Market Failure and the Role of Government
Chapter 7: Market Failure and the Role of Government
When a market fails to allocate resources efficiently, we call this Market Failure. In such cases, the government intervenes to restore efficiency.
1. Externality
A situation where the actions of one person impose a cost or provide a benefit to a third party without payment being made for it.
| Type | Description | Example | Government Action |
|---|---|---|---|
| Negative Externality | Social Cost > Private Cost (Overproduction) | Pollution, Noise | Pigouvian Tax, Regulation |
| Positive Externality | Social Benefit > Private Benefit (Underproduction) | Basic Research, Landscaping | Subsidies |
Coase Theorem: If property rights are clearly defined and transaction costs are sufficiently low, private parties can negotiate to solve externality problems efficiently without government intervention.
2. Public Goods
Goods or services that can be consumed by everyone simultaneously.
- Characteristics:
- Non-rivalry: One person’s consumption does not reduce the amount available for others.
- Non-exclusivity: People cannot be excluded from consuming the good even if they do not pay for it.
- Market Failure: Because of non-exclusivity, the Free-rider Problem occurs—people enjoy the benefits without paying. Consequently, markets produce less than the socially optimal amount.
3. Information Asymmetry
A situation where one party to a transaction has more information than the other.
- Adverse Selection: Before a transaction, the poorly informed party ends up trading with an undesirable partner (e.g., used car market, insurance). -> Solutions: Signaling (degrees, certifications), Screening.
- Moral Hazard: After a transaction, the poorly informed party cannot observe the other’s behavior, leading to undesirable actions (e.g., principal-agent problem). -> Solutions: Incentive design, Monitoring.
4. Market Failure vs. Government Failure
Government intervention does not always result in the best outcome. Government Failure occurs when interventions worsen resource allocation due to imperfect information, political motives, or bureaucratic inefficiency.
Key Checklist
- A factory emits smoke, causing damage to residents without compensation. Which is larger, private cost or social cost? (Answer: Social cost)
- Which characteristic of public goods leads to the ‘free-rider problem’? (Answer: Non-exclusivity)
- What do we call the phenomenon in the used car market where only low-quality cars are traded? (Answer: Adverse Selection)
- What is the theorem stating that externalities can be solved through negotiation if transaction costs are zero? (Answer: Coase Theorem)
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