Market Failures and Government Intervention in Economics
Market Failures and Economic Inefficiencies
Understanding Externalities
Externalities arise when market prices fail to account for some side effects of production or consumption. An externality exists when the production of a good or its consumption directly affects consumers or businesses not participating in the purchase or sale of this good, and when these effects are not reflected in market prices.
Types of External Effects
- In Production:
- Negative (e.g., air pollution from car manufacturing)
- Positive (e.g., technology spillover, apiculture benefiting nearby agriculture)
- In Consumption:
- Negative (e.g., secondhand smoke from tobacco consumption)
- Positive (e.g., education benefiting society)
Negative Externalities
With negative externalities, markets tend to produce a quantity much larger than is socially desirable.
Internalizing Externalities
To internalize an externality is to alter incentives for people to take into account the external effects of their actions.
Pollution Permits and Licenses
Transferable pollution permits or licenses can also achieve the desired objectives of a pollution tax with relatively lower costs than using direct controls.
Positive Externalities
With positive externalities, markets tend to produce a quantity much smaller than is socially desirable. A market with a positive externality associated with the production or consumption of a commodity will be inefficient. In market equilibrium, the social benefit often exceeds the private benefit, leading to underproduction.
Public Goods and Common Resources
Defining Public Goods
Public goods are goods that can be consumed by everyone without exception, and the cost of extending service to an additional person is zero. (Note: Public goods are typically non-rivalrous and non-excludable, unlike private, rivalrous, or excludable goods).
The Free Rider Problem
A free rider is a person who receives the benefit of a good but avoids paying for it.
Common Resources
Common resources are goods that are rivalrous but not excludable, meaning they are not owned by any particular individual and their use by one person diminishes another’s ability to use them.
The Tragedy of the Commons
The Tragedy of the Commons tells us that common resources are used more than is desirable from the standpoint of society as a whole.
Information Asymmetries
Imperfect Information
Sometimes, due to imperfect information supplied by producers or consumers in markets, well-informed decisions cannot be made.
Asymmetric Information
Asymmetric information occurs when information about the quality and characteristics of goods and services exchanged, or the actions or characteristics of agents, is not symmetrically distributed between consumers and producers.
Government Intervention and Public Policy
Functions of State Intervention
The intervention of the state has three main functions:
- To improve economic efficiency by combating market failures.
- To stabilize the economy and promote economic growth.
- To seek equity by improving income distribution.
Distributive Policy
What is Distributive Policy?
Distributive policy consists of a set of measures that the government aims to modify the primary distribution of income among social groups or individuals to make it more equitable.
Instruments of Distributive Policy
Instruments available include:
- Taxes: Compulsory contributions from citizens and public sector enterprises (direct and indirect).
- Transfers: Payments from the public sector to citizens and companies without direct compensation.
- Direct intervention in the market mechanism.
Poverty and the Welfare State
Understanding the Poverty Rate
The poverty rate is the percentage of the population whose family income is less than an absolute level, known as the poverty line. This level is set by governments according to the size of each family, below which a family is considered to be in poverty. Considerations for defining poverty include family composition, age, and race.
The Welfare State
The emergence of the welfare state means that the state modifies market forces to protect individuals from certain contingencies and guarantee them a minimum standard of living.