Chapter 16
Market
Failures and
Government
Intervention
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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.
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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.
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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.”
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16-4
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.
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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.
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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.
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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).
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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.
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Allocative Inefficiency
External cost of a negative externality
Price
MCS1
p1
pC
p2
S=MCp
MCS2
•
•
External
benefit of
a positive
externality
•
D = MB
Q1 QC Q2
With a negative
externality, a free
market produces
too much of the
product.
With a positive
externality, a free
market produces
too little of the
product.
Quantity
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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
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Table 16.1 Four Types of
Products
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Figure 16.1 An Externality
Leads to Allocative Inefficiency
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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.
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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.
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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.
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Asymmetric Information
APPLYING ECONOMIC CONCEPTS 16.2
Public Goods Experiments in the
Laboratory and in the Classroom
APPLYING ECONOMIC CONCEPTS 16.3
Used Cars and the Market for “Lemons”
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Summary
Four basic causes of market failure:
1. Firms with market power
2. Externalities
3. Common-property resources and public goods
4. Asymmetric information
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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.
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Broader Social Goals
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.
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Broader Social Goals
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.
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Broader Social Goals
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.
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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
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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
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Indirect Costs
Some examples of indirect costs are:
• changes in costs of production
• costs of compliance of regulations
• “rent-seeking” behavior
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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.
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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.
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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
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