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Market Failure and Governmental Failure

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 II. International Conference on Emprical Economics and Social Science (ICEESS’ 19)
June 20-21-22, 2019 / Bandırma - Turkey

MARKET FAILURE AND GOVERNMENTAL FAILURE

Dr. Şahin KARABULUT*

ABSTRACT

There are many questions such as what should be the role of the government in the economy,
whether it is successful or failure, what is the market's ability to provide economic stability alone, the
impact of government intervention on the market, the role of government or market in healthy
functioning of the system purely.

In this context, in cases where the market fails, Neo-classical economists argue that public
intervention is necessary and legitimate. On the other hand, Public Choice Theory argues that the
government may fail for various reasons just like the market. Therefore, market failure and
governmental failure have been debated for years.

In this study, market failure and governmental failure have been examined theoretically from
various perspectives.

Keywords: Market, Government, Failure, Regulation, Public.

Jel Codes: B13, G28, P43.

1. INTRODUCTION

The market economy is the system in which the producers and consumers freely carry out their
activities in the national economy that expresses all the economic activities. On the other hand, The
regulation of the private sector activities by the state or state-owned production and consumption
activities, such as the private sector, refers to the public economy. Within this structure, whether or not
the market economy alone is sufficient to provide social welfare is an important issue of debate. In other
words, without the public economy, the market is investigated to provide self-optimization. When the
mainstream economic approaches, the Physiocrats and the Classical Economics are examined, they
argue that the economy will be self-balancing by factors such as “Natural Order” and “Invisible Hand”.
The market economy ensures that all resources are effectively distributed and the economy achieves an
optimal level. This is called the “first-best” in the economic literature. In this case, public activities are
the exception in the economy.

*
Karamanoğlu Mehmetbey Üniversitesi, İktisadi ve İdari Bilimler Fakültesi, Maliye Bölümü, e.mail: sahin-
karabulut@hotmail.com, Orcid: 0000-0001-7955-6404.

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However, Neo-classical Economics argues that the market cannot achieve the ideal result due to
externalities, asymmetric information, collective goods, virtuous goods. In this context, “Market Failure
Theory” has been developed. Public regulation is required to ensure the “second-best”. Keynesian
economists have claimed a compensatory fiscal policy in order to overcome adverse market conditions
and to distribute resources effectively in case of market failure. This theory has been successful for many
years and generally accepted. However, until the 1970s, the role and functions of the government in the
economy increased. The public has grown excessively and new problems have emerged due to the
increase of public intervention.

For this reason, “Governmental Failure Theory”, in other words “Non-market Failure Theory”,
was developed by the Public Choice Economists against “Market Failure Theory”. Governmental
failure, in the simplest terms, refers to the negative situation caused by the government’s intervention
and regulations on the economy. This is due to the excessive growth of state functions. The increasing
power and authority of the administrators cause the governmental failure. As a result, the Public Choice
Theory has revealed that the state may fail for various reasons like the market. In this study, market
failure and governmental failure have been examined theoretically from various perspectives.

2. THE CONCEPT OF PUBLIC FINANCE AND MARKET FAILURE

In its simplest form public finance is to manage the goods of the state and it is related with income
and expenditure of public authorities. The word “Public” is used normally for Government or State. All
type of Governments can be included in public authorities. That’s why it can be said that Public Finance
is related with income - expenditure of all type of Governments Centre, State and local and income -
expenditure of all type of Governments (Deco404, 2014: 2).

On the other hand, the state's area of finance is known as public finance and public finance
examines the economic and financial aspects of public sector activities. In this context, it is necessary
to know the characteristics and elements of public sector and the scope and characteristics of economic
and financial activities. These issues are covered by the theory of public finance (Altay, 2017: 24).

When the factors of public finance are examined, four factors emerge. These factors are public
(social) requirements, public goods and services, public expenditures and public revenues. Individuals
cannot meet on their own social requirements but it must be met such as internal security, external
security, justice and diplomacy. These requirements are called as public requirements. Second factor of
public finance is public goods and services. These goods provide the meet of public requirements. In
this area, the army can be given as an example to ensure national security. On the other hand, police
system for individual security, judicial system for justice and parliament for diplomacy are other
examples of public goods and services. Certainly, a certain amount of expenditure is required for the
provision of these public goods and services. These expenditures constitute the third factor of public

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finance, ie public expenditures. In order to finance public expenditures, it is necessary to generate

income from certain sources. In this respect, public revenue is compulsory and this is the last factor of
public finances. Although the government can generate income from many sources such as property,
interest, debt and donation, taxes are the most important and major source of income.

2.1. Market Failure

The First fundamental theorem of welfare economics asserts that the economy is Pareto efficient
only under circumstances or conditions. There are many important conditions under which markets are
not Pareto efficient. These are referred to as market failures, and they provide a rationale for government
activity (Stiglitz, 2000: 77). The reasons that cause this failure are as follows.

 Public (Collective Goods)

 Semi-Public Goods
 Externalities
 Merit and Demerit Goods
 Free Goods
 Imperfect Competition Markets
 Economies of Scale
 Natural Monopoly
 Risks and Uncertainty in Market
A public good is defined as one which is not subject to exclusion and is subject to jointness in its
consumption or use. Characteristics of non-excludability and jointness of consumption or use, create
situations in which market arrangements may fail to meet individual demands for public goods. Special
forms of governmental or quasi-governmental organization are required to deal with these
contingencies. The problems, however, occur largely in relation to the organization of collective
consumption. As long as appropriate collective consumption units are organized, several alternative
options can be used for the production and delivery of public goods and services. These options include
private suppliers as well as governmental agencies serving as suppliers (Ostrom and Ostrom, 1977: 7).
Accordingly, they are often classified as market failures and as justified cases for government
intervention. The public domain appears as a residual category, with states performing tasks that
markets cannot (Kaul and Ronald, 2003: 4).

Quasi-public goods have characteristics of both private and public goods, including partial
excludability, partial rivalry, partial diminishability and partial rejectability. Examples include healthy
and education. Markets for these goods are considered to be incomplete markets and their lack of
provision by free markets would be considered to be inefficient and a market failure (Economics Online,

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2019). If there is only the market in this area, the social cost of it is too much. The social state cannot
be indifferent to these costs.

Externality is the benefit or cost overflow to other producer or consumers resulting from
production or consumption activity. Instances where one individual’s actions impose a cost on others
are referred to as negative externalities. But not all externalities are negative. There are some important
instances of positive externalities, where one individual’s actions confer a benefit upon others (Stiglitz,
2000: 80). Externalities that disrupt the resource disruption cannot be priced that is, out of market. After
all these explanations, government intervention is necessary to resolve the negative externalities that
arise in particular from producer.

Merit goods are private goods useful to society such as vaccine, daycare center, eventide home.
The main problem of these goods is the lack of production in the market. Therefore, the missing part of
production on market that must be produced by the government. On the other hand, demerit goods are
private goods that are harmful to society such as, cigars, marijuana and drugs. The main problem of
these addictive goods is the excessive production in the market and this excessive production must be
by the government. Prohibition and taxation can be used for do this.

Free goods are 'goods', whether consumer goods or productive inputs, which are useful but not
scarce; they are in sufficiently abundant supply that all agents can have as much of them as they wish at
zero social opportunity costs. Any 'gift of nature', whether it be a good such as air, or a primary input
such as labour or land, might be a free good under certain circumstances. But a produced commodity
can be a free good, other than in the market period, only ifit is a joint product. As is at once obvious
from the example of air, the free nature of a good is not an intrinsic property; thus air above the earth's
surface is, in most circumstances, a free good but air under water or in deep mines is not (Steedman,
1989: 158). These goods have common ownership and they do not have a market price. Besides main
problem in these goods is excessive consumption. Excessive consumption cannot be prevented by the
market actors, but government can do this.

The degree of ‘publicness’ refers to the extent to which people can be prevented from benefiting
once the good is provided. In the case of a pure public good, nobody can be prevented from enjoying
the benefits – they cannot be excluded nor do the benefits enjoyed by others reduce the benefit available
to anybody else. A lighthouse is a practical example – passing ships cannot (practically) be prevented
from benefiting simultaneously from its presence. A similar point could be suggested regarding air
traffic control or satellite communications but there is an important difference: it is technically practical
to prevent some from benefiting (from receiving signals). This possibility of exclusion means that such
goods are not purely public. They are described as club goods – only members of the club are granted
the benefits (Morrissey, Velde and Hewitt, 2002: 38). The main problem in club goods is the exclusion

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costs. Government intervention is necessary as these exclusion costs lead to reduced social welfare and
market failure.

In order to achieve Pareto optimum and the first best, perfect competition conditions must be
valid. The conditions of perfect competition consist of atomicity, mobility, transparency, homogeneity
and flat price and all of these conditions must be met in order to achieve perfect competition.
Considering these features perfect competition cannot be achieved due to the absence of one or more of
them. The result is likely to emerge in imperfect competition markets such as monopoly, monopsony,
oligopsony and oligopoly.

There are a variety of reasons why competition may be limited. When average costs of production
decline as a firm produces more, a large firm will have a competitive advantage over a small firm. There
may even be a natural monopoly, a situation where it is cheaper for a single firm to produce the entire
output than for each several firms to produce part of it. On the other hand, firms may also engage in
strategic behavior to discourage competition. They may threaten to cut prices if potential rivals enter,
and such threats may both be credible and serve to discourage entry (Stiglitz, 2000: 78). These markets
that emerged by moving away from ideal market conditions can cause social welfare loss through price
mechanism and wastage. This situation requires the government intervention.

Organizations can give benefit from growth and stability in many ways, including greater
efficiencies through economies of scale, increased organization’s power, the ability to withstand
environmental changes, increased profits, and increased prestige for organizational members. As stated,
a fully developed company can have an advantage when using economies of scale, given the fact that it
can be present in nearly every functions of a business, including manufacturing, purchasing, research
and development, marketing, service network, sales force utilization and distribution. Economies of
scale occur due to increase quantity of output as the average cost per unit of output decreasing, which
often have limits, such as passing the optimum design point where costs per additional unit begin to
increase. Economies of scale are savings because of the size of the company or quantity of output. When
a company is able to reduce unit costs only by increasing output, it is in a position to benefit from
economies of scale. These savings may be due to internal or external factors. Internal factors resulting
from better use of expertise and specialized knowledge within the company. While external factors
obtained from the goodness of industry in a particular location. Nevertheless, in competition
terminology, economies of scale is regarded as creative yet powerful weapon used by larger organization
towards smaller competitor in order to penetrate into competitive market (Ariffin vd., 2016: 3). In this
respect, economies of scale are likely to be the cause of market failure.

Genuine risks and uncertainty characterize the past, present and future and must be taken into
account in any decisions that affect the organizations objectives. In any economic activity risk and

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uncertainty are found combined in different proportions, but uncertainty cannot be eliminated
completely, no matter how complete the risk management may be. Situations and interdependencies not
initially taken into account can occur anytime. Such unforeseen events can cause deviations to
fundamentally change the data configuration. Thus, uncertainty becomes a potential source of risk when
arising from imperfect information or resorting to sources often incompatible with the actual situation
of a business or the competitive market (Toma, Chitita and Sarpe, 2012: 979). Derivative markets consist
of forex, future, forward, option, swap markets and these markets have excessive risks and uncertainty.
Therefore, an intuition such as a government is required to the set the rules and reduce the risk for the
formation of derivative markets.

As a whole, all the explanations so far explain the reasons for the existence of the state in the
economy. The theory of market failure was widely applied and successful until the 1970s. However, the
role and weight of the state in the economy has increased considerably due to these practices. This has
led to excessive growth of the state and disruptions in the economy. As a result of these developments,
public choice economists developed the governmental failure theory.

2.2. Governmental Failure

It has been argued that market failure, due to external economies, public goods, scale of
economies and natural monopolies etc. necessitates government interference with the economy. For
many years, some economists have advocated government intervention to correct market failures. One
of the most important contribution of the Public Choice Theory to the economics is that it developed a
"Theory of Governmental Failure" as opposed to a "Theory of Market Failure" developed within
Theoretical Welfare Economics. By this they argue that government enacted policies produce inefficient
and/or inequitable consequences as a result of the traditional behavior of participants in the political
process. Public choice economists argued that the fact that the market is inefficient does not imply that
government will do any better (Aktan, 2015: 43).

Government failure, then, arises when government has created inefficiencies because it should
not have intervened in the first place or when it could have solved a given problem or set of problems
more efficiently, that is, by generating greater net benefits. In other words, the theoretical benchmark of
Pareto optimality could be used to assess government performance just as it is used to assess market
performance. Of course, the ideal of a completely efficient market is rarely, if ever, observed in practice.
From a policy perspective, market failure should be a matter of concern when market performance
significantly deviates from the appropriate efficiency benchmark. Similarly, a government failure
should call a government intervention into question when economic welfare is actually reduced or when
resources are allocated in a manner that significantly deviates from an appropriate efficiency benchmark

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(Winston, 2006: 2). As a result, the Public Choice Theory has revealed that the state may fail for various
reasons like the market. Some of the reasons for this failure are as follows.

• Lack of full competition in policy

• No transparency in policy

• Lobbying in politics

• Political myopia.

• Political advocacy and partisanship

• Service favoritism

• Unequal distribution of public power and authority

• Waste and extravagance in government spending

Just as the conditions of perfect competition in the market economy are utopian, the conditions
of perfect competition do not apply in politics. Factors such as the lack of full knowledge of voters and
the disappearance of transparency in the political process emerge as factors preventing perfect
competition in politics. Besides, there may be various unfair distributions in the public sector as well as
inequality of income distribution in the market economy. A similar imbalance in income distribution in
the market economy is seen in the distribution of power and authority in the public sector. In the
decisions taken and applications made in the public economy, the habit of short-term thinking is valid.
According to politicians, the best policies are the policies which ensure winning the elections. When
looked in this way, instead of implementing investment projects with important contributions to the
economy in the long term, it is more rational to implement projects that will be directly useful to voters
in the short term. Voters ’tendency to focus on very recent economic conditions at election time may
perversely tempt incumbents to pursue “myopic policies for myopic voters” and this situation is one of
the reasons for political myopia. The governments are always in the tendency of favoring its party
members. As a result of these patronage relations called “clientelistic politics”, economic resources are
distributed to the political supporters and partisan groups by the political power. It must be significantly
stated that the most widespread political external economies are rent creation and rent allocation. In
short, efforts of rent creation, rent allocation and rent seeking are indications of governmental failure.
Politicians, bureaucrats and public officials who spend the state's money in the public economy often
do not pay attention to themselves when they spend their money. People who use or benefit from the
property of the state do not use the same property as they do with their own property. This leads to
wastage and extravagance in public spending and results in governmental failure (Aktan, 2017: 3-9). As
a result, government interventions to compensate for market failures may result in governmental failure.

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3. CONCLUSION

In this study, the theory of market failure and state failure are examined theoretically. The market
itself is undoubtedly not sufficient to achieve Pareto optimum and faces many problems. Therefore, in
order to overcome such failures in case of market failure, it can be said that government intervention is
necessary in these cases. The state can intervene in the market indirectly, by means of regulations, or
directly such as market activity. However, this is a situation that needs to be very careful. If public
intervention is used sufficiently, it is expected to have a positive impact on resource allocation.

However, government intervention to resolve market failures can also fail to achieve a socially
efficient allocation of resources. Government failure is a situation where government intervention in the
economy to correct a market failure creates inefficiency and leads to a misallocation of scarce resources.
As a result, neither the government alone nor the market is far from perfect.

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Aktan, C. C. (2015) “Sources of Governmental Failure and Imperfect Information as Political Failure”,
International Journal of Economics and Finance Studies, 7(2): 42-51.

Aktan, C. C. (2017) “Why Limit Government? An Introduction to the Study of Government Failure
from Public Choice Perspective”, International Journal of Economics and Finance Studies, 9(2):
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Altay, A. (2017) “Kamu Maliyesi”, 3nd Edition, Ankara: Seçkin Yayınları.

Ariffin, S.T., Sulaiman, S., Mohammad, H., Yaman, S.K. and Yunus, R. (2016) “Factors of Economies
of Scale for Construction Contractors”, International Congress on Technology, Engineering, and
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Deco404 (2014) “Public Finance”, New Delhi: Laxmi Publications.

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Steedman, I. (1989) “Free Goods”, Eatwell, J., Milgate M. and Newman P. (eds.) General Equilibrium,
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