how government might deal with market failure

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6.1 External Influences – Economic

Objective – How Government Might Deal with Market Failure (and Other Economic Interventions)

When the free market does not allocate resources efficiently a market failure occurs, reducing overall economic welfare. Governments intervene for three main reasons:

  • To correct market failures and improve allocative efficiency.
  • To support business growth, innovation and employment (enterprise‑encouragement).
  • To constrain activities that threaten health, safety, the environment or consumer rights.

Intervention also helps achieve the macro‑economic objectives of growth, low unemployment, price stability and a stable external balance.

1. Types of Market Failure (Cambridge 9609 6.1.2)

  • Public goods – non‑rival and non‑excludable (e.g. national defence, street lighting).
  • Externalities
    • Negative – costs imposed on third parties (pollution, noise).
    • Positive – benefits enjoyed by third parties (education, vaccination).
  • Information asymmetry – one party has better or more information (used‑car market, financial products).
  • Market power – monopoly or oligopoly that can set price above marginal cost.

2. Government Intervention – Three Broad Categories

  1. Corrective (or regulatory) measures – aim directly at fixing a market failure.
  2. Supportive (or enterprise‑encouragement) measures – help firms grow, innovate and create jobs.
  3. Constraining (or protective) measures – limit or shape business activity for health, safety, environmental or consumer‑protection reasons.

3. Detailed Intervention Table

Market Failure / Policy Goal Intervention Category Tool / Mechanism Purpose / Effect Typical Example
Public Goods Corrective Direct provision Government supplies the good because private firms cannot earn a profit National defence, public parks, street lighting
Corrective Financing through taxation Spreads the cost across all users BBC licence fee, council tax for waste collection
Externalities Corrective Pigouvian tax (per‑unit tax) Internalises the marginal external cost (SMC‑PMC) Carbon tax on CO₂ emissions
Corrective Subsidy (per‑unit payment) Internalises the marginal external benefit (SMB‑PMB) Feed‑in tariffs for renewable electricity, education grants
Corrective Regulation / standards Sets legal limits or performance standards Vehicle emission standards, smoke‑free legislation
Corrective Tradable permits (cap‑and‑trade) Sets an overall cap and lets firms trade allowances EU Emissions Trading Scheme (EU ETS)
Corrective Liability rules (e.g. “polluter pays”) Forces firms to bear the cost of damage they cause Environmental Damage Compensation Act
Information Asymmetry Corrective Consumer‑protection & mandatory disclosure Requires clear labelling, safety warnings and product information Food‑labelling regulations, Financial Conduct Authority (FCA) rules
Market Power (Monopoly/Oligopoly) Corrective Competition policy (antitrust) Prevents abuse of dominant position and promotes competition Break‑up of British Telecom, price‑cap regulation of water utilities
Support for Business & Enterprise Supportive Grants & R&D tax credits Reduce the cost of research and development Innovate UK grant, US R&D Tax Credit
Supportive Low‑interest loans / loan guarantees Lower financing costs for start‑ups and SMEs British Business Bank Start‑Up Loans
Supportive Business‑rate relief & targeted tax reductions Improve profitability and influence location decisions Small‑Business Rate Relief, reduced corporation tax for creative industries
Supportive Apprenticeship & training schemes Raise skill levels and reduce hiring costs UK Apprenticeship Levy, Germany’s Dual Vocational Training
Supportive Export promotion & trade agreements Help firms access overseas markets UK Export Finance, EU Single Market access
Supportive Enterprise zones & tax‑free areas Offer reduced rates of corporation tax, business‑rates relief and simplified planning UK Enterprise Zones, US Opportunity Zones
Supportive Public procurement & innovation hubs Provide a guaranteed market and networking for new technologies Government contracts for green tech, UK Catapult Centres
Constraining Business Activity Constraining Health & safety legislation Mandates risk assessments and safety standards Health and Safety at Work Act (UK)
Constraining Minimum wage / National Living Wage Sets a floor for hourly pay to protect low‑paid workers National Living Wage (UK)
Constraining Licensing & permits Controls entry to regulated sectors (e.g., alcohol, gambling) Liquor licence, Gambling licence
Constraining Environmental caps & technology standards Sets maximum emission levels or requires best‑available‑technology EU Industrial Emissions Directive, UK Climate Change Act
Constraining Consumer‑protection statutes Guarantees rights to refunds, warranties and product safety Consumer Rights Act 2015 (UK)
Constraining Advertising standards & truth‑in‑advertising laws Prevents misleading or harmful promotions Advertising Standards Authority (ASA) rulings

4. Economic Theory Behind Corrective Tools

Negative externality – Social marginal cost (SMC) > Private marginal cost (PMC). A Pigouvian tax t set equal to the marginal external cost aligns the two curves:

\( t = SMC - PMC \)

Positive externality – Social marginal benefit (SMB) > Private marginal benefit (PMB). A subsidy s equal to the marginal external benefit raises the private benefit to the social level:

\( s = SMB - PMB \)

Graphically, a tax shifts the supply curve upward from PMC to SMC, reducing output from the market‑equilibrium quantity Qm to the socially optimal quantity Qs. A subsidy shifts the demand curve upward (or the supply curve downward) to achieve Qs for a positive externality.

5. Macro‑Economic Objectives & Government Policy Tools (Cambridge 9609 6.1.2)

  • Objectives
    • Economic growth
    • Low unemployment
    • Price stability (low inflation)
    • External balance (stable exchange rate)
  • Fiscal policy – changes in government spending and taxation
    • Expansionary: higher spending or tax cuts → AD shifts right → higher output, lower unemployment (possible inflation).
    • Contractionary: lower spending or tax rises → AD shifts left → lower output, reduced inflation.
  • Monetary policy – actions by the central bank
    • Interest‑rate cuts → cheaper borrowing → investment ↑, consumption ↑ → AD right‑shift.
    • Interest‑rate rises → borrowing cost ↑ → investment & consumption ↓ → AD left‑shift.
    • Quantitative easing / open‑market operations affect the money supply and long‑run interest rates.
  • Supply‑side policies – improve productive capacity and potential output
    • Education & training, infrastructure investment, deregulation, tax incentives for R&D, labour‑market reforms.
    • Targeted at increasing long‑run growth without generating inflationary pressure.

These macro tools influence business decisions on:

  • Investment (cost of capital, expected demand)
  • Location (tax incentives, infrastructure quality)
  • Pricing (inflation expectations, tax rates)
  • Labour hiring (minimum wage, unemployment benefits)

6. Evaluation – Advantages and Limitations of Government Intervention

Aspect Advantages (Why it can work) Limitations / Risks (Why it may fail)
Corrective taxes/subsidies Internalise external costs/benefits; move market outcome toward social optimum; revenue can fund other public services. Accurate measurement of marginal external cost/benefit is difficult; may create dead‑weight loss if set incorrectly; administrative costs.
Regulation & standards Provides certainty; can quickly eliminate harmful practices; protects vulnerable groups. Can be inflexible; may increase production costs and reduce competitiveness; risk of regulatory capture.
Competition policy Promotes lower prices, innovation and consumer choice; prevents abuse of market power. Legal battles are lengthy and costly; determining “dominant” position can be subjective.
Supportive measures (grants, tax credits, enterprise zones) Encourages investment, R&D and job creation; can target specific sectors or regions. Potential for rent‑seeking and “dead‑weight” losses if firms would have invested anyway; fiscal cost; may distort competition.
Constraining measures (minimum wage, environmental caps) Protects low‑paid workers and the environment; improves public health and safety. Raises business costs; may lead to reduced employment or relocation; possible black‑market activity.
Macro‑policy (fiscal/monetary) Can stabilise the economy during recession or inflation; influences aggregate demand directly. Time lags (recognition, implementation, impact); risk of crowding‑out private investment; may affect exchange rates and external balance.
Overall – Government failure None – acknowledges that intervention is not automatically beneficial. Policies may be poorly designed, based on inaccurate data, or driven by political lobbying; bureaucracy adds cost; unintended consequences (e.g., black markets, rent‑seeking).

7. Suggested Diagrams for Revision (Cambridge exam expectations)

  • Supply‑and‑demand diagram showing a negative externality: PMC, SMC, market equilibrium (Qm, Pm) and socially optimal equilibrium after a Pigouvian tax (Qs, Ps).
  • Supply‑and‑demand diagram for a positive externality with a subsidy shifting the demand curve upward (or supply downward) to the socially optimal point.
  • AD‑AS diagram illustrating:
    • Expansionary fiscal policy – right‑shift of AD, effect on output and price level.
    • Contractionary monetary policy – left‑shift of AD.
  • IS‑LM diagram showing the impact of a change in interest rates on investment, aggregate demand and equilibrium output.
  • LRAS shift diagram to illustrate supply‑side policies that increase potential output.

8. Key Points to Remember (Exam Checklist)

  1. Market failure provides the economic justification for government action.
  2. Different failures require different corrective tools:
    • Public goods → direct provision or taxation.
    • Externalities → Pigouvian taxes, subsidies, regulation, tradable permits.
    • Information asymmetry → consumer‑protection and mandatory disclosure.
    • Market power → competition policy and price‑cap regulation.
  3. Supportive (enterprise‑encouragement) policies include grants, R&D tax credits, low‑interest loans, apprenticeship schemes, export promotion, enterprise zones and public‑procurement incentives.
  4. Constraining policies protect health, safety, the environment and consumers but increase business costs (minimum wage, health‑and‑safety law, licensing, environmental caps).
  5. Macro‑economic objectives are pursued through fiscal, monetary and supply‑side policies; each influences business decisions on investment, location, pricing and labour.
  6. Evaluation must consider efficiency, equity, administrative cost, time‑lag, possible government failure and unintended side‑effects.

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