GOVERNMENT POLICIES TO ACHIEVE EFFICIENT RESOURCE
ALLOCATION AND CORRECT MARKET FAILURE
By Abeer Nabeel Habresh
Market failure is the economic situation where by the market forces of
demand and supply do not achieve efficiency ie.there is inefficient distribution
of goods and services in a free market.
Examples may include;
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Lack of public goods
Underproduction of merit goods
Overconsumption of demerit goods
Information failure
etc.
Market failures leads to negative externalities such as through the
overconsumption of demerit goods e.g.; cigarettes leading to air pollution and
harm to the health of third parties such as lung cancer, this lead to costs such
as medical costs, as a result governments intervene in markets to try to
eliminate or reduce market failures.
This can be done through the following ways;
1.SPECIFIC AND ADVALOREM INDIRECT TAXES.
Indirect taxes are those charged on goods and services not directly to income
and profits. These can be of different forms such as specific and advalorem tax
whereby specific taxes are in the form of a fixed amount per unit whereas
advalorem taxes are at a proportion of the price charge for the good. As a
result, with advalorem taxes there will be a higher tax charge when the price is
higher.
Indirect taxes are used to discourage the production and consumption of
demerit goods such as cigarettes, this is because the consumption of these
products causes more harm to the direct consumer than they realise i.e.,
health problems, and they cause negative externalities such as air pollution,
and so the government may impose these taxes which may work as follows;
As the tax charge is imposed, producers or retailers are liable to pay a certain
amount per product, this acts as an increase in cost per unit and so firms need
to increase prices in order to get the same return per unit as before, the
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possibility of doing this will depend on the elasticity of demand for the product
where by the more elastic the demand for a product is the more likely firms
are to pass on a higher proportion of the cost of the tax to consumers in terms
of higher prices, as a result, with the high cost fewer units of output will be
supplied which will work in solving the market failure of overproduction and
through higher prices consumers may reduce their consumption therefore
reducing overconsumption. This can be shown using the diagram below;
Advalorem tax
Specific Tax
The effectiveness of this policy may depend on several factors such as;
the elasticity of demand, where by the more elastic the demand the firm
will be less able to transfer more of the tax to consumers with higher
prices as the demand will fall by a higher percentage, also there is a
possibility of tax evasion which will lead to producers not paying their
tax charge and the taxes not being able to work their function in
addressing the overconsumption and overproduction of demerit goods.
Therefore, the government should make sure to conduct thorough
research before deciding on whether to tax, which product to tax and
how much to tax.
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2.SUBSIDIES
Subsidies are direct payments made by the government to producers of goods
and services. This is done to provide a financial incentive for the firm to
increase their output and so can be used by the government to try to address
underproduction and underconsumption of merit goods e.g., Education.
This is done because merit goods provide more private benefits as well as
external benefits which are not realized and considered by the consumers.
This measure works by providing a financial help to firms which acts as a
reduction in costs allowing firms to increase their supply without having to
invest as much per product i.e., the marginal cost. As a result, firms’ supply
curve will shift outwards i.e., to S1 a which increase output therefore reducing
underproduction and as output increases, prices will also decrease i.e., to P1
which will encourage greater consumption which will reduce the market failure
of underconsumption of merit goods. This effect can be illustrated by the
following diagram;
The effectiveness of this policy will depend on whether the firms will pass on
some or more of the benefit of the subsidies to consumers in terms of lower
prices whereby the more price inelastic the demand is the less proportion of
the subsidy will be passed on because consumers are not sensitive to price
changes and so higher prices will maximise profit for producers as a result, the
subsidy is less likely to work in solving the market failure.
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3.PRICE CONTROLS
Price controls refers to the means of correcting market failure through setting
price boundaries which includes maximum and minimum price.
i)Maximum price is a price that is fixed where firms can not legally exceed this
price, it is also known as a price ceiling. An effective maximum price is set
below the market price.
This form of intervention will force producers to reduce their prices ie.for
staple food items, petrol, rent, utilities etc., for example from Pe to Pmax this
will make them more affordable to customers allowing them to purchase more
of such goods with their current level of income, as a result consumption of
these goods will increase and consumers will gain greater welfare and utility
therefore improving living standards.
This policy may also be used for merit goods which are underconsumed in a
free market such as education, thus helping to reduce or correct the market
failure of underconsumption of merit goods.
However, this kind of policy will lead to a shortage(Q2-Q1) in the market, this is
because the financial incentive for producers to supply more will decrease. To
correct this, a government can impose a policy of buffer stock schemes where
they should take it upon themselves to supply the shortage amount i.e., Q2Q1, by doing this, a higher quantity of the merit goods will be supplied at the
lower prices thus encouraging consumers to consume more of such goods
therefore making the policy more effective.
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ii)Minimum price is a price that is fixed where firms can not charge below this
price, this ia also known as a price floor. An effective minimum price is set
above the market price.
This policy can be used by the government on overconsumed demerit goods
such as cigarettes, it works by forcing producers to increase their prices i.e.,
from P1 to Pmin, which means that consumers will have to pay more for the
same amount of goods therefore discouraging their purchase, as a result they
will buy fewer goods i.e., Q3 to Q1 or their income will not be able to afford as
much cigarettes as before there reducing consumption. As a result, negative
externalities caused by the previously overconsumed demerit goods will
decrease such as air pollution therefore the policy is working to tackle the
market failure as shown in the diagram below;
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This policy will be effective in increasing the price of demerit goods however
the extent to which it will work to reduce consumption depends on the
elasticity of demand whereby if the demand for the good is inelastic e.g.,
because of addiction, then consumption of the goods will reduce by a smaller
percentage thus making the policy less elastic. The more elastic the demand
for the demerit good is the more effective the policy will be.
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4.PRODUCTION QUOTAS
Production quotas are limits or restrictions set by the government on the
quantity of a particular goods or service that can be produced. This can be
used to tackle the market failure of overproduction of demerit goods or goods
whose production cause a lot of environmental impacts.
By setting these quotas on demerit goods such as cigarettes whereby a limit
will be set below the market quantity and producers cannot produce anymore
beyond that quantity, this will reduce the amount of cigarettes in the domestic
market leading to fewer cigarettes being smoked, as a result there will be
lower private and external costs such as air pollution and people having more
income to spend on other more beneficial areas of expenditure such as food,
therefore living standard in the economy will increase.
This policy will be effective in the short run as there will be a shortage of the
demerit goods in the market however in the long run, such goods may be
imported and black markets may develop therefore, to avoid this the
government should ensure laws and regulations are set to reduce the extent of
these issues.
5.PROHIBITIONS AND LICENCES.
Prohibitions refer to the outright banning of certain activities or products that
have a negative impact on the society. This can be used by the government to
correct the market failure of the overproduction and overconsumption of
demerit goods.
This can be applied for example to harmful drugs. The government prohibiting
the sale and purchase of such goods will ensure that no one consumes such
goods in the society this is because such goods cause negative effects such as
increased crime rates, unsafe environment etc. and so they should make sure
anyone who breaks this law faces serious consequences for it.
This policy is highly effective if serious consequences are set such as long jail
time and a regulatory body such as a good police force is set to investigate any
suspicions and make sure the law is being followed.
License refers to a permit to do something, this can be used in the way that
certain activities such as providing healthcare facilities need a license to ensure
that certain standards are met so as to avoid people receiving treatments from
unqualified individuals such as people pretending to be doctors, this can be
done by the government to avoid risk to people’s lives from receiving e.g.,
unsafe medicine and treatments from unqualified people.
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6. REGULATIONS AND DEREGULATIONS.
Regulations refer to rules or laws set by the government to control and guide
economic activities. These can be used to address issues such as, for example
by setting limits and fines for certain levels of air pollution in order to
discourage firms from doing them and so to encourage them to employ
practices such as types of technology or machines that minimize such
externalities in order to avoid having to pay such costs.
This policy may not be effective in the short run because of the high costs of
installing more environmentally friendly procedures like the machines,
however if the government sets large fines then in the long run firms may
prefer to invest into those technologies in order to avoid constantly being
charged such high fines and facing issues with the law, as a result they may
find it more cost effective to invest in those technologies therefore making the
governments attempt to correct the market failure more effective.
Deregulation is the removal or easing of rules and laws by the government,
this can be used for example to correct the market failure of abuse of market
power by monopolies which exploits customers with high prices where by the
government will deregulate barriers to entry in markets to encourage greater
competition market efficiency, this is because more firms entering the market
will force firms to look for ways to cut down on costs so that they can lower
prices in order to attract customers and survive in the markets as a result
consumers will enjoy lower prices and so they can afford to purchase more
goods therefore improving their living standards.
This kind of measure is especially applicable for more essential goods and
services such as food and healthcare in order to promote better welfare and
lower inequality in the economy.
7.DIRECT PROVISION
This refers to the situation where the government steps in to supply goods and
services to ensure their availability and affordability. This is used by the
government to correct the market failure of unavailability of public goods in a
free market due to the free rider problem, therefore since public goods such as
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street lights are still important despite people not being willing to pay for them
since others can still consume them without paying, the government will have
to step in to provide them themselves as a result public goods will become
available in the market and so the market failure can be solved.
This kind of policy is very effective in solving such market failure however it
comes with the limitation of opportunity cost of the money spent in
providing these goods since the money could have been spent on other
areas that may be more important at that time such as healthcare if the
economy has an ageing population. But also, this policy may lead to
taxation being increased e.g., to workers income in order to finance the
provision, as a result, consumer disposable decreases which reduces the
amount of goods they can afford and so worsening their living
standards.
8.POLLUTION PERMITS
Pollution permits involve giving firms a legal right to pollute a certain amount,
such as a certain levels of carbon dioxide per year.
This can be used by the government to reduce negative externalities such as
industry waste being disposed in rivers and lakes which reduces
the availability and access to clean water. By imposing such limits,
the government can reduce the amount of pollution because firms
which exceed the limits will be heavily fined and so to avoid such
high costs, they will look for ways to reduce the levels of pollution
therefore reduce negative externalities such as, diseases in the
economy and so improving living standards therefore making the
policy effective.
However, it should be thought of that the government needs to make sure
they are being extremely strict about not exceeding the limits in
order to make sure firms follow the rules set and not try to avoid
them such as by reporting lower levels of pollution without being
investigated.
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As shown in the diagram above, the first diagram shows a tax on carbon which
is an example of another measure to reduce the market failure
which a pollution permit may work similar to, a tax increases costs
and so it forces producers to reduce production which will reduce
the amount of pollution caused whereas with a pollution permit,
only a limited amount of pollution is allowed for each firm and
exceeding it leads to a serious fine and so firms will have to
reduce their production levels or to invest in better measures
which will cause lower pollution in order to avoid issues with the
law such as law suits and so avoiding increase in costs in that
criteria, as a result the market failure is reduced.
9.PROPERTY RIGHTS.
Property rights refer to the legal ownership of resources and how they can be
used.
A government can attempt to use market rights to tackle market failure by
implementing laws and regulations that protect individuals and business
ownership over their property. This can be used to tackle negative externalities
by enforcing regulations that force producers and consumers to consider the
costs they impose on third parties, this can be done for example, by imposing a
tax on pollution to compensate for peoples right to clean air or clean
environment, this makes causing a negative externality more of a private cost
and so, firms will try to reduce negative externalities e.g., by using more
efficient, less waste technology to avoid increases in their costs and so there
will be less externalities in the market making the policy work.
Finally, this policy may be effective in reducing the extent of market failure if
the legal cost of investigating and prosecuting a firm which breaks the laws i.e.,
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in court is less than the compensation received as legal costs may be high
which may make the policy not cost effective.
10.NATIONALISATION AND PRIVATISATION
Nationalisation is the transfer of a firm or industry from private ownership to
state ownership or control.
This is done by the government to ensure that certain goods or services
provided are accessible and affordable to everyone especially for more
essential items such as water supply in order to ensure that everyone in
the country can have access to clean safe water. Therefore, if in an
economy a certain essential service has an unequal distribution whereby
others do not have access to or cannot afford them and they are being
controlled by the private sector e.g., water or electricity supply then the
government can nationalize them in order to provide a more equal
distribution so that all people can have access to these important
services therefore reducing problems such as the risk of diseases, as a
result reducing market failure.
Privatisation is the transfer of ownership of firms from the public sector to the
private sector.
This can be used by the government to help correct the market failure of
inefficiency in the public sector due to no or very low competition, it
works by transferring ownership to the private sector i.e., by selling a
certain firm to private individuals, whereby in the free market there is
high levels of competition and so the firm will strive to increase
efficiency and innovation which there will be more able to do due to no
more excessive government control and government motives such as
focus on political matters rather than increasing efficiency, as a result
market efficiency will increase and consumers will enjoy better quality
products with potentially lower prices, owners will enjoy more profits
and the government will benefit with better living standards in the
economy. However, this policy may not be good if the firms will charge
higher prices than was charged by the government because the
consumers will become worse off by not being able to afford as much as
before and so the policy may not be effective.
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11.PROVISION OF INFORMATION.
Provision of information refers to the government trying to correcting the
market failure of asymmetric information by conducting measures to
give consumers more information regarding the extent of benefits of
merit goods eg,education and the extent of the harm from demerit
goods eg,alcohol.
This kind of measure can be used to tackle the market failure of
overconsumption of demerit goods and underconsumption of merit
goods.
As consumers are given more information e.g., through health campaigns they
become more aware of the benefits of consuming merit goods like fruits
as well as the harm from consuming demerit good like alcohol both to
themselves and to the society, they become able to make better
decisions and so they end up consuming more merit goods and less
demerit goods, as a result improving health for the direct consumers and
increasing net benefit to third parties such as reduction in the spread of
diseases i.e., through increased consumption of vaccines.
12.BEHAVIOURAL INSIGHTS AND NUDGE THEORY
Behavioral insights refer to the application of behavioral science to understand
how people make decisions and to design policies that encourage
desired behaviors.
Nudge theory refers to the use of subtle cues and prompts to influence
people’s choices without restricting their freedom of choice. I.e., it
refers to
‘nudging’ consumers to make better choices meaning to subtly guide them.
For example, to tackle the market failure of the overconsumption of soda
which is a demerit good, the government can subsidise the
production of fruit juice and make it more available this together
with fruit juices now being cheaper will indirectly encourage
consumers to consume more of them and less of the soda, this
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counts as a nudge rather than directly setting a production quota
which will forcefully limit consumption.
This policy may be effective because it is often cost effective since it normally
relies on low-cost measures and also it allows more freedom of
choice and so consumers will not feel forced to consume healthier
by the government but rather, they will feel encouraged making
them more willing to cooperate rather than trying to rebel.
However, it may be criticized that this policy is manipulative and
so may be rebelled therefore could make it ineffective and may
lead to unintended consequences e.g. if a government tries to
influence people to eat healthier by placing healthier food options
at eye level in markets, despite this potentially leading to an
increase in consumption of healthier foods it may also lead to
increase in prices which may reduce how much people can afford
and consume therefore may lead to inequality with more rich
people being able to afford eating healthier than poor.
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