Market Failures by Erik F.

Meinhardt

This section sets out to define and describe market failures, how government
intervention prevents them or minimizes their effects, and the arguments
against government intervention.

I. Definitions and descriptions

Market failure occurs when free markets do not bring about economic
efficiency, that is to say when a Pareto sub-optimal allocation of resources
exists in a particular economy. Market failures remain one of the best reasons
for government intervention within an economy on moral and economic
grounds, arguably, in the best interest of the public.

The following are detailed descriptions of several market failures in no

particular order:

A. Public goods—Public goods are goods wherein the consumption of

them does not necessarily prevent another person from also
consuming it, nor does that consumption make less of the good
available for consumption by others. Scholars commonly present
breathable air as an example of a public good for virtually everyone
has access to consume it and its consumption does not limit the
amount available.

Public goods pose a problem for the market because by their nature it
cannot provide for them. The private sector will not make a profit from
a good which everyone can enjoy whether or not they pay for it. The
lighthouse example comes to mind: no matter who pays for the
construction of a lighthouse on a particular island, every passing ship
will benefit from the protection it provides and no way exists for
excluding those who did not pay. In addition, not every rational
consumer (including those who did originally pay) will keep paying for
a public good if they can still benefit from it without paying. The
private sector knows the nature of public goods, and would never build
the lighthouse in the first place.

These things combined mean that the private sector cannot profit and
it will thus under-provide the good. In the case of a lighthouse, if an
island fishing industry relies on the protection from a lighthouse, this
under-provision means that the fishing market will collapse. Hence, we
have a market failure. The market fails to provide essential public
goods. Other examples of public goods are: defense and police forces,
street lighting, roads and infrastructure, public parks, et cetera.
Similarly, “merit goods” include public health services, public
 education, public libraries and museums, public radio/television et
cetera.

B. Imperfect competition—Imperfect competition occurs when an

agent in the market gains market power and the market can no longer
meet the conditions necessary for perfect competition. This means the
agent can alter the price of a good or service within the market without
losing customers because it controls either all or a large portion of the
market. The problem of imperfect competition plagues most markets
and requires government intervention to achieve efficiency, proving
that a pure market cannot be Pareto optimal.

The monopoly, a prime example of imperfect competition, serves as an

appropriate way to demonstrate market failure. In a monopoly, one
firm remains the only seller of a certain product or service, the market
proves difficult to enter into as a seller, there are no comparable
products for consumers, and the firm in control can alter the price of its
good or service as it wishes. This leads the firm to overprice its product
and under-produce it in order to maximize profits. Since it has no
competitive pressures upon it, the firm can do this without losing
customers. Society suffers as a result of the monopoly causing higher
unemployment (no need to hire more employees if a firm can under-
produce) and higher prices. This leads to allocate inefficiency of the
product and a Pareto sub-optimum equilibrium; hence we have a
market failure.

C. Asymmetric information—Information asymmetry occurs when one

party to a transaction has more or better information than the other
party involved. There are two specific examples of the asymmetrical
information problem, which I will explain using the automobile
insurance market as my model:

1. Adverse selection—A risky driver would get a bargain if he/she

purchased automobile insurance; whereas a non-risky driver would
actually lose money. This comes as a result of the insurance
companies not knowing information about whether or not certain
drivers are risky or not. The insurance company must raise
premiums for everyone in order to compensate for the amount it
will dispense on behalf of the risky drivers. Some non-risky drivers
will thus not buy the insurance, leading to a higher rate of risky
drivers buying insurance in general, raising the premiums even
more. The outcome which results from the lack of information
leaves the non-risky drivers priced out of the automobile insurance
market and is inefficient.
 2. Moral hazard—An easy example to explain, this problem occurs
when those who have insurance take greater risks. An uninsured
person would less likely drive riskily than an insured person. When
someone purchases automobile insurance, the cost of his/her
accident is externalized to the insurance company. Thus, it seems
they have a higher likelihood to be more careless and risky when
driving. The insurance company cannot monitor the driving of its
clients and thus, has incomplete information. Again, the insurance
company must raise premiums in order to compensate for those
who will drive riskily as a result of having insurance. This prices out
those who would not drive riskily if they had insurance and leads to
inefficiency.

II. Government intervention

Some scholars argue that government intervention is a good way to prevent

market failures from occurring and to lessen their effects. They argue that
the government does this in the best interest of the people. Many methods
exist for a government to utilize when intervening in the economy. I describe
some of them as follows:

A. Taxation and subsidies—The government frequently uses taxation

(taking money away from agents) and subsidizing (giving money to
agents) in order to correct market failures. Taxation can discourage
certain behaviors like monopolizing and overpricing. It is used to
provide for public sector production of public goods and is also used to
enforce the other government intervention methods. It collects money
to provide for national defense, public infrastructure and roads, public
safety and health services and public schools, libraries and museums.
Subsidies, on the other hand, encourage certain behaviors like
producing a certain good. They can help reduce the cost of paying for
merit goods like education, healthcare, and the arts, for example. Also,
they can encourage production of certain crops and also reduce
scientific research costs for public interest.

B. Public sector production—The government employs this method to

deal with the problem of public good market failures. Using taxation,
the government collects money and then provides public goods—like
national defense or law enforcement, for example—to the citizenry. The
government can also nationalize industries to prevent monopoly and
provide public goods. Public works such as the Hoover Dam can
provide for beneficial infrastructure. Also, by providing for health
insurance, the government can reduce costs and provide a public good
at the same time. By pooling a massive amount of people together to
buy insurance, the cost of insurance is driven down
 C. Antitrust legislation—The government passes these laws to limit the
formation of monopolies and prevent imperfect competition. They
make anti-competitive behavior like price fixing, geographic market
allocation (cartels), and bid rigging illegal.

D. Regulation—The government can require businesses to behave in

certain ways. For example, by forcing car companies to make
automobiles with seatbelts, the government is, in a way, providing a
public good and also reducing insurance costs. Another example of this
is requiring cigarette companies to put health warning labels on their
products. This increases information and reduces insurance costs yet
again.

III. Contra government intervention

Other scholars counter that government intervention to prevent market

failures might not actually solve the problems better than the market. I
summarize some of their arguments as follows:

A. Government failure—The main argument against government

intervention is that the government itself is very inefficient at
regulating the market. Political self-interest has politicians often pork
barrel spending–using taxes and subsidies to favor their own districts
rather than achieving efficiency. Also, lobbyists of certain organizations
can petition for harsher laws against their competitors which create
more imperfect competition. It is also argued that government
intervention in the form of taxes causes disincentives to productivity.
Finally under this heading is the problem of imperfect information—
Pigou argued that regulatory agencies are worse than individual actors
in an economy at gathering information. The government cannot ever
really know enough about people’s wants and needs based on how
they vote.

B. Private production of public goods—Some people think that public

goods can actually be provided for without government intervention.
The simplest example of this relies on charitable giving to provide for
citizens’ education and healthcare.

C. Natural monopoly—Sometimes government intervention is not

needed, as in the case of natural monopolies. This falls under the
theory of contestable markets, but it basically says that competitive
markets and efficiency can be achieved under certain monopoly
situations. Low cost airlines are the best example of a natural
monopoly.