Explain what is meant by ‘market failure’ and consider how far government intervention can reduce market failure.

Cambridge A level June 2019 paper 4

Define market failure: Market failure exists when a free market left to its own devices and free from any form of government intervention, fails to lead to the optimum use of scarce resources.

The price mechanism: The essence of a market system is price mechanism, often quoted as "invisible hand". Operating on its own, without government intervention, price mechanism allocates resources through decisions taken each day by consumers and businesses.

Why market failure occurs: However, the competitive outcome of the free market is not always efficient from the point of view of society as a whole. The market system is believed to have failed as it results in a loss of economic and social welfare.

Market failure explained in terms of :

-lack of knowledge

Merit and demerit goods are examples of imperfect information. Consumers don’t perceive quite well how good or bad a particular product is for them: either they do not have the right information or they simply lack some relevant information. The problem is that imperfect information causes market forces to lead to an inappropriate amount of merit and demerit goods being produced or consumed.


-externalities

An externality occurs whenever actions by firms or consumers impose costs or confer benefits on others who are not involved in the transaction.The essence of the problem created by externalities is that market forces lead to either too little or too much production.

Positive and negative externalities: With a positive externality, a competitive free market produces too little of the good and with a negative externality it produces too much of the good. When negative production externalities exist, social costs exceed private cost.



-public goods

A distinct type of market failure exists in case of public goods.A public good is non-excludible, non-rival and nonrejectable. These features give rise to the free rider problem; people receiving benefits from a good without contributing to its cost. Hence it develops a situation in which everyone believes that others will take on the burden of paying for goods such as national defense and streetlights. Since the exclusion principle does not apply to these goods, private enterprises have no economic incentive to supply them.

A discussion of the forms of government intervention

The role of the government is to intervene in markets that are not seen to be allocating and using resources in the most efficient manner. Government policy and methods of intervention can be summarized under four broad headings: regulation, financial intervention, direct provision and improving information.

-regulation

-state provision

It is possible for a government to take over the production of a good or service, either in whole or in part.
State-owned industries are often referred to as nationalized industries such as electricity, coal mining and railway industries are entirely owned and managed by the state in many countries.
It is also very common to find some goods and services being produced by both the state and the private sectors. Education and health care are particularly good examples of these types of service.

-taxation

In case of financial intervention indirect taxes such as changes in VAT and excise duties can be used to raise the price of demerit goods and products with negative externalities.

-subsidies

Subsidies to consumers will lower the price of merit goods such as grants to students to reduce the internal costs of staying on in full-time education.


The degree to which government intervention can reduce market failure.
However, the critics argue that government intervention does not always improve efficiency.

They believe that the pursuit of self interest, limited information and tendency to look for quick fixes among politicians can result in a further loss of efficiency.

The limits of government knowledge limiting the beneficial outcome.

Even with good intentions governments seldom get their policy application correct.
They can tax, control and regulate but the eventual outcome may be a deepening of the market failure or even worse a new failure may arise.
Thus, a failure to deliver efficient use of resources by the free market system is normally considered as justification for some form of government involvement.