Alternatively, the government may also impose an output quota which is defined as the limit for the quantity that the industry can legally produce, therefore effectively reducing the over-consumption of the good generating either negative externalities or demerit goods.
[Insert a diagram for output quota showing how this policy cures the problem]
The original equilibrium is determined by the intersection of MSC and MSB. When the government imposes a quota, the new equilibrium price increased while output falls. Therefore, the quota effectively increases the equilibrium price and decreases the equilibrium quantity of the good.
In the case of positive externalities and merit goods, the government may choose to adopt the policy of subsidies to effectively reduce the extent of under-consumption of the good, to raise the consumption or production of a good to bring about a more socially desirable outcome.
[Insert diagram on subsidies showing how this policy cures the problem]
Giving producers a per unit subsidy that is equal to MEB lowers their production costs and shifts the MPC to the right. The initial social equilibrium of Qs where MSB = MSC now coincides with the new private equilibrium. Allocative efficiency is now achieved as output is now raised to the socially optimal level.
Alternatively, the government may also provide for the good completely free to the society, so as to reduce the extent of under-consumption of the good that brings about positive externalities or merit goods. Also, in the case of public goods, there is a missing market and usually governments have to provide the good for society. Public goods are goods that are non rival and non excludable, which means that they cannot be "used up" when someone consumes them, such that there is less of the good for others, and which means that no one can be excluded from the consumption of the good, respectively. For instance, defence and street lighting are both public goods because they are non rival and non excludable goods. These two conditions of non-rivalry and non-excludability imply that the good has MC = 0, and also that there will be free riders, and therefore profit oriented companies simply will not produce the good as they are assumed to be profit driven.
[Insert diagram on free provision of goods showing how this policy cures the problems (plural)]
For free provision, the social outcome where output is at Qs, is when MSB = MSC. When the output is subsidized, MSC shifts to the right, where the socially optimal output of Qs is achieved. Therefore the effective price of the good is now zero and the entire cost of the good generating positive externalities or merit goods is now absolutely borne by the government.
However, although government intervention in the market may seemingly be beneficial in helping to shift prices and output to the socially desirable outcomes, they may not always be justified, as there are limitations to it as well. In the case of demerit goods and externalities, high implementation, enforcement and mentoring costs may be incurred by the government in fulfilling its role as an interventionist and thus the total administrative costs may exceed the benefits from implementing such measures, leading to an overall decline in society’s welfare. Taxing the public may also be politically unpopular and therefore hinder governments from implementing such measures by placing political interest over economic ones.
However, although government intervention in the market may seemingly be beneficial in helping to shift prices and output to the socially desirable outcomes, they may not always be justified, as there are limitations to it as well. In the case of demerit goods and externalities, high implementation, enforcement and mentoring costs may be incurred by the government in fulfilling its role as an interventionist and thus the total administrative costs may exceed the benefits from implementing such measures, leading to an overall decline in society’s welfare. Taxing the public may also be politically unpopular and therefore hinder governments from implementing such measures by placing political interest over economic ones.
Moreover, in the case of merit goods and positive externalities, using subsidies to resolve the problems posed may be economically costly and full provision may lead to over-production and over-consumption beyond the socially optimal level and therefore lead to allocative inefficiency as well, therefore proving that government intervention is not justifies and not effective to a large extent.
Hence, in the final analysis, whilst government intervention in the case, where market failure arises, may be beneficial to a limited extent in helping society to maximize its welfare, in the long term, the costs of government intervention may far exceed the short term benefits enjoyed by society as seen in the limitation of using subsidies, quotas, taxes and free provision. Therefore, markets should be rid of government intervention to a maximal extent, because it is only effective in the short run and to minimal extents and therefore is unjustified as a whole.
JC Economics Essays - H1, H2 A level Economics - tutor's comments on the essay: This economics paper is clear cut, direct, and to the point, and tries its best to answer the question. There are of course a few improvements which can be made to it - try to think about what the improvements are. However, more importantly, as this is a 15 mark examination question, it is the part (b) from another part (a) question, and therefore linked to it in a particular way. Economics exam questions on market failure at H1 and H2 levels often ask for explanation in part (a) of the question, followed by deeper analysis and more evaluative comments on the same topic in the second part of the essay. This is an important thing to note - explanation will not get the highest marks here, but analysis and deeper thinking. Perhaps you could focus on the essay's well-written conclusion, which evaluates market failure and the impact of government intervention. This makes this economics essay come to a well-reasoned, nuanced, balanced, evaluative conclusion, which greatly helps the essay get higher examination marks. Thanks for reading and cheers. Special thanks to AG, who will surely be an outstanding undergraduate candidate at Nanyang Technological University, and the other students who made this essay possible: SH, JC, NT, M, and SS. Thanks for reading and cheers.
