Market Failures and Government Intervention

Chapter 16
Market
Failures and
Government
Intervention
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to
1. Explain the “informal” defense of free markets.
2. Define an externality and explain why they lead to allocative

inefficiency.
3. Explain why public goods are underprovided by private
markets.
4. Explain why free markets may not achieve some desirable
social goals.
5. Describe the direct and indirect costs of government
intervention, and some of the important causes of
government failure.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-2
Basic Functions of Government
The operative choice is between which mix of markets and

government intervention best suits people’s hopes and
needs.
When government’s monopoly of violence is secure and

functions with restrictions against its arbitrary use, citizens
can safely carry on their ordinary economic and social
activities.

Basic Functions of Government
Adam Smith (1723-1790)

As the founder of British classical economics, Adam Smith, put it a long
time ago:
“The first duty of the sovereign [is] that of protecting the society
from the violence and invasion of other independent
societies…. The second duty of the sovereign [is] that of
protecting, as far as possible, every member of society from the
injustice of oppression of every other member of it.”

The Case for Free Markets
The formal case for free markets is based on the concept of

allocative efficiency.
The informal case is based on three central arguments:
1. Free markets coordinate actions automatically.

2. The pursuit of profits leads to innovation and rising
material living standards.
3. Free markets decentralize economic power.

Automatic Coordination
A decentralized market system adjusts quickly to changes.
As market conditions change, prices in a market economy

also change — decision makers can react continually.
A market system coordinates without anyone needing to

understand how the whole system works.

Free Markets
Innovation and Growth

Firms in free markets innovate because they get to keep the
rewards.
Similar motives give individuals an incentive to invest in
human capital.
Decentralization of Power
Market systems have less centralized power than planned
economies.

Market Failures
Market failure: a situation in which the free market fails to

achieve allocative efficiency.
Market Power
Firms with market power will typically reduce output below

competitive levels and lead to allocative inefficiency.
This is the motivation for competition policy (Chapter 12).

Externalities
Externality: when actions taken by firms or consumers

impose costs or confer benefits on third parties.
Individual agents care about private costs. But what matters

for allocative efficiency is social cost.
Even if all markets were perfectly competitive, externalities

would lead to allocative inefficiency.

Allocative Inefficiency
External cost of a negative externality

With a negative
externality, a free
MCS1 market produces
Price
S=MCp too much of the

product.
p1 • MCS2
• With a positive
p C
p2 External externality, a free

• benefit of market produces
a positive
externality too little of the
D = MB product.
Q1 QC Q2 Quantity
Nonrivalrous and Nonexcludable Goods
A product is rivalrous if one person’s consumption of it means

that no one else can also consume it.
A product is excludable if people can be prevented from
consuming it.
There are four different types of goods:

- private goods
- public goods
- common-property resources
- excludable but nonrivalrous goods
Table 16.1 Four Types of
Products

Figure 16.1 An Externality
Leads to Allocative Inefficiency

Free-Rider Problem
APPLYING ECONOMIC CONCEPTS 16.1

The World’s Endangered Fish
The existence of public goods and common-property

resources raises the free-rider problem.
The private market will generally not produce efficient

amounts of public goods because it is impractical and
often impossible to make users pay.
Public goods must therefore be provided by government.

Figure 16.2 The Optimal
Provision of a Public Good
How much of a public

good should the
government provide?
The MB curve for society
is the vertical sum of the
individual MB curves.
Therefore, provide the
quantity where MC = MB.

Asymmetric Information
Parties involved in a transaction may have asymmetric

information, leading to market failure.
Moral hazard exists when one party to a transaction has both

the incentive and the ability to shift costs on to the other party.
- often arises with insurance contracts.
Adverse selection refers to the tendency for people who are

more at risk than average to purchase insurance, and for
those who are less at risk to reject insurance.

Asymmetric Information

Public Goods Experiments in the
Laboratory and in the Classroom

Used Cars and the Market for “Lemons”

Summary
Four basic causes of market failure:
1. Firms with market power

2. Externalities
3. Common-property resources and public goods
4. Asymmetric information

Broader Social Goals
Even with no market failures, government may choose to

intervene for other reasons.
Income Distribution
The tax-and-transfer system redistributes income, as do

many policies such as employment insurance and child
benefits.
Policies designed to redistribute income often reduce

economic efficiency.

Preferences for Public Provision

Some things, like justice and police services, are viewed
by most people as being better provided by government
than by the private sector.
Protecting Individuals from Others

Individual freedom generally does not include having the
freedom to harm others.

Paternalism
Some government policies are designed to protect
people from themselves.
Social Responsibility
It is generally illegal to “buy” your way out of mandatory
national service or to sell one’s right to vote.

Economic Growth
Growth in productivity is crucial for increases in our
material living standards.
Governments now routinely ask how various policies will
affect the economy’s growth rate.
A General Principle
Free markets are unlikely to generate outcomes consistent
with most people’s social goals, but …
… there is often a tradeoff between achieving these social
goals and achieving allocative efficiency.
Government Intervention
Governments use cost-benefit analysis to weigh the costs

and benefits of specific policies.
The Tools of Government Intervention
• Public provision
• Redistribution programs
• Regulation

The Costs of Government Intervention
All government intervention involves resource costs.

These costs must be weighed against the potential benefits
of the intervention.
The costs of government intervention are of two types:

- direct costs
- indirect costs

Indirect Costs
Some examples of indirect costs are:
• changes in costs of production

• costs of compliance of regulations
• “rent-seeking” behavior

Government Failure
Some government failure is an inescapable cost of

democratic decision making.
Public choice theory examines the incentives of individual

decision makers and tries to explain political and economic
outcomes.
Government decision makers often face political constraints

that lead them to act against the broad public interest.

Table 16.2 Net Benefits from
Road Construction
Results: Albert and Bob will use democracy to

appropriate resources from Charlene (through taxation)
while reducing economic efficiency.

How Much Should Government
Intervene?
To evaluate the costs and benefits of government

intervention, we must compare two realistic alternatives:
- the free market as it actually works
- government intervention as it actually works
EXTENSIONS IN THEORY 16.2

A Problem with Democracy

Market Failures and Government Intervention

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Chapter 16

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

1. Explain the “informal” defense of free markets.

2. Define an externality and explain why they lead to allocative

The operative choice is between which mix of markets and

When government’s monopoly of violence is secure and

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-3

Adam Smith (1723-1790)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-4

The formal case for free markets is based on the concept of

The informal case is based on three central arguments:

1. Free markets coordinate actions automatically.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-5

A decentralized market system adjusts quickly to changes.

As market conditions change, prices in a market economy

A market system coordinates without anyone needing to

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-6

Innovation and Growth

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-7

Market failure: a situation in which the free market fails to

Firms with market power will typically reduce output below

This is the motivation for competition policy (Chapter 12).

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-8

Externality: when actions taken by firms or consumers

Individual agents care about private costs. But what matters

Even if all markets were perfectly competitive, externalities

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-9

External cost of a negative externality

S=MCp too much of the

p2 External externality, a free

A product is rivalrous if one person’s consumption of it means

There are four different types of goods:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-12

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-13

APPLYING ECONOMIC CONCEPTS 16.1

The existence of public goods and common-property

The private market will generally not produce efficient

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-14

How much of a public

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-15

Parties involved in a transaction may have asymmetric

Moral hazard exists when one party to a transaction has both

Adverse selection refers to the tendency for people who are

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-16

APPLYING ECONOMIC CONCEPTS 16.2

APPLYING ECONOMIC CONCEPTS 16.3

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-17

Four basic causes of market failure:

1. Firms with market power

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-18

Even with no market failures, government may choose to

The tax-and-transfer system redistributes income, as do

Policies designed to redistribute income often reduce

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-19

Preferences for Public Provision

Protecting Individuals from Others

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-20

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-21

Governments use cost-benefit analysis to weigh the costs

The Tools of Government Intervention

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 16-23

All government intervention involves resource costs.

The costs of government intervention are of two types: