Market Failures: Government Solutions & Economic Interventions
Market Failures and State Intervention
Market failures often necessitate state intervention to achieve economic efficiency and social welfare.
Understanding Externalities
Externality: Occurs when the production or consumption of goods directly affects consumers or businesses not participating in the purchase or sale, and when those effects are not entirely reflected in market prices.
Externalities may be associated with either production or consumption and can be positive or negative.
Negative Externalities in Production: Pollution
Pollution is a classic example of a negative externality because its significant social cost is not reflected in the market price. A clear example is a paper mill that expels contaminated water into a river. In this case, the social cost is greater than the private cost.
Positive Externalities in Production
This happens when the social cost is less than the private cost. Consider a farmer who produces apples and a beekeeper located on adjacent plots. The bees provide pollination for the apples, which means the private cost of honey production is greater than the social cost due to the added benefit to the apple farmer. Furthermore, the dissemination of technology produced by companies may also be considered a positive externality.
Externalities in Consumption
- Negative Externality: The effect of tobacco smoke on those around the smoker.
- Positive Externality: Education, as a more educated population creates a better society.
To promote or impede such consumption externalities, the State provides subsidies in the case of positive externalities and Pigouvian taxes in the case of negative externalities.
State Instruments to Combat Negative Externalities
Governments employ various instruments to address negative externalities:
Social Regulations: Direct Controls
Direct controls are based on directives where the State gives companies detailed instructions on the technology to be used, the pollution they can emit, and where these measures should be applied. Companies are then required to implement them. Such intervention often receives harsh criticism, arguing that it increases costs, hurts the weakest businesses, and imposes rigid measures.
Market-Based Measures
This category includes two main types of action:
- Imposition of Taxes on Emissions: With the establishment of taxes according to the pollution or waste generated, the company pays the social cost of its activity. However, a tax alone may not maintain precise control over pollution levels.
- Establishment of a Maximum Level of Contamination Through Pollution Licenses: With tradable pollution permits, businesses can acquire the right to emit a certain amount of waste. The State can withdraw or limit this amount by selling or regulating these licenses. This is considered an effective measure as it allows market forces to operate in pollution control.
Public Goods: An Extreme Case of Externality
Public Goods: These are goods where the cost of extending service to an additional person is zero, and it is impossible to exclude anyone from enjoying them. The state usually offers these. There are pure public goods and non-pure public goods; the latter may sometimes be offered by private companies.
Imperfect Information
Asymmetric Information: Occurs when information on the quality and characteristics of goods and services exchanged, or on the actions or characteristics of agents, is not distributed symmetrically among them.