Government Intervention in The Market

H2 Economics Lecture Notes
Government Intervention in the Market
RAFFLES JUNIOR COLLEGE
JCl H2 ECONOMICS 2007
GOVERNMENT INTERVENTION IN THE MARKET

This theme examines the nature of market failure, its causes and possible policy remedies. Candidates should be able to understand
why markets may not allocate resources efficiently and the methods of dealing with market failure, together with an evaluation of their
effectiveness.
Outline of Contents
1
Rationale for government intervention

1.1 Why governments intervene
1.2 Cost Benefit Analysis (CBA)
1.2.1
How does the cost-benefit approach differ from private sector appraisal?
1.2.2
Framework of CBA
.
Methods by which government intervene
2.1
Externalities
2.1 .1
Government pOlicies towards negative externalities
a) Taxes
b) Legislation or government regulation
c) Education, campaigns and advertisements
d) Nationalisation
2.1.2
Government policies towards positive externalities
a) Subsidies
b) Legislation or government regulation
2.1.3
Direct provision of merit goods
2.2
Direct provision of public goods

2.2.1
Provision of public goods
2.3
Imperfect Markets
2.4
Government policies to redistribute income and wealth

2.4.1
The tax system
2.4.2
Benefits
a) Monetary benefits: Universal and mean-tested
b) Benefits in kind: Direct provision of goods and services
2.4.3
Evaluation of the policy
Government failure
3.1 What is government failure?
3.2 Why are there government failures?
References
1. Sloman, J., Economics, 6th Edition, pp. 308-326, Hertfordshire: Prentice Hall
2. Bamford, Brunskill, Cain, Grant, Munday & Waiton. AS Level and A Level Economics,
Cambridge University Press: 2002. pp. 62-79.
Raffles Junior College
Arts Department (Economics Unit)

Syllabus Content
A. Rationale for government intervention
B. Methods by which government intervene in markets and the impact on market outcomes
> Market dominance - Use of taxes, direct regulation and anti-monopoly policy to
control and regulate large firms
> Externalities - Use of:
o taxes to correct negative externalities

o subsidies to correct positive externalities
o the direct provision of merit goods
> Public Goods - Direct provisions of public goods
> Inequality - Redistribution policies (direct taxes and subsidies), social security
policies to bring about a more equitable distribution of income and wealth
C. Government Failure
Candidates should be able to
>
>
>
>
Understand what is meant by a cost-benefit approach in the context of externalities

Explain why governments intervene in the markets to correct market failures
Explain the various methods by which government intervene in markets and the likely impact
of the methods on market outcomes.
Discuss how governments may create inefficiencies when they intervene in markets due to
factors such as political objectives, administrative costs and lack of information
Arts Department (Economies Unit)

Govern ment Intervention in th e Market

1.
Rationale for government intervention
1.1
Why does a government intervene in a market economy?
Resource allocation in a market economy is based on the price mechanism signalling and
directing resources to the production of goods in accordance with consumer preferences . A
market economy is efficient if certain assumptions are in place:
Sellers have no market power. They cannot reduce output to increase price.
There are no externalities: benefits and costs do not extend to third parties.
All goods are private goods.
'Market failure' is a phrase that can be used to apply to two sets of circumstances.
The first set of circumstance is the failure of the market system to achieve efficient allocation of
resources . There are three reasons for this failure: public goods, externalities and monopoly
power.
Market failure occurs when :
1) The market mechanism fails to supply certain goods or services (public goods)
2) the market mechanism can supply the goods and services but not at the socially efficient level
- when market over-produces or under-produces (externalities)
3) the market-based environment creates firms with strong market power which place consumers
in a disadvantaged position (monopoly power)
The sources for above cases of market failure:
a) Public goods-the properties of these goods (non-rivalry in consumption and non
excludability) enables households to act as free-riders; they will not want to reveal their
demand for the good and therefore firms will face difficulties in charging for
consumption.
b) Externalities-market decisions only consider self interest (private cost and benefit); in
the absence of government intervention firms and households will ignore the effects of
their actions on others (third-party effects). Market over-produces goods with negative
externalities and under-produces goods with positive externalities .
c) Market power-a profit-maximising firm with market power will produce output below
the socially-optimal level at a price greater than marginal cost instead of the output
where price equals marginal cost.
The second set of circumstance is the failure of the market system to serve social goals such as
an equitable distribution of income.
A market economy pays high wages to people whose services are in heavy demand relative to
supply (eg skilled labour) and pays low wages to those whose services are not in heavy demand
relative to supply (eg unskilled labour or those whose skills are no longer useful to employers) .
There is nothing to prevent a group of households from becoming too poor to afford an adequate
amount of goods and services to live on . This unequal distribution of income may not be
acceptable to society's value for fairness .

Goyernment Intervention in the Market
Market failure is a situation where the free market leads to a misallocation of resources . A
particular good in the market is either over-produced or under-produced leading to a less than
optimal outcome. Market failure can also be associated with a market producing a distribution
of income that society finds unacceptable.
All governments in the world intervene to a greater or lesser extent and the reasons for
intervention vary enormously between them. However, the justification for intervention is usually
given under two broad headings:
(1) to achieve allocative efficiency in resource allocation
(2) to achieve a fair or equitable distribution of resources in the economy.
If the main microeconomic objectives of allocative efficiency and equity are not achieved by
markets, there may be a case for a government to intervene to correct a market failure . However,
government intervention does not necessarily always improve the outcome in markets.
Sometimes government intervention make markets worse off than if there was no intervention. In
that case, we have "government failure" (more of that later). But how do we know whether the
government should intervene or not? Government intervention should go ahead if the benefit of
intervention exceeds the cost of intervention. Cost-benefit analysis is the tool used to identify and
measure benefits and costs of government programme aimed at correcting market failure .
1.2
Cost-benefit analysis (CBA)
Definition of CBA: CBA is a technique for evaluating all the costs and benefits i.e. the social
costs and social benefits to society as a whole, arising from a particular economic action or
project in order to decide whether or not it should go ahead.
Market failure occurs when there is a divergence between private and social benefits and costs. It
is in such circumstances that a cost-benefit approach is used by governments as a means of
decision making, not least to ensure that the right choice of action is being made. The analysis
-helps government decide whether to go ahead with various projects such as building a new
motorway, implementing a new health-care programme, etc.
Cost-benefit analysis (CBA) attempts to quantify the opportunity costs to society of the various
possible outcomes or sources of action by establishing whether the benefits to society from the
project outweighs the cost, in which case, the project should go ahead; or whether the costs
outweighs the benefits, in which case it should not.
1.2.1
How does the cost-benefit approach differ from private sector appraisal?
It differs from the private sector methods of appraisal in 2 main respects:
a) It includes all of the costs and benefits, not just private ones.
b) It often has to impute private non-monetary costs and benefits where no market price is
available. E.g. how to value the degradation of scenic beauty or the loss of agricultural land in
the case (say) of building new houses on an attractive area?
Raffles Junior Col/ege

1.2.2
Framework of CBA
There are 4 main stages in the development of a cost-benefit analysis:

Stage 1: Identify all of the relevant costs and benefits arising out of any particular project.
This involves establishing what are the private costs, the private benefits, the external costs and
the external benefits.
There are particular problems when it comes to establishing external costs and benefits. These
are often controversial, not easy to define in a discrete way and have the added difficulty that it is
not possible to draw the line in terms of a physical or geographical cut-off.
Stage 2: Putting a monetary value on the various costs and benefits
This involves assigning a monetary value is to each cost and benefit (i.e . estimates of the
monetary value of non-monetary costs and benefits and externalities are made). This is
necessary as a common unit of measurement is needed to add up all costs and benefits.
However, difficulties in measurement arise when a monetary value has to be imputed for costs
and benefits where no market prices are available. For example, how to put a monetary value on
the cost of accidents, particularly where serious injuries or a loss of life is involved?
Stage 3: Forecasting future benefits and costs (where applicable)
Forecast future costs and benefits where projects have longer-term implications which stretch well
into the future . A value is given to future costs and benefits, as not all of these will occur at the
same time.
Note: Calculations involving discounting for Net Present Value is not required.
Stage 4: Decision Making
The overall costs are compared to the overall benefits; if the costs are less than the benefits the
project should be implemented because allocative efficiency in the economy will improve.
Conversely if costs exceed benefits, the project should not be implemented.
However, in practice, cost-benefit analysis faces a number of problems which include:

, _ which costs and benefits should be included;
how to put monetary valru...:ce.:::.-s-'o:.c..n-'-..t:.:...h:..::e.:.cmc:.:.' --_ _ _ _ _ _ _ _ _---.
Identification
of all relevant costs

and benefits
Putting a monetary
value on all relevant
costs and benefits
Figure 1: Stages in cost-benefit analysis
Arls Deparlment (Economics Unit)

2.
Methods by which government intervene
2.1
Externalities
The government uses taxes or subsidies to make markets take into account externalities. We can
also look at merit and demerit goods as an extension of the idea of externalities:
A merit good may be described as a good that has positive externalities associated with
it but this is not true vice-versa, i.e. not all goods that has positive externalities is
considered as a merit good.
A demerit good may be described as a good that has negative externalities associated
with it.
6ott( d.-v YWO""1' en"",; 'ttilo oce"r
2.1.1
Government policies towards Negative Externalities
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a)
Financial Intervention - Taxes
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A tax would be imposed on the firm that causes the externality; for exalnple a paper-making firm
which pollutes a water-way (negative externalities in production; MSC>MPC). The government
forces the firm to pay for the external cost (the harm inflicted onto third parties as a result of the
pollution). The negative externality (external cost) is said to be internalised by the firm.
Supply curve with tax,

S2 = MSC = MPC + MBC
Price per ton

. ' I
-Le\ ."\
Supply curve without tax,
SJ=MPC
I I
Demand, DJ = MPB
Q2
QI
Tons of paper
per day
Figure 2: Market effects of a tax to correct negative externalities
In Figure 2, without government intervention, the equilibrium point occurs at point E, where
supply, S1, which is given by MPC or marginal private cost, equals demand, 0 1, which is given by
MPB or marginal private benefit. However, if external cost of water pollution is included in this
diagram, then the supply curve becomes S2 or MSC, marginal social cost. The vertical distance
between these two supply curves is marginal external cost, MEC. The socially optimal level of
output is therefore equal to Q2, where 8 2 cuts the demand curve. At this socially optimal level of
output, the marginal external cost is equal to the vertical distance AB .
With government intervention, a (specific) tax equal to the marginal external cost is imposed. This
tax adds to the cost of producing paper and thus the supply curve S2 is also equal to the MPC
plus tax. The price the paper is sold increases from P1 to P2. This is less than the tax applied by
the government.
As a result of the tax, for each unit sold, the producer receives a price P2 from the market but gets
to keep only P3 for himself after the tax is paid. Thus, the producer bears a part of the burden of

the tax (P l-P3). The total tax paid is equal to the area [1 + 2], of which the consumer's share of the
burden is area [1] and the producer's share is area [2].
"'" Evaluation of tax instrument

Merits!Advantages
A tax instrument allows a

market to continue operating
according to market forces and
reach a state of equilibrium. In
contrast, a regulation to control
a negative externality (eg quota
on pollution) does not allow
price to equilibrate quantity
demanded to quantity supplied .
The market (price mechanism)
is not allowed to do its job of
allocating resources.
Taxation provides revenue for
the government to finance
social
and
community
development projects.
Disadvantages/Limitations
The policy requires accurate valuation of the external
cost which in practice is difficult.
An over-valuation of external cost means that output is
below social optimal and the society's welfare is
reduced. An under-valuation of external cost implies
that although output is lowered by the tax, it is not
enough to bring output to the socially optimal level. With
the lack of precision, society's welfare cannot be
maximized .
The effectiveness of tax in reducing production level is
also constrained by price elasticity of demand. Where
demand is highly price inelastic, effect of tax on output
is ineffective unless the tax is very large.
b)
Government regulation
Government regulation is the process of controlling business activities through laws and
administrative rules. The government can pass legislation to prohibit or regulate behaviour that
imposes external cost. To prohibit or limit pollution for instance, legislation can be used in forcing
potential polluters to bear the costs of a more proper disposal of industrial wastes. Such action
forces potential offenders, under the threat of legal action, to bear all the costs associated with
their production .
Evaluation
'
A likely problem with government regulation is that enforcement of regulations may be difficult and
costly. For example, a regulation against excessive pollution requires the government to spend
resources to check factory by factory, firm by firm, how much and what kinds of pollutants are
being emitted. If the chances of being caught and the penalties for being caught are small, the
regulation may have little effectiveness.
c)
Provision of Information
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The direct provision of information by the government is a'imed at educating the public about the
external costs of some goods. It is hoped that, as a result, consumption of the goods would be
discouraged. The demand curve will shift leftwards, lowering the equilibrium output to the optimal
output.
Evaluation
However, to be efficient, the costs of these measures must not outweigh the benefits as a result
of them, Furthermore, one must consider the duration needed for the effects of such measures to
be felt, especially if the problem of external cost is a serious one which must be dealt with in the
short run ,
d)
Nationalisation
Governments can ensure the "correct" quantity of a good is produced by producing the good
itself. (This will be reviewed in a later topic "Firms and How They Operate",)

2.1.2 Government policies towards Positive Externalities

a)
Subsidies
Financial intervention to overcome market failure caused by external benefits or positive
externalities will take the form of a subsidy. A subsidy can be made either to the producer or
consumer. If the socially optimal output is produced and consumed, with the imposition of a
subsidy, the external benefitS3re said to be internalised.
i)
Positive externality in consumption

In Figure 4a, the equilibrium without government intervention is at point C where
MPC = MPS. In this case, the marginal external benefit is added to the MPS curve
to give the MSS curve. The MSS represents society's demand curve for the
product. With government intervention, a subsidy of AS per unit to consumers will
shift the demand curve from MPS to MSS resulting in an efficient level of output,
Q2.
Price
MSC
= MPC
P2 .....
(' I r
:./'
MSB
"'(', .
=MPB + MEB
Quantity
Figure 4a: External Benefit (Consumption) and use of subsidies
i)
Positive externality in production
Price
S[ =MPC
S2= MPC - subsidy
D2 = MSB =MPB + MEB

DI =MPB
Fig 4b
External benefits and use of a subsidy
Quantity
Subsidies to producers reduce the cost of supplying the product into the market. This is shown in
Figure 4b. The equilibrium without government intervention is at point F where MPC = MPS or D

= S1 . In this case, marginal external benefit is added to the MPB curve to give the MSB or
marginal social benefit curve. The MSB represents society's demand curve for the product.
If the government subsidises the production of this product, the supply curve moves to the right
from S1 to S2, which equals MPC minus the subsidy. The marginal cost of supplying the good is
reduced by the amount of subsidy and the vertical distance GH is equal to the value of the
subsidy provided . Thus, the equilibrium after the subsidy is given by the point H, which is where
0 1 crosses S2 and the optimal amount of goods O2 is sold by the market.
Very often, the issue being discussed pertaining to government subsidy in the supply of merit
goods is not about whether the government should be involved but rather how much should public
resources be allocated to subsidising merit goods and which merit goods deserve more resources
than others? The constraints on government budget and the distributive effects (who get to enjoy
government subsidies) are the main issues in discussions.
Eva uaf I on 0 f po rICY

Merits/Advantages
subsidy is considered the most

correct
the
effective
way
to
misallocation of resources arising from
positive externalities since it can be
easily implemented to bring about an
production
and
in
increase
consumption .
Demerits/Disadvantages
The valuation of the external benefit generated

at the social optimal output level is in practice a
difficult task. An overestimation will lead to over
consumption of the good. An underestimation
will lead to less than social optimal consumption
but at this level it is at least more than the
market equilibrium level.
High government expenditure is required to

provide for the subsidy required ~ which will
require high tax rates that can subsequently
discourage effort and investment in the country.
b)
Legislation or government regulation
Legislation and regulations are reiatively easier to implement. Examples include regulations on
use of crash helmets or car seat belts; regulations requiring landowners or households to
maintain their property in good condition; laws on compulsory education .
The problem with all legislation/regulation is in enforcement. Constant checking is needed and
this can translate into high costs for the government.
C)
Nationalisation
.
Governments can ensure the "right" amount of a good is produced by producing the good itself.
(This will be reviewed next term under "Firms and How They Operate".)
2.1.3
Direct Provision of Merit Goods
Recall that a merit good:

is a good whose consumption the government encourages eg education.
tends to be under-consumed because individuals under estimate its benefits.
A merit good is under consumed due to the divergence between individual and government
preferences on these goods. For the case of merit goods, the government could provide goods
and services directly; for example, healttl and education. There are 4 reasons why some merit
goods are provided free or at below cost: '
a) Social justice: Society may feel that such goods should not be provided according to ability
to pay. Rather because of their intrinsic desirability, merit goods should be accessible to all.


b) Large positive externalities: People, other than the consumer may benefit substantially. If a
person decides to get treatment for an infectious disease, other people benefit by not being
infected. A free health service thus helps to combat the spread of disease.
c) Dependants: If education were not free, and if the quality of education depended on the
amount spent, and if parents could choose how much or little to buy, then the quality of
children's education would depend not just on their parent's income, but also on how much
they cared. A government may choose to provide such things free in order to protect children
from 'bad' parents. A similar argument is used for providing free prescriptions and dental
treatment for all children.
d) Ignorance: Consumers may not realise how much they will benefit. If they had to pay, they
might choose (unwisely) to go without. Providing health care free may persuade people to
consult their doctors before a complaint becorfles serious.
If we accept the argument that education provides external benefit, then one solution would be to
provide a subsidy to education. In Singapore, for example, the government subsidises primary,
secondary and university education. Students (parents) will still have to pay towards their
education in the form of a fee, which can be represented by P3 in Figure 5. The government
provides the difference between P2 and P3 by providing a subsidy (AB).
Price
MSC
=MPC
MSB
=MPB + MEB
MPB
Quantitv
Figure 5: External benefits and use of subsidies
2.2
Direct Provision of Pure Public Goods
In the case of public goods and services, such as streets, pavements, national defence, etc, the
market fails to provide. In this case, the government must take over the role of provision . To
decide on the amount of public goods to provide, the government uses CBA. If the social benefits
of a project exceed the social cost, then it will be socially efficient to provide the good. To decide
on the amount of public goods to provide, the government uses CBA. If the social benefits of a
project exceed the social cost, then it will be allocatively efficient to provide the good.
RECALL
The free market may fail to produce public goods. There maybe consumer
demand for such products (consumers are willing and able, in principle to pay
for the product's services), but the free market may not have a mechanism for
guaranteeing their production. This is due to the problem of 'free-riding'. No
one is prepared to purchase the product as there is a strong incentive to wait
for someone else to do so and then to enjoy the benefit without incurring any
cost. If everyone behaves in this way, then the product is not produced.

2.2.1 Provision of a pure public good

With a pure public good, once it is provided, the marginal cost of supplying one more consumer is
zero. Assuming no external costs, MSC is zero. Thus MSB = MSC at a price of zero dollars. Zero
dollars is thus the socially efficient price.
Example: A lighthouse, once constructed and in operation , there is no extra cost of providing the
service to additional passing ships. Even if it were possible to charge ships each time they make
use of it, it would not be socially desirable.
Note: The term 'public good' does not mean that the good is supplied by government! The term
'public' refers to the way the good is consumed - non-rival and non-excludable.
2.3
Imperfect Markets
(To be covered next term under a topic: "Firms and How They Operate".)
2.4
Government policies to redistribute income and wealth
If there are concerns that the free market leads to inequity then there are policies that the
government can try to use to reduce inequality in wealth and income. There are 3 main types of
policies that are available:
2.4.1 The Tax System
A tax system can reduce inequalities in income and wealth. In particular, a progressive tax system
that takes a larger percentage of income from those who earned high incomes than those who
earned a lower level of income will reduce income differentials. That is, the average rate of tax
rises as people earn higher incomes. Most income tax systems are progressive in nature.
Taxes can be imposed upon wealth in order to reduce wealth inequalities. One example might be
inheritance tax. Individuals who inherit more than a certain amount of wealth may have to pay
seme gf the value of that wealth in tax to the government.
2.4.2 Benefits
A progressive tax system reduces the gap in income and wealth between the rich and the poor.
This gap is further reduced if the poor received benefits from the government. The poor could
receive both monetary benefits and benefits in kind .
a) Monetary benefits refer to financial payments
b) Benefits in kind refer to provision of goods and services free to the poor
a) Monetary Benefits
A simple way to redistribute income is to pay benefits to those on low incomes. Money is raised
through the tax system and then paid to low income individuals and families in order to increase
their disposable income. There are two types of such benefits :
i)
Means-tested benefits: These benefits, such as income support, are

paid to those with low income. Recipients of such benefits have to
prove that their incomes are below a certain level. An example would
be unemployment benefit. However, they are not always claimed by
.those for w.hom they are designed because of thea:rIDcuJiy in 3QQ!ying
Jor these benefits (hard-to-understand forms to fill up). They can also
~reate a
disincentive to work. If .such benefits are reduced through an
Cash given to people

who meet a test of
need based on
income.
individual earning
9

more, then there is an incentive not to ~arn mOLe .

-- ---ii)
Universal benefits: These are paid out to everyone in certain categories regardless of
their wealth and income. Examples include state pensions, sickness benefit and child
-- Oenelif~Such benefits ~ome the twoproblem~ associated wi!b mean-tested benefits.
However, they imply ,.p..ayjng_out .money tg- many Wh9 do not need it and therefore tend to
..be expensive to operate.
b) The direct provision of goods and services

A further way of reducing inequalities in society is for the government to provide certain important
services free of charge to the user. Such services are financed through the tax system. If such
services are used equally by all citizens, then those on lowest incomes gain most as a percentage
of their income. Inequality is thus lowered.
The two most significant examples of such free provision in many contemporary societies are
health care and education. These markets are characterised by various market failures. However,
these failures do not, according to standard economic theory, justify free provision to the
consumer. The justification must thus be on the grounds of equity. The view is that everyone
should have access to a certain level of health care and education regardless of wealth and
income. Thus , these services are provided universally free: they are the material equivalent of
monetary universal benefits .
2.4.3 Evaluation of Policy
A progressive tax combined with mean-tested benefits and universal benefits targeted at groups
prone to poverty, will redistribute income from rich to poor. Such a tax system, however, do cause
problems.
,
o If a tax is too progressive it will act as a disincentive to work and effort especially for those
earning higher incomes as they are taxed more.
<...
o~ Means-tested benefits are often expensive to administer and have low take-up rates
because some people find forms difficult to fill in or feel embarras~ed to apply.
o Universal benefits are more straightforward to administer and do not have a stigma
~ttached to them, but soLiiie o f the mon~y may go to those who do not need Tt.
3.
Government Failure
3.1
What is Government Failure?
All real-world markets fail in some way. When a government intervenes to address a market
failure, allocative efficiency may not necessarily improve. It could worsen.
Government Failure refers to situations where allocative efficiency is reduced following
government intervention to correct market failures .
3.2
Why are there Government Failures?
Some actions by a government have unintended effects. Government attempts to offset market
failures either by removing market forces or cushioning their effect (by the use of subsidies,
welfare provisions, guaranteed prices or wages, etc); can prevent the market from dealing with
the problem more effectively. The difficulty is that generally, the market's ways of dealing with
problems work only in the long run. As government deals with the short-run problems, it
eliminates the incentives that would have brought about a long-run market solution. For example,
subsidies may allow inefficient firms to survive. The market may be imperfect, but it does tend to
10

encourage efficiency by allowing the efficient to receive greater rewards. Hence, government
intervention may create further inefficiencies and thus not improve the use of scarce resources in
a society. The reasons for government failure (why government intervention makes things worse)
are:
1) Problem of Incentives
Government intervention in the economy may create undesirable incentives that create
inefficiencies. Some examples of the ways this can happen are:
,. The imposition of taxes can distort incentives.
o If a high marginal tax rate is imposed on income, it discourages people from
working harder to gain more income since most of the additional income will be
taxed away . .Scarce labour resource becomes less productively efficient.
o Disincentive to consume and produce created by the tax leading to the wrong
amount of a product being produced.
4 Desire by politicians to get elected. So popular policies are introduced to capture votes eg
.minimum wage law . ...::., ('.
..
4 Those running public services may have inappropriate incentives. Once products are
provided by the government, then the profit motive of the private sector is largely removed.
The question then remains as to what may be the incentives to those in charge of
providing public services. There is no entirely clear answer to this question. At its worst, it
could become a total lack of incentive to produce the product well or attempts to defraud
the system.
- - - - . _. - .. --.
2) Problems of Information
Regulating is a difficult business. To intervene effectively, even if it wants to, the government must
have good information; but just as the market often lacks adequate information, so does the
government. Very often the government may not know the full costs and benefits of its policies. It
may -genuinely wish to P'iJrSue the interests of consumers or any other group and yet, may be
unaware of people's wishes or misinterpret their behaviour. Hence, they may tmLoduce policies
t~acLtQgLeater economic inefficiency. Examples include:
4 A lack of information about the true value of a negative externality. It is often very 9ifficult
to obtain ao a_ccur~te v.alue of a negative externality such as pollution. It is oifficult both
to put an accuratE; figure to all of the costs imposed and to trace the source of the
pOiTu-tfon itself. The problem with this is that it then becomes very difficult to impose the
corcect val~_e of a tax that attempts to reduce production to an efficient level. The wrong
I.evel of tax will lead to the wrong level of production.
4 ,A I",ck of information .abQut the level of consumer demand of a product. If the
government is providing a product free of charge to the consumer, then some estimation
of the level of consumer demand is required. This could be the case with a public good,
such as a lighthouse or a national defence system . Such products may not be provided
by the market system and thus the government provides them. However, the
government must try to provide the right amount of such products. If it does not estimate
the level of demand accurately, then the wrong amount of the product may be produced
and thus there is .allocative inefficiency.
11

Goyernment InteNention in the Market
3) Problems of Distribution
Government intervention in the running of the economy is often justified by the need to reduce
inequity. However, it is possible that government intervention might sometimes increase inequity.
For example, the imposition of any tax will have a distributional effect. Thus a tax on energy use
that aims to reduce harmful emissions of green house gases will have different effect on different
groups of people. If the tax is on the use of domestic fuel (such as Kerosene in Indonesia), then
low income households may feel the greatest effect as the tax on fuel oil may make the life of the
poor worse as they use proportionately more domestic fuel than others in society. This could be
.
seen as unfair and increasing inequity in society. - /
4) The bureaucracy and inefficiency of government intervention
Government intervention involves administrative costs. The more wide-reaching and detailed the
intervention, the greater the number of people and material resources that will be involved. If the
state employs too many -.)sources or uses them ineffiCiently, economic welfare will be reduced .
(Recall: One of the Microeconomic objectives is to allocate scarce resources efficiently;
productive & allocative efficiency.)
I
5) Time lags
It takes time for a government to recognise that market failure is occurring, to draw up an
appropriate policy measure and to implement it. By the time policy measures are introduced, the
problems may have become acute, requiring more radical measures, or economic circumstances
may have changed, necessitating different measures.
6) Shifts in government policy
The economic efficiency of an industry may suffer if government intervention changes too
frequently. It makes it difficult for firms to plan ahead if they cannot predict tax rates, subsidies,
price and wage controls.
12
H2 Economics lC 1 2007
Lecture note on Market Failure: Government Intervention
In case you have not already done so, please make the necessary amendments to the
figure 4b on page 6 of your lecture notes.
i)
Remove the areas "1" to "4"
ii)
Remove "E"
iii)
Output QI and Q2 on the horizontal axis
Thank you.
Price
External
SI =MPC
benefit
S2= MPC - subsidy
P2
PI
P3
._._ . _ . _._.
D{ ='MSB =MPB + MEB

DI =MPB
Fig4b
Q\
Socially
optimal output
Quantity

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H2 Economics Lecture Notes