Market Failure
The Meaning of Market Failure
By the end of this section you should understand the following…
 You should understand that market failure occurs whenever a market leads to a
misallocation of resources.
 You should appreciate the difference between complete market failure (resulting in a
missing market), and a partial market failure, where a market exists but contributes to
resource misallocation.
 You should understand how public goods, positive and negative externalities, merit
and demerit goods, monopoly and other market imperfections and inequalities in the
distribution of income and wealth can lead to market failure.
 You should be able to give examples of each of these causes of market failure.
What is market failure?
Market failure: occurs when freely-functioning markets, fail to deliver an efficient allocation of resources.
The result is a loss of economic and social welfare.
Market failure exists when the competitive outcome of markets is not efficient from the point of view of society as
a whole. This is usually because the benefits that the free-market confers on individuals or businesses carrying
out a particular activity diverge from the benefits to society as a whole.
Markets can fail because of…
1. The private sector in a free-market cannot profitably supply to consumers pure public goods and quasipublic goods that are needed to meet people’s needs and wants.
2. Imperfect information means merit goods are under-produced while demerit goods are over-produced
or over-consumed
3. Factor immobility causes unemployment hence productive inefficiency
4. Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and
consequent social exclusion which the government may choose to change
Complete and partial market failure
One useful distinction is between complete market failure when the market simply does not supply products at
all (i.e. we see ―missing markets), and partial market failure, when the market does actually function but it
produces either the wrong quantity of a product or at the wrong price
Missing market: a situation in which there is no mechanism by which the needs of potential buyers and
sellers can be reconciled
Market failure and economic efficiency
Market failure results in productive inefficiency. Businesses are not maximising output from given factor inputs.
This is a problem because the lost output from inefficient production could have been used to satisfy more wants
and needs. Furthermore, resources are misallocated by producing goods and services not wanted by
consumers. This is a problem because resources can be put to a better use making products that consumers
value more highly.
In the following section we will look at each market failure in detail.
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Public Goods
By the end of this section you should understand the following…
 You should understand that pure public goods are non-rival and non-excludable and
recognise that the significance of these characteristics.
 You should understand the difference between public and private goods, and consider
whether under certain circumstances a public good may take on some of the
characteristics of a private good.
Public goods provide an example of market failure resulting from missing markets. To understand this, it is
helpful first to discuss what is meant by a private good or service.
A private good or service has two main characteristics
1. Excludability
A ticket to the theatre or a meal in a restaurant or pay-per-view sporting events are private goods are both
examples of private goods because buyers can be excluded from enjoying the product if they are not willing
and able to pay for it. Excludability gives the service provider (the seller) the chance to make a profit. When
goods are excludable, the owners can exercise property rights.
2. Rivalry
If you order and then enjoy a pizza from Pizza Hut, that pizza is no longer available to someone else.
Likewise driving your car on a road uses up road space that is no longer available at that time to another
motorist. With a private good, one person's consumption of a product reduces the amount left for others to
consume and benefit from - because scarce resources are used up in producing and supplying the good or
service.
Characteristics of Public Goods
As one might expect, the characteristics of pure public goods are the opposite of private goods:
1. Non-excludability
The benefits derived from pure public goods cannot be confined solely to those who have paid for it. Indeed
non-payers can enjoy the benefits of consumption at no financial cost – economists call this the ‘free-rider’
problem - and it means that people have a temptation to consume without paying!
2. Non-rival consumption
Consumption of a public good by one person does not reduce the availability of a good to everyone else – the
marginal cost of supplying a public good to an extra person is basically zero.
Examples of Public Goods
There are relatively few examples of pure public goods. Examples include flood control systems, some of the
broadcasting services provided by the BBC, public water supplies, street lighting for roads and motorways
and lighthouse protection for ships.
Quasi-Public Goods
A quasi-public good has many but not all the characteristics of a public good. Quasi public goods are:
1. Semi-non-rival
Up to a point, extra consumers using a park, beach or road do not reduce the space available for others.
Eventually beaches become crowded as do parks and other leisure facilities.
2. Semi-non-excludable
It is possible but often difficult or expensive to exclude non-paying consumers. E.g. fencing a park or beach
and charging an entrance fee; building toll booths to charge for road usage on congested routes
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Public goods and market failure
Pure public goods are not normally provided at all by the private sector because they would be unable to
supply them for a profit. Thus the free market may under-provide or even fail totally to provide public goods.
It is therefore up to the Government to decide what output of public goods is appropriate for society. To do this, it
must estimate the social benefits from making public goods available. Putting a monetary value on the benefit
derived from street lighting and defence systems is problematic partly because elections are rarely won and lost
purely on the grounds of government spending plans and the turnout at elections continues to fall.
The case for government intervention in the case of public goods
The non-rival nature of consumption provides a strong case for the government rather than the market to provide
and pay for public goods.
Many public goods are provided more or less free at the point of use and then paid for out of general taxation or
another general form of charge such as a licence fee.
State provision may help to prevent the under-provision and under-consumption of public goods so that social
welfare is improved.
Turning public goods into private goods
Over the last 25 years, countries around the world have looked to providing more goods and services using
market systems rather than by government intervention. Both left- and right-wing governments have favoured
this approach, but it is particularly difficult to turn public goods into private goods.
It is possible to get businesses to pay private sector firms to give added levels of security, but privatising the
police or the army or the courts system is probably not feasible. Thus, the use of 'private defence contractors' in
Iraq has been the subject of recent debate, especially in light of their immunity from prosecution.
One area of possible success has been in road pricing systems. New ICT-based technologies mean that it is
possible to calculate what use individual drivers make of which roads at what times, and to charge for road use.
Experiments in Singapore have been copied with some success in other parts of the world, and the UK
government has said that it might be interested in moving towards a national form of road pricing.
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Merit and Demerit Goods
By the end of this section you should understand the following…



You should understand that the classification of merit and demerit goods depends
upon a value judgement and that such products may also be subject to externalities.
You should also understand how under-provision of merit goods and over-provision of
demerit goods may result from imperfect information.
You should be able to illustrate the misallocation of resources resulting from the
consumption of merit and demerit goods using diagrams showing marginal private and
social cost and benefit curves.
Underprovision of merit goods: incomplete markets
A merit good: one which is underprovided by the price mechanism and it tends to yield more benefit to
individuals than they realise.
The value of these goods to the individual is not fully understood or appreciated and consequently insufficient
resources are allocated to their production and consumption. Education, training and health-care services are
often depicted as merit goods. If individuals were fully aware of the long-term benefits of these goods, more
would be consumed.
The under consumption of merit goods in a free market is shown in the diagram below, where the perceived
benefit of consuming fresh fruit and vegetables on a regular basis is depicted by the demand curve D2, leading
to an equilibrium price and quantity of P2, Q2.
However, the actual benefits to consumers are greater, indicated by demand curve D3, where price and quantity
should be at P3, Q3.
The underprovision is shown by the distance between Q2 and Q3. (Remember that the demand curve
represents the amount of benefit consumers gain from a good: higher demand means a higher level of benefit.)
The market for fresh fruit and vegetables: examples of merit goods
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Merit goods differ from positive externalities in that merit goods focus on the extra benefit to the individual
concerned whilst positive externalities refer to benefits gained by others who are not part of the activity.
However, most merit goods yield positive externalities.
For example, students staying on at school in the sixth form are consuming a merit good since it is likely to
increase their future earnings and offer wider career choices; it is also a positive externality since employers may
gain from the increased productivity of more educated and skilled workers.
Merit goods can also be defined by the political process as 'those goods a government wants more to be
consumed of in society'. Government intervention is often required to increase their provision and
consumption, for example, the compulsory wearing of seat belts whilst travelling in a car or the use of crash
helmets on motorbikes; even the legal requirement of firms to fit plugs to all electrical appliances before their
sale to consumers in the UK is an example of government- inspired merit goods provision.
The underprovision of merit goods in society represents a market failure. The causes of this type of market
failure can be traced back to several factors…
1. The lack of information or knowledge of merit goods
People may not realise the full value of consuming merit goods such as using a health club regularly or obtaining
vaccinations.
2. The long-term nature of the benefits gained from merit goods
People tend to focus more on short-term rather than long-term benefits. For example, in the short run, under free
market conditions, there is too little consumption of private insurance, dental care and education. However, later
on in life many people regret this and wish they had consumed more.
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3. The unequal distribution of income and wealth
Some economists view inequality as a cause of market failure since many people may be unable to afford to buy
merit goods, leading to under consumption. For example, the low-paid, unemployed and sick may not have
sufficient funds to afford private health-care insurance.
Overprovision of demerit goods
Demerit goods: goods which are overprovided by the price mechanism and tend to yield more cost to
individuals than they realise.
The dangers of such goods to the individual are not fully understood or recognised and consequently too many
resources are allocated to their production, leading to over consumption.
Tobacco, alcohol and drugs are often depicted as demerit goods. If individuals were fully aware of the long-term
harmful consequences of these goods, less would be consumed.
The over consumption of demerit goods in a free market is shown in the diagram below, where the perceived
benefit of consuming tobacco is depicted by the demand curve D2, leading to an equilibrium price and quantity
of P2, Q2.
However, the actual net benefits to consumers are fewer, indicated by demand curve D1, where price should be
at P1 and quantity Q1.
The term 'net benefit' refers to the benefit minus costs to individuals of consuming the good.
The market for tobacco: a demerit good
Demerit goods differ from negative externalities in that the former focus on the extra cost to the individual
concerned whilst the latter refer to the costs imposed on others not part of the activity.
However, most demerit goods yield negative externalities. Tobacco smokers are consuming a demerit good
since it is likely to reduce their life expectancy, but it is also a negative externality since there will probably be
increased absenteeism from work due to ill health and greater pressures placed upon the National Health
Service.
Demerit goods can also be defined by the political process as 'those goods a government wants less to be
consumed of in society'. Government intervention is often required to reduce their provision and consumption,
for example, high taxation on tobacco and placing health warnings on cigarette packets.
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The overprovision of demerit goods in society represents a market failure. As with merit goods, the causes can
be traced back to imperfect market knowledge and the failure of consumers to value the long-term
consequences of their decisions.
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Immobility of Factors of Production
By the end of this section you should understand the following…
 You should understand that the immobility of factors of production is likely to result in a
misallocation of resources and therefore cause market failure
Another cause of market failure is the immobility of factors of production. There are two main types of factor
immobility, occupational and geographical immobility.
Occupational Immobility
Occupational immobility: occurs when there are barriers to the mobility of factors of production between
different sectors of the economy which leads to these factors remaining unemployed, or being used in
ways that are not efficient.
Some capital inputs are occupationally mobile – a computer can be put to use in many different industries. And
commercial buildings such as shops and offices can be altered to provide a base for many businesses. However
some units of capital are specific to the industry they have been designed for – a printing press or a nuclear
power station for example.
One of the main causes of unemployment is that workers lack the skills required by expanding industries in the
economy. People often experience occupational immobility.
For example, workers made redundant in the sheet metal industry or in heavy engineering may find it difficult to
find a new job. They may have specific skills that are not necessarily needed in growing industries which
causes a mismatch between the skills on offer from the unemployed and those required by employers looking for
workers. This problem is called structural unemployment.
Clearly this leads to a waste of scarce resources and represents market failure.
Geographical Immobility
Geographical immobility refers to barriers that prevent people moving from one area to another to find work.
There are good reasons why geographical immobility might exist…
 Family and social ties.
 The financial costs involved in moving home including the costs of selling a house, removal expenses
and other associated expenditure.
 Huge regional variations in house prices.
 Differences in the general cost of living between regions and also between countries.
Policies to improve the mobility of labour to reduce occupational immobility…
 Invest in training schemes for the unemployed to boost their human capital to equip them with new
skills and skills that can be transferred from one occupation to another.
 Subsidise the provision of vocational training by private sector firms to raise the skills level
To reduce geographical immobility…
 Reforms to the housing market designed to improve the supply and reduce the cost of rented properties
and to increase the supply of affordable properties.
 Encourage part-ownership / part-rented housing
 Specific subsidies for people moving into areas where there are shortages of labour – for example
teachers and workers in the National Health Services.
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Inequalities in the Distribution of Income and Wealth
By the end of this section you should understand the following…
 You should understand that, in a market economy, an individual’s ability to consume
goods and services depends on their income and wealth and that an unequal
distribution of income and wealth may result in an unsatisfactory allocation of
resources
The free-market system will not necessarily respond to the needs and wants of those with insufficient
economic votes (money) to have any impact on market demand because what matters in a market based
system is your effective demand (backed up by an ability an willingness to pay) for goods and services.
Not only do free markets create inequalities in income, but also they allocate resources to those members of
society who are prepared to pay the most. As noted earlier, some economists have likened the price mechanism
to a system of economic votes…
 Each pound of income is the equivalent of one vote.
 Those with the most votes will determine not just what is produced for society but who consumes such
production.
 If there is a shortage of a good or service, competition between buyers will force up prices until
equilibrium between buyers and sellers is reached.
 Those who cannot afford the market price of the good or service will go without.
Those members of society who have larger incomes will be able to consume more resources than those with
relatively smaller incomes. Some people would regard such inequalities as unfair.
Are inequalities in the distribution of Income and wealth an example of market failure?
This is hard to answer. When we are discussing inequality and poverty, we cannot escape having to make value
judgements, or normative statements. Ultimately, what constitutes an 'unacceptable' distribution of income
and what if anything the government should do about this is a value judgement and is a political issue beyond
the scope of economics. That said, there is plenty of evidence that high and rising levels of inequality of income
and wealth can lead to negative social consequences, i.e. external costs that affect the whole of society.
The Poverty Trap
The poverty trap affects people living in households on low incomes. It creates a disincentive to look for work
or work longer hours because of the effects of the income tax and welfare benefits system
For example, a worker might be given the opportunity to earn an extra £60 a week by working ten additional
hours. This boost to his/her gross income is reduced by an increase in income tax and national insurance
contributions. The individual may also lose some income-related welfare benefits and the combined effects
of this might be to take away over 70% of a rise in income, leaving little in the way of extra net or disposable
income. When one adds in the possible extra costs of more expensive transport charges and the costs of
arranging child care, then the disincentive to work may be quite strong.
Government Policies to Reduce Poverty
Policies to reduce relative poverty normally focus on…
(a) changes to the tax and benefits system
(b) policies designed to increase employment and reduce unemployment
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When evaluating different policies to reduce poverty consider some of these related issues…
 Cost
 Effectiveness
 Impact on others in the economy
1. Changes to the tax and benefits system
For example, increases in higher rates of income tax would make the British tax system more progressive and
reduce the post-tax incomes of people at the top of the income scale. The risk is that higher rates of taxation
may act as a disincentive for people to earn extra income and might damage enterprise and productivity.
2. A switch towards greater means-tested benefits
Means testing allows welfare benefits to go to those people and families in greatest need. A means-test
involves a check on the financial circumstances of the benefit claimant before paying any benefit out. This would
help the welfare system to target help for those households on the lowest incomes. However means tested
benefits are often unpopular with the recipients.
3. Linking the state retirement pension to average earnings rather than prices
This policy would help to relieve relative poverty among low-income pensioner households. Their pension would
rise in line with the growth of average earnings each year
4. Special employment measures
Government employment schemes seek to raise employment levels and improve the employment prospects of
the long-term unemployed.
5. Increased spending on education and training
Unemployment is a cause of poverty and structural unemployment makes the problem worse. There are
millions of households where no one in the family is in any kind of work and this increases the risk of poverty.
6. The National Minimum Wage
It is a statutory pay floor that employers cannot legally undercut. The beneficial impact of the minimum wage has
been concentrated on the lowest paid workers in service sector jobs where there is little or no trade union
protection.
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Government Intervention in the Market
Rationale for Government Intervention
By the end of this section you should understand the following…
 You should understand the reasons for government intervention in markets.
In a free market, scarce resources are allocated through the price mechanism where the preferences and
spending decisions of consumers and the supply decisions of businesses come together to determine
equilibrium prices.
The free market works through price signals. When demand is high, the potential profit from supplying to a
market rises, leading to an expansion in supply to meet rising demand from consumers. In general, the free
market mechanism is a very powerful device for determining how resources are allocated among competing
uses.
The government may choose to intervene in the price mechanism largely on the grounds of wanting to change
the allocation of resources and achieve what they perceive to be an improvement in economic and social
welfare.
The main reasons for policy intervention are…
1. To correct for instances of market failure.
2. To achieve a more equitable distribution of income and wealth
3. To improve the performance of the SA economy both domestically and on the international front.
Methods of Government Intervention to Correct Distortions in Individual
Markets
By the end of this section you should understand the following…
 Candidates should be able to use basic economic models to analyse and evaluate the
use of indirect taxation, subsidies, price controls, buffer stocks, pollution permits, state
provision and regulation to correct market failure.
There are a number of methods that governments have developed to correct or minimise the adverse
consequences of market failures.
These include…
1. Indirect Taxation
2. Subsidies
3. Price Controls
4. State Provision
5. Regulation
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1. Indirect Taxation
One of the most significant examples of market failure occurs when the price paid for a good or service fails to
reflect the real cost in terms of resources. This means that some goods and services are under priced in terms of
the actual resources used in their production and leads to a misallocation of resources in the sense that oversupply will occur.
Indirect tax: imposed on producers (suppliers) by the government.
Examples include duties on cigarettes, alcohol and fuel and also VAT. A tax increases the costs of a business
causing an inward shift in the supply curve.
The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect
tax, the supplier may be able to pass on some or all of this tax onto the consumer through a higher price. This is
known as shifting the burden of the tax and the ability of businesses to do this depends on the price elasticity of
demand and supply.
In the left hand diagram, demand is elastic
so the producer must absorb most of the
tax and accept a lower profit margin on
each unit sold. When demand is elastic, the
effect of a tax is to raise the price – but we
see a bigger fall in quantity. Output has
fallen from Q1 to Q2.
In the right hand diagram demand for the product
is inelastic and therefore the producer is able to
pass on most of the tax to the consumer by raising
price without losing much in the way of sales.
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Who pays the tax? The burden of taxation
When demand is price elastic, the producer cannot
pass on much of the tax to the consumer, they must
absorb the majority of the tax themselves
Conversely, when demand is inelastic, the
producer is able to pass on most or perhaps all of
an indirect tax to the consumer by raising the
market price.
The Government would rather place indirect taxes on commodities where demand is inelastic because the tax
causes only a small fall in the quantity consumed and as a result the total revenue from taxes will be greater. An
example of this is the high level of duty on cigarettes and petrol.
Specific taxes
A specific tax is where the tax per unit is a fixed amount – for example the duty on a pint of beer or the tax per
packet of twenty cigarettes. Another example is air passenger duty
Ad valorem taxes
Where the tax is a percentage of the cost of supply – e.g. value added tax currently levied at the standard
rate of 14%.
Tobacco tax is an example of a product on which both specific and ad valorem taxes are applied.
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2. Subsidies
Subsidy: a payment by the government to suppliers that reduce their costs of production and
encourages them to increase output.
The effect of a subsidy is to increase supply and (ceteris paribus) reduce the market equilibrium price. The
subsidy causes the firm's supply curve to shift to the right. The amount spent on the subsidy is equal to the
subsidy per unit multiplied by total output. Occasionally the government can offer a direct subsidy to the
consumer – which has the effect of boosting demand in a market.
Different Types of Producer Subsidy
a) A guaranteed payment on the factor cost of a product – e.g. a guaranteed minimum price offered to
farmers such as under the Common Agricultural Policy (CAP).
b) An input subsidy which subsidises the cost of inputs used in production – e.g. an employment subsidy
for taking on more workers.
c) Government grants to cover losses made by a business – e.g. a grant given to cover losses in the
railway industry or a loss-making airline.
d) Financial assistance (loans and grants) for businesses setting up in areas of high unemployment –
e.g. as part of a regional policy designed to boost employment.
To what extent will a subsidy feed through to lower prices for consumers?
This depends on the price elasticity of demand for the product. The more inelastic the demand curve the
greater the consumer's gain from a subsidy. Indeed when demand is perfectly inelastic the consumer gains most
of the benefit from the subsidy since all the subsidy is passed onto the consumer through a lower price. When
demand is relatively elastic, the main effect of the subsidy is to increase the equilibrium quantity traded rather
than lead to a much lower market price.
The effect of a subsidy on the market price is greatest when demand is inelastic. When demand is price elastic,
a subsidy will have more of an effect on quantity traded.
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Economic and Social Justifications for Subsidies
Why might the government be justified in providing financial assistance to producers in certain markets and
industries? How valid are the arguments for government subsidies?
a) To keep prices down and control inflation – in the last couple of years several countries have been
offering fuel subsidies to consumers and businesses in the wake of the steep increase in world crude oil
prices.
b) To encourage consumption of merit goods and services which are said to generate positive
externalities (increased social benefits).
c) Increase the revenues of producers during times of special difficulties in markets.
d) Reduce the cost of capital investment projects – which might help to stimulate economic growth by
increasing long-run aggregate supply.
e) Subsidies to slow-down the process of long term decline in an industry
Economic Arguments against Subsidies
The economic and social case for a subsidy should be judged carefully on the grounds of efficiency and
fairness. Might the money used up in subsidy payments be better spent elsewhere? Government subsidies
inevitably carry an opportunity cost and in the long run there might be better ways of providing financial support
to producers and workers in specific industries.
Free market economists argue that subsidies distort the working of the free market mechanism and can lead to
government failure where intervention leads to a worse distribution of resources.
a) Distortion of the Market: Subsidies distort market prices – for example, export subsidies distort the
trade in goods and services and can curtail the ability of LEDC’s to compete in the markets of rich
nations.
b) Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary
c) Financial Cost: Subsidies can become expensive – note the opportunity cost!
d) Who pays and who benefits? The final cost of a subsidy usually falls on consumers (or tax-payers)
who themselves may have derived no benefit from the subsidy.
e) Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure – i.e.
it delays much needed reforms.
f)
Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments.
g) There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means
which have less distorting effects.
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3. Price Controls
Price controls: the imposition of a maximum and/or minimum price by the government that could be
above or below the market equilibrium.
Maximum Prices
The Government can set a maximum price in an attempt to prevent the market price from rising above a certain
level. To be effective a maximum price has to be set below the free market price.
One example of a maximum price might be when shortage of foodstuffs threatens large rises in the free market
price.
Other examples include rent controls on properties – for example the system of rent controls still in place in
Manhattan in the United States. A maximum price seeks to control the price – but also involves a normative
judgement on behalf of the government about what that price should be.
An example of a maximum price is shown in the next diagram. The normal equilibrium price is shown at Pe – but
the government imposes a maximum price of Pmax. This price ceiling creates excess demand equal to quantity
Q2-Q1 because the price has been held below the equilibrium.
It is worth noting that a price ceiling set above the free market equilibrium price would have no effect whatsoever
on the market – because for a price floor to be effective, it must be set below the normal market-clearing price.
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Minimum Prices
Minimum price: a legally imposed price floor below which the market price cannot fall.
To be effective the minimum price has to be set above the equilibrium price. Perhaps the best example of a
minimum price is the minimum wage.
How does a minimum wage work?
The minimum wage is a price floor – employers cannot legally undercut the current minimum wage rate per
hour. This applies both to full-time and part-time workers. Labour supply and demand curve analysis can be
used to show the effects.
A diagram showing the possible effects of a minimum wage is shown below. The market equilibrium wage for
this particular labour market is at W1 (where demand = supply).
If the minimum wage is set at Wmin, there will be an excess supply of labour equal to E3 – E2 because the
supply of labour will expand (more workers will be willing and able to offer themselves for work at the higher
wage than before) but there is a risk that the demand for workers from employers (businesses) will contract if the
minimum wage is introduced.
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Possible disadvantages of a minimum wage
Although all political parties are now committed to keeping the minimum wage, there are still plenty of
economists who believe that setting a pay floor represents a distortion to the way the labour market works
because it reduces the flexibility of the labour market.
a) Competitiveness and Jobs: Firstly a minimum wage may cost jobs because a rise in labour costs
makes it more expensive to employ people and higher labour costs.
b) Effect on relative poverty: Is the minimum wage the most effective policy to reduce relative poverty?
There is evidence that it tends to boost the incomes of middle-income households where more than one
household member is already in work whereas the greatest risk of relative poverty is among the
unemployed, elderly and single parent families where the parent is not employed.
Evidence on the minimum wage – has it worked?
a) Employment: Since the minimum wage was introduced, unemployment in Britain has fallen and the
level of employment in the British economy is now at a record high although the economy has avoided a
recession throughout this period.
b) Inflation: In many sectors firms find it hard to pass on higher wage costs to final consumers – limiting
the inflationary effect of the minimum wage
c) Wage costs: The minimum wage affects only a small proportion of workers and the effects on the wage
bills of most businesses is not a significant factor in their employment decisions. In the short term, the
demand for labour tends to be inelastic with respect to changes in wages
d) Discrimination: The minimum wage has had an impact on the earnings of part-time female workers.
e) Productivity: It is hard to identify any strong positive effect on labour productivity - but efficiency gains
have been made in most low-paying industries, a trend which started before the minimum wage was
introduced
4. State Provision
Governments may make the judgement that the arguments in favour of particular merit goods are so convincing
or the positive externalities so overwhelming that the market system should be completely by-passed by the
state.
In the 19th century the market system did little to ensure that water suppliers were safe and that wastes were
properly disposed of, so local government stepped in to fill the gap. Since then other services have been
provided by the UK government. Most children are educated in state-provided and tax-funded schools. Similarly,
the government pays for the armed services, police, courts and road building and all governments in the world
intervene to provide some of these kinds of services.
Increasingly, many governments have tried to move away from state provision in the belief that market-based
provision is more efficient, or because of the potential political popularity of lower taxes. It is argued that stateowned or run provision is more inefficient because, unlike market-based provision, there are less likely to be
financial incentives to reward success or to punish failure.
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5. Regulation
We take for granted the many company and civil laws that provide a framework to protect consumers, producers
and factor suppliers from being exploited. This legal framework helps ensure that markets work and are trusted.
Such confidence is vital, especially in matters relating to banking and company finance.
Governments often go further than just providing the legislative framework to support markets. They also use
direct controls to limit the negative effects of market failure. Governments have the power to pass laws and use
the existing legislative framework in an attempt to control and constrain the behaviour of firms and industries that
generate negative externalities.
For example, in the UK:
 emissions of potentially dangerous chemicals are subject to regulations
 advertising by the tobacco industry is limited
 car safety is promoted by annual car tests (MOT).
There are countless other rules and regulations, most of which we take for granted. Governments have the
power to ensure that laws are not broken but even the power of the courts and the judicial system are not strong
enough to stop the production and consumption of some demerit goods - the market for illegal drugs in the UK
exists and functions much like any other free market and there seems little that successive governments can
actually do to cut the consumption of cannabis, ecstasy and heroin. Recent efforts by the government to
promote healthy eating in schools also appear to have had limited success.
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Government Failure
By the end of this section you should understand the following…
 You should understand that government failure occurs when government intervention
in the economy leads to a misallocation of resources.
 You should appreciate that government intervention in the economy, for example to try
to correct market failure, does not necessarily result in an improvement in economic
welfare. Governments may create, rather than remove, market distortions.
 Inadequate information, conflicting objectives and administrative costs should be
recognised as possible sources of government failure.
Government failure: government intervention in the market that leads to a misallocation of resources.
In other words, government actions might actually lead to a worse allocation of resources than that achieved by
the free market.
Possible sources of government failure are…
1. Inadequate information
2. Conflicting objectives
3. Administrative costs
4. Unintended effects
5. Short-termism.
1. Inadequate information
How does the government establish what citizens want it to do?
Can the government ever really know the true revealed preferences of so many people?
How does the government know how many extra houses need to be built in the UK over the next twenty years?
Is building thousands of extra homes in an already congested South-east the right option?
Are there better solutions?
Often a government will choose to go ahead with a project or policy without having the full amount of information
required for a proper cost-benefit analysis. The result can be misguided policies and damaging long-term
consequences.
The success of many of the policy options outlined in the previous section rely on the government having
excellent data and information on the markets in which they wish to intervene.
For example, if a government is using some form of tax to correct a negative externality, it has to be able to
estimate accurately the external costs. If its estimates are too high, then the market will be further distorted.
This theoretical example is illustrated in Figure 5.6, where the government overestimates the external costs
involved in the production of a given good or service.
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In the diagram above, the additional tax is set at xy rather than ab, resulting in consumers paying more than the
product is worth in terms of resources used. This does not necessarily mean that resources are allocated less
efficiently or effectively compared to a market-based solution, but it does mean that governments need really
accurate data if their policies are going to succeed. Even if this requirement is satisfied, this type of policy relies
also on forecasted or projected data which by its nature is likely to be less reliable than historical data.
2. Conflicting Objectives
At a macroeconomics level, it is possible that the policy objectives of government may not be compatible.
For example, a government wishing to reduce unemployment by stimulating total demand in the economy may
generate inflation if the supply capacity of the nation is limited.
It is not surprising that what might start out as a clear economic objective can end up as a messy compromise.
3. Administrative Costs
Government intervention can prove costly to administer and enforce. The estimated social benefits of a particular
policy might be largely swamped by the administrative costs of introducing it.
Governments and civil servants make mistakes, and these errors can add to costs. The UK government has
attempted to improve the management and efficiency of the NHS by computerising medical records.
Interventions such as these - as with research and development into new weapons - are notorious for going over
budget. Moreover, the imposition of any control or regulation necessitates sanctions for non-compliance. Wellmeaning legislation can result in spiralling administrative costs.
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4. Unintended effects
The law of unintended consequences is that actions of consumer and producers - and especially of
government - always have effects that are unanticipated or "unintended."
Particularly when people do not always act in the way that the economics textbooks would predict – this is of
course the essence of a social and behavioural science – we do not live our lives in sanitised laboratories where
all of the conditions can be controlled.
The law of unintended consequences is often used to criticise the effects of government legislation, taxation and
regulation. People find ways to circumvent laws; shadow markets develop to undermine an official policy; people
act in unexpected ways because of ignorance and / or error.
Unintended consequences can add hugely to the financial costs of some government programmes so that they
make them extremely expensive when set against their original goals and objectives.
5. Short-termism
Short-termism: choosing options for their likely short-term effect while neglecting their possible longterm effects
Critics of government intervention in the economy argue that politicians have a tendency to look for short term
solutions or “quick fixes” to difficult economic problems rather than making considered analysis of long term
considerations.
For example, a decision to build more roads and by-passes might simply add to the problems of traffic
congestion in the long run encouraging an increase in the total number of cars on the roads. The Commission
for Integrated Transport has criticised the Government for a failure to develop a properly integrated transport
policy. They clearly believe that government failure is endemic in our transport industry – although we should
remember that their view is normative, based on value judgements!
Secondly criticisms of the huge increases in state spending on the National Health Service. Government critics
argue that much of the extra spending is being ―lost in higher pay and administration rather than finding its way
into improving front-line health services. The risk is that short-term decision-making will only provide short term
relief to particular problems but does little to address structural economic problems.
Critics of government subsidies to particular industries also claim that they distort the proper functioning of
markets and lead to inefficiencies in the economy.
For example short term financial support to coal producers to keep open loss-making coal pits might prove to be
a waste of scarce resources if the industry concerned has little realistic prospect of achieving a viable rate of
return in the long run given the strength of global competition.
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