Market Failure: Causes, Types, Example and Government’s Role!
Types of Market Failures:
Asymmetric Information:
As the name suggests, there is asymmetry or lack of symmetry (or equality) in the information with to all economic agents who are part of a market. This means that the information available to both agents involved in a transaction/exchange is not the same. The information set with both agents is unequal.
One is less/more ignorant than the other agent. This asymmetric information exists when one agent has less/more knowledge than the other agent involved in the transaction. Information is not same with both agents, which causes the market to reach an inefficient and in optimal level of equilibrium. The Nobel Prize winner of 2001, George Akerlof illustrated this market failure with his famous market for ‘lemons’.
In the market for used cars, (lemons are used cars that have a bad quality and the term was coined by ‘Akerlof’ as a classic case in the game theory literature) only the lemons are sold-implying that those used cars that have bad record are sold. The better cars remain unsold as the buyers have no way of knowing which car is a good and which one is a lemon. Since the owners of lemons are willing to sell at a low rate and sellers of good cars are willing to sell only at a higher rate, buyers go for lower priced cars as they have no way to distinguish between good and bad cars.
Buyers are only willing to pay for the ‘average’ car, which is lower than the price of a good car and higher than the price for a lemon. Hence all the bad ones get sold at lower prices and the good car sellers are unable to sell and remain outside the market for used cars.
In this way the market forces work to ‘adversely’ choose only the bad cars for transactions. The good ones are driven out of the market by the market mechanism. This situation is clearly socially in optimal and inefficient. Society would want all cars to be sold at appropriate prices.
The in-optimality can be seen in terms of the observation that the past record of cars sold (lemons) would be worse than the record of those cars which are not sold and driven out of the market. This problem is called the ‘adverse selection’ problem, as the market mechanism ‘adversely/ wrongly’ selects the bad cars to be sold, while the good cars are unable to sell.
It happens because the information about the record of the good car is known only to the seller and not the buyer; information about past records of every car is not known uniformly among buyers and sellers. Other illustrations are found in the job market (quality of workers is better known to the employee and not employer at the time of recruitment), insurance market (where the client knows more about the probability of putting up a claim than the insurer).
The solution to the problem of asymmetric information lies in making information available to both buyer and seller, reducing the extent of asymmetry. One option is to allow the agent with more/better information to give some indication about the quality of the product to the agent with the lesser information.
If a better used car owner offers a guarantee/warranty of some limited time, it signals the ‘good’ quality of the car to prospective buyers. Alternatively the agent with the less information may invest in acquiring this information by getting a check done by his mechanic. But this comes with a cost of paying for the mechanic’s services.
Example-True Value is a firm owned by Maruti Suzuki that sells old cars. It offers a warranty to the buyer for any defect for a limited period of time from purchase date. This reassures buyers that the quality of car bought will be satisfactory. Buyers are likely to buy from True Value than an unknown dealer as the warranty and the name of Maruti offers some indication of the quality of the old car offered by True Value.
‘Signalling’ is therefore one option to reduce the degree of asymmetry of information in the market. The warranty on the old car is a ‘signal’ here to the buyer. Alternatively information may be acquired to reduce the problem by either agent in the transaction. This is often costly (like the mechanic’s fees) and not done if left to market mechanism alone.
In another example of the problem of adverse selection, consider the health insurance policy as the product in the market. Asymmetry in information exists as the patient (buyer of health policy) is better informed of her health condition and medical history than the insurance provider (seller).
The insurance policy provider will like to charge a premium which the healthy will find too costly, leading them to decline the policy. The less healthy will buy the policy- the market forces have adversely selected only the less healthy, driving the healthy out of the market for insurance. A possible way to reduce this problem is that the insurance company gets a medical check done on prospective buyers, and prices the policy in line with the medical report.
This is often done in real life, especially for older buyers. Note that this entails a cost (for the medical check) which can drive up the price of the policy itself. In all the above cases the asymmetry in information is observed/ manifested before the transaction takes place. In another type of problem called moral hazard, the asymmetry is revealed after the transaction has been done.
Consider the insurance policy case again. Even if we assume that a medical test was done to reduce the degree of asymmetric information, there is no guarantee that the policyholder will look after herself after the insurance is bought. If someone does not smoke at the time of buying insurance, but starts smoking after buying the cheaper insurance the hazard becomes clear. So moral hazard creeps in after the transaction is done.
Thus, the difference between moral hazard and adverse selection is that the information asymmetry manifests itself before the exchange in adverse selection, whereas the asymmetry creeps in after the exchange has been done in moral hazard. Both can exist independent of each other as the asymmetry in both cases comes up at different times—before the transaction and after the transaction.
Externalities:
Market mechanism in the form of demand (by consumers/buyers) and supply (by sellers/producers) forces is based on the assumption that if a consumer is buying a good then she alone derives the benefits from that good. If you were to buy a new pair of shoes, then only you enjoy comfort from wearing them.
You do not consider the happiness that your sister may feel because she is the one who helped you select them. In the same way market mechanism assumes that a producer will consider only those costs that she has to incur. If she is dirtying the region by emitting foul smell she does not account for the air purifier that needs to be installed in the next door building. All these are cases of externalities.
Externalities can occur in production as well as consumption.
Consumption Externalities exist when my consumption of a good affects not only my welfare, but also the welfare of another agent, who has not have spent for the good. This can be negative or positive. When I spend on my garden and beautify it, my neighbour benefits from its beauty and serenity as she can see the garden from her balcony. But she has not paid for the garden and its upkeep. So her welfare increases without paying for the garden- this is a positive externality.
Look at the opposite of this. If I smoke in a room shared with a friend, then I derive pleasure from smoking. My friend who does not like smoking also inhales smoke without paying for it. Her welfare is reduced due to smoke inhalation, while I gain welfare. In both case private benefit/ welfare to the person who spends in order to consume is different from the total benefit received by a non payer and the payer. In the case of garden, private benefits to me from a beautiful garden are lower than social benefits, making it a positive externality or a ‘good’ externality.
In the case of smoking by the private benefit from smoking is higher than social benefit (which is reduced as my friend does not like it), making it a negative externality. There is a divergence between private and social benefits, causing an externality.
We now look at externalities in a more detailed way. This will allow us to find the solution to alleviate this problem as well. Note that equilibrium occurs at a point where the marginal benefit equals the marginal cost for every economic agent – consumer or producer.
Negative Production Externality:
A negative externality in production occurs when a firm makes a decision but does not bear the full cost of it. It equates marginal private cost (MPC) with its marginal private benefit (MPC) and reaches Qs. Society would like to equate marginal social cost with its marginal private benefit, and reach Qs.
As we show in figure 6, the private cost of production (MPC) is lower than social cost of production (MSC) for all levels of output. This results in society wanting to produce less of the good, (Qs) whereas it is produced in higher amount (Qp). Figure 6 shows a negative externality in production.
Positive Production Externality:
A positive externality in production occurs when the social cost of production (MSC) is lower than private cost of production (MPC). The firm will equate MPC with MPB to reach Qp, but society will look at MSC and MPB to produce more of the good, (Qs). As Qp < Qs the good is under produced- society wants more of it than the private level of production. Figure 7 shows a positive externality in production.
Negative Consumption Externality:
A negative externality in consumption occurs when a consumer makes a decision that benefits her, but it harms others who are ‘inadvertently’ affected by the decision. The total benefits to all people are lower than the benefits to the consumer who paid for the good. The private benefit from consuming good is higher than social benefit, so that society would like to consume less of the good, (Qs) whereas it is consumed at a higher level (Qp). Figure 8 shows a negative externality in production.
Positive Consumption Externality:
A positive externality in consumption occurs when an individual makes a decision but the benefit from it helps others also (who have no role in decision). The private benefit from consuming good is lower than the social benefit, so that more of the good is socially desirable. For the consumer, her rationality allows her a lower level of consumption (Qp) as compared to socially desired level (Qs). Figure 9 shows a positive externality in consumption. 
To sum up, an externality is a harmful/beneficial side effect borne by those who not directly involved in the production/consumption of a good. There is a difference in the privately optimal level of good and the socially desirable level of good, which makes such cases examples of market failures. The market mechanism fails to produce the socially desirable level of output of such goods. The problem arises because of the nature of goods themselves- pollution, smoke, music, beauty of environment.
This divergence between private and social optimal levels can be reduced if we recognize the basic problem of lack of markets for such goods. The property rights for such goods are not defined. If rights can be provided then externalities become normal goods that can be traded.
These rights create a market for the good under consideration, allowing self-interest to guide the economic agents to find a mutually acceptable level of the good. For example, second hand smoke is a good with a negative externality. Let a smoker and non-smoker share a room. The smoke generated by the smoker is inhaled (consumed) by the non-smoker even though he is not involved in producing the smoke.
Hence smoke is the externality good here. If there are no rights over smoking, then smoke is a negative externality. If rights to smoking are given to the smoker or the right to clean air is given to the non-smoker then they can bargain over the amount of smoke acceptable to both. Rights create a market for ‘smoke’, and offer one way to reduce the gap between socially desirable and privately optimal levels.
(ii) A negative externality occurs when an individual/firm makes a decision but does not incur full costs associated with the decision. The costs to the individual or firm are less than the cost to society.
Nature of Goods – Public Goods and Common Goods:
When we think of any good in the market, it is natural to think that it will be and must be used by those who pay for it. For example, a shirt will be worn by those who pay for it. The non payers are ‘excluded’ from wearing it (unless the buyer decides to allow his friends to wear it). This shirt is therefore ‘excludable’ in consumption. Also consumption of this shirt in terms of wearing it implies that others cannot use it (two people cannot wear it at one time!). Consumption of the shirt causes ‘rivalry’ as more than 1 person can’t consume it at the same time.
The consumption of the shirt by one person interferes with the consumption of the same shirt by another person. Consumption of the shirt is then ‘rivalrous’ due to the nature of the good itself. In contrast, a non rivalrous good can be used by more than one person at one time (like a TV show that can be watched simultaneously by more than 1 person without affecting the viewership of others).
Rivalry and excludability are two important aspects of any good. Note that it does not matter who pays for the good or if a payment is even made. These two aspects depend on the nature of the good and are not based on the buyer’s payment at all. For example, the road we walk on is a good, though we don’t pay for it.
This road can be analysed as a good in terms of Rivalry and excludability alone, without worrying about whether it has been paid for or not. Since it is a public road, it enjoys non excludability- we can’t exclude anyone from walking on it. Also my use of the road does not reduce its use by someone else (assuming little traffic on it!), making it non rivalrous also. We can then use these two aspects to make a 2 x 2 table to segregate all types of goods.
(i) A non rivalrous good can be used by more than 1 person at the same time.
(iii) A non-excludable good is one which can be used by all, without excluding anyone.
We use box 1.6 to define each type of good below:
1. Private Goods:
As the name suggests, these goods are privately owned. They are both excludable and rivalrous in nature, and ownership gives the right to exclude consumption by multiple consumers. Most goods that we buy from the market/spend money on fall in this category. Books, personal phones, food, movie tickets are examples.
2. Public Good:
As the name suggests, these goods are owned by and are for the public -there is no single owner. These are non rivalrous and non-excludable, in complete variance with private goods. Consider defence forces that guard us on the border or police services in your locality. Note that there is no direct charge for these services; also no one can be excluded from the safety/security they provide making them non excludable.
Also security provided to one person does not reduce the security provided to another person, making consumption of these services non rivalrous in nature. Multiple people can consume these goods/services without adversely affecting each other’s consumption of these goods/services. A DDA park with free entry is another example of a public good.
These goods are associated with ‘free ridership’ also. A free rider is a consumer who wants a ‘free’ ride. He consumes a good but does not pay for it, assuming that others will pay for it. He ‘rides’ on the assumption of others paying for the good that he enjoys. If all consumers think in this way, and refuse to pay then who will pay for the good? In an extreme case no one pays and the good remains unavailable to all- no one gets to take the ‘ride’.
Take the case of students living in a flat A on sharing basis. The next door flat B also has some students who have Wi-Fi connection. The students in flat A manage to hack into the account and start using the Wi-Fi from flat B. Flat A students does not pay for the Wi-Fi but use it, making them free ride on students in flat B who pay for the Wi-Fi connection.
Take the case of erecting a light pole in the common area of these flats for greater security. Each student refuses to pay towards the pole since he believes that others will pay. This way the light from the pole will become a free good for each student. But in a collective way the results are not as expected. When everyone refuses to pay, the pole is not erected and all remain without light. In this case the good (electric pole) remains missing, and consumption is zero.
The market mechanism fails to cause consumption of the pole and light from it. All suffer from the absence of light because each one wanted to free ride on the others payment for the pole, though it is in common interest of safety of all to have the light from the pole. These examples illustrate the association of free rider problem and public goods clearly. In extreme cases it leads to non provision of the good in question. Since the good is ‘missing’ the market mechanism has failed to cause efficient consumption levels, which qualifies for a case of market failure.
Example of Free Ridership:
In the old days lighthouses were built along the coast to prevent ships from running aground on rocks in unfamiliar ports. By shining a beam of light over a port and guiding ships away from rocks, these vital buildings reduced the risk for ship captains and were generally considered to be extremely valuable resources. Curiously, lighthouses were almost always run and maintained by local governments. Why? The answer to this lies in the nature of the good.
A lighthouse is a public good. The light that it shows/facilities provided by the light house can be used by a ship without hindering the use by other ships, (non-rivalrous consumption) The light is not diminished if 1 or many ships benefit from it. Many ships can use the light simultaneously without affecting others consumption of the light. There is no way that anyone can stop a ship from using the light (non-excludability).
The problem is that every ship owner will like to free ride. If a private developer were to ask a price/willingness to pay for the light the captain of each ship will reveal a low willingness. This is because each captain believes that other captains will be truthful and the lighthouse will be built. Once built, he can use it by paying a low price for its upkeep. This is ‘free-riding’.
Every captain wants it but they show they are not interested and are unwilling to pay in the hope that others will show their true need and pay for it. Every captain wants to use the lighthouse without paying for it (or paying a low price) and ‘free riding’ on others. If everyone pays a low price the lighthouse is not viable and does not get built or maintained by private firms. This is why the government needs to step in and provide a public good, in the interest of social welfare and safety of ships and people on them.
The same case can be made for medical care or vaccinations. If a person takes medical care then, it benefits not just this person but others around him also as the risk of infection spreading is lesser. Even if a person spends on medical care, its benefits are reaped by many others who don’t pay for it. Consumption of medical services or vaccination are non excludable – we can’t stop anyone from benefitting from less spread of the virus against which vaccination was done (non rivalrous). And there is no way we can limit these benefits to the payer only (non exclusion).
As a result this is a public good. At the private, individual level less people will opt for medical care as it costs money. From a society’s viewpoint more medical care is required for efficiency. The private benefits are lower than social benefits. This encourages government provision which looks at social benefits to decide the level of medical care that is optimal in the economy.
Low Congestion Good:
This good is non-rivalrous and excludable. Consider the DDA Park again. Assume that we can now charge per person for entry to the park. This way use of the park is excludable- the payment/fee can be used to exclude users. By its very nature the use of the park is non-rivalrous many people can use it at the same time (assuming that there is no rush to walk in it or use its swings). As long as there is low congestion the benefits can be reaped by multiple users simultaneously.
If the congestion rises to a high level, then the use of the park by 1 person will affect its use by others. However it is assumed that the fee charged ensures that high congestion is not reached. This explains why the name of such goods is ‘low congestion’ goods. Low congestion is ensured by excludability.
If congestion does rise then consumption can become rivalrous. A good example is toll roads and toll bridges. The users pay for the services, because the congestion is low enough to allow them to use the road for faster travel in an effective way. If there is heavy traffic then users may not use the road as it no longer saves time for them, for which they were paying in the first place.
Common Property Good:
Let us return to the DDA Park which was free for everyone to walk into. Assume that it is morning time and the park is very crowded and the walking area is crowded. Now the consumption of this area by one person stops another new person from walking on it due to crowding, which makes consumption rivalrous in nature. Such a good which enjoys rivalrous and non-excludable consumption is a common good. This also explains why such parks are often overcrowded.
Such goods often suffer from the tragedy of commons problem. Consider a grazing ground full of grass in a village. All people who have cows in their homes bring their cows for grazing here. As a result, the ground is crowded and there is little grass-left for cows. With little grass left the purpose of bringing them here is defeated. But no one realizes they are contributing to the depleting grass.
Each one thinks that it is the ‘other’ cows (and not his own cows) who are causing the depletion of grass. Because such goods are ‘common’ for all and the use can’t be excluded it becomes worse for all – the ‘tragedy’ is that everyone suffers without realizing that each of them is contributing to the cause of their common tragedy.
A similar thing happens to the lawns around India Gate during New Year day. As there is no entry fee, many people reach the place to celebrate the New Year. This causes a huge rush and overcrowding on the lawns, making it impossible to sit on the grass and enjoy oneself.
Each visitor believes that the crowding is due to all the others reaching the lawns, without realizing that she herself is also contributing to the crowd. A ‘common’ ground becomes a ‘tragedy’ because no one is able to enjoy the lawns and ambience as it is overcrowded.
Another example is the free Wi-Fi provided in public areas like your own college. When everyone uses the Wi-Fi the download speed for each user is lowered; sometimes we are unable to download even messages on Whatsapp. Each of us blames ‘others’ for the low speed; not realizing that we are also contributing to the low speed by using it. This way the actual level of use of Wi-Fi (as a good) is much lower than the efficient level which allows downloads.
In all the cases above the market has failed to ensure optimal and efficient level of consumption of the good in question, except for private goods. In a public good there can be zero consumption as the good is absent due to unwillingness to pay for it and free ridership.
For a congestion good, the amount of the good used is lower than socially desirable level society would want all people to use the toll road). A common good is in contrast as it is overused. Such a good must be used in lesser amounts if the benefits are to reach the users. The market leads to a consumption level that exceeds the socially optimal levels.
Correction of Market Failure:
Once we acknowledge that market mechanism can fail (to ensure production of socially optimal amounts of a good), we now look into ways to deal with the problem. Each solution is based on the cause of the failure. We can also investigate if the government has a role to play in mitigating the problem.
Methods to Correct Market Failures:
Note that an ideal solution to market failure is to remove the cause of the failure. In most cases it is not possible due to the very nature of the good involved. At best we can improve the outcomes given by the market mechanism, so that we are closer to the socially optimal outcome.
1. Consider the information asymmetry problem. A possible way to reduce the asymmetry is to issue rules that require voluntary disclosure of information. If the government puts up a database of all cars in public domain then any prospective buyer can check the details for the used car he wants to buy at zero cost. In the same way government can mandate that all manufacturing companies take a quality assurance certificate from registered agencies, which shows that quality standards have been maintained.
ISI mark on electrical appliances, hallmarking of jewellery are examples of such assurances. Such rules give a ‘signal’ to the buyer about the quality of the product. An appliance without ISI mark will be deemed inferior to an appliance with ISI mark.
2. Consider the problem of common good that is overused. This good can be made fee based, which converts in into a low congestion good. But this suggestion runs into trouble as some people believe that government must provide some goods free, as we pay taxes to it. They believe that government must not be like private companies that charge for all goods.
3. Consider public goods, which suffer from free rider problem. A possible solution to reduce the severity of non-provision of the good is to charge a small fee from all towards that good. Involving the users is also an option that public private partnerships rely on. The Bhaagidari Scheme of Delhi government is an example.
It allows such partnerships between government and resident welfare associations towards public goods like security, cleanliness and safety. Once the people are involved their willingness to ensure delivery of such goods is higher, making it easier to provide these goods.
The problem of externalities has been dealt with extensively in Economics as this problem is manifested in real life and often affects critical areas like health and welfare. A variety of solutions have been provided by theory.
4. Fixing limits on the amount of good produced that is creating the externality. If we refer to the figure 3 we would want a level of Qs, (instead of Qp, which is privately optimal) to be produced. The government can set a limit on output level at Qs level. Any excess production must be fined and production must be stopped in extreme cases of violation. This is called the command and cap solution. The problem with this solution is that enforcing it is difficult as it is forced on producers rather than a self-enforcing solution.
5. Taxing the good that causes negative externality. The problem of overproduction in a negative externality exists as the marginal private cost (MPC) of producing the good is lower than the marginal social cost (MSC). If we can increase the private costs then the difference between Xs (socially optimal level) and Xp (private optimal level) can be eliminated as shown in figure 10. One way to do this is to tax the good X.
A tax on every unit (shown by the dotted line) will increase private marginal cost (MPC shifts from MPC1 to MPC2). The optimal level of production is now X2, which is lower than Xs. We are still not producing the socially optimal level of Xs, but the gap between Xs and actual production is lesser now. (Xs-Xp < Xs-X2); the externality still remains but its extent is lower now. If we can tax in a way that equates MPC2 to MSC then the private optimal level will equal social optimal level of X, eliminating the externality completely.
This was suggested by an economist A C Pigou, leading such a tax to be called the Pigou Tax. The only problem in this tax is that it is difficult to derive/quantify the curves MPC and MSC in a precise manner. This makes it difficult to determine the optimal tax rate required. If we do not know the curves exact location then we do not know the optimal tax rate on each unit to be levied.
Due to this problem, such taxes are used to reduce the extent of externality, rather than eliminate it completely. A ‘sin’ tax on cigarettes and alcohol is one such example. Government levies highest tax rates on these items in order to increase the private cost of these goods, and hope for lower consumption levels. The socially desirable level of tobacco is probably zero, but it is not attained.
6. Subsiding the good with positive externality. This is in complete contrast to the case above. Remember the garden whose beauty was enjoyed by the neighbour without contributing towards the garden upkeep. Society would want the garden to be maintained, but the owner may not do as properly as it costs money.
The socially optimal level of garden beauty (as a product that is produced) is higher than the private level of production. To encourage socially optimal level, the government can grant a subsidy to the garden owner. This will help him to reduce his costs, causing higher level of production of garden beauty.
A real life example is the distribution of free plants and saplings by the Municipal Corporation of Delhi on a regular basis. The idea is that plants generate greenery which is a positive externality. To encourage higher level of greenery through more plants, saplings are given free so that the people who plant them can be saved from the cost of buying the saplings from the market.
7. Ronald Coase, the 1991 Nobel Prize winner focused on transaction costs to provide another solution to the problem of externality. He suggests setting up ‘property’ rights to ensure a self-enforcing optimal state that relies on market mechanism itself. Consider the friend who did not like to smoke, but was forced to inhale passive smoke due to her smoker roommate.
If passive smoke could be bought and sold in a market, then the smoker will buy it from someone who is willing to sell passive smoke. The market for ‘passive smoke’ is missing, which precludes such buying and selling. Now let us create a market for it by allotting rights over passive smoke. Let us give the right to a clean air to all.
Now those who don’t like smoking can tell the smokers that their right to clean air is violated -either stop violating this right or pay us for violating it. At best this payment must equal the health costs associated with passive smoke. Since it ‘costs’ to smoke now, the smoker will account for this cost and rationally reduce his smoking level.
A similar right to smoking will have same effects. Now the passive smoker can pay the smoker for reducing the level of cigarette consumption. This payment is now a benefit that smoker gets from reducing his consumption. If the payment is valued more than the pleasure from smoking, the smoker will reduce his level of smoking. Thus, we need a payment that balances the pleasure from smoking. This payment is then a ‘price’ of smoking; a market for smoking has been created.
Once a market is created, the self-interests of smoker and non-smoker (who is the passive smoker) will ensure a solution that reduces the extent of externality. The difference between the socially optimal level and private optimal level will be lowered. The problem of externality is often described as the problem of ‘missing markets’ also.
The solution lies in creating market with property rights. Note that the solution will be same irrespective of who gets the right (the right to smoke or the right to clean air). As long as property rights are provided, a market is created that reduces the externality. Another example is the case of development projects like industrial development that are rooted in public interest, but cause pollution that affect farmers negatively due to decline in soil quality, and water quality caused by pollution that leaks into the soil.
The problem exists because there is no market for soil or river water that is used for irrigation. Such a market can be created if the government were to grant the right to standardized water quality and soil to farmers. This would allow them to demand the river water from any industry that uses it, reducing the amount available for farmers. Industry can then buy water from farmers at a ‘price’ that is mutually agreeable. The market mechanism will come into force and the solution will be self-enforcing.
Accordingly if I can charge for the garden view then my neighbour will ‘consume’ the good (which is the view) only after paying for it. In the same way if rights over clean area are given to people living in the area then the factory owner will be charged for throwing waste in the area.
This will make him reduce/stop the waste that he throws and the ‘waste’ (which is the good here) does not suffer from market failure. Assignment of property rights is the solution to the problem of externalities, as the gap between marginal cost and benefit is reduced to zero.
Thus we can have multiple ways to reduce the degree of market failure:
1. Command and cap policy.
2. Taxing the good causing a negative externality- Pigou tax.
3. Subsidising the good causing a positive externality.
4. Fee based use of a common good.
5. Reducing the information asymmetry by standardization
6. Granting property rights.
Role of Government in Correcting Market Failure:
It is possible to reduce the extent of market failure with corrective action. This reduction must be considered as a decrease in the gap between the socially optimal level and privately optimal level (provided by the market mechanism) of a good.
In some cases corrective action can cause the socially optimal and privately optimal levels to match, but this is not the general case in real life. In reality, any solution will only reduce the extent of market failure. For example the pollution levels do not drop to desired social levels, but are at best controlled using various rules and fines.
The next question that comes to mind is: who will undertake these corrective measures suggested above? It is obvious that such measures must be backed by a competent authority, which is capable of making and enforcing laws. In any modern economy this authority lies with the government.
This provides for a larger role for the government in terms of making rules/laws, and then enforcing them and following up with punitive measures if the rules are not adhered to. Thus in terms of reducing the extent of market failures, the government has a role to play in almost every solution proposed. This can take many forms depending on the cause of the failure as well as the proposed theoretical solution.
1. The government makes laws / rules to limit the extent of pollutants that can be discharged by a firm, and fixes these levels as well.
2. The government assigns property rights. It decides what park is public (open to all) and which ones can be paid for. For example in Delhi DDA sports complexes are owned by the government but access is fee / membership based. A ban on smoking in public places is equivalent to giving the right to clean air to people. Similarly, the ban on loud music after 11 pm in Delhi implies that people have been given the right to silence after 11 pm.
3. The government mandates laws that require firms to install equipment that lowers pollution levels. It also requires firms to discharge their waste responsibly, after proper treatment to reduce the toxicity content and pollution level. The government now allows only CNG run public transport (buses and autos) in Delhi- this is an example of a law that forbids pollution creating fuel to be used.
4. Taxing polluting good is also an effective way to reduce the quantity used of the good- a higher tax on cigarettes is an example. As smoking causes a negative externality, the government seeks to limit its consumption with higher taxes.
5. Government agencies are responsible for grading and standardizing many goods. FSSAI on all eatable items, Agmark on food commodities, BEE mark on electrical appliances, BS standards on cars and vehicles, hallmarking for jewellery are clear examples where such ratings/marks as used a signal to reduce the degree of asymmetry in the market. A gold bangle with hallmark on it is a signal that the gold is pure, as compared to a non hallmarked bangle.
6. In extreme cases the government can make laws to deal with cases of market failure. The odd-even rule in Delhi is one such example. It was a rule made when pollution levels were beyond safe levels.
7. The government gives a subsidy on solar panels. This is done to encourage use of solar power, which is currently underused, but is a case of positive externality.
8. The government provides many public goods, which would not be provided privately. Examples include roads, police, street lighting, waste management, parks. More recently Delhi Government has installed gyms in public parks, as private provision would lead to no provision, though gyms promote health. The facilities of free medical treatment, as well as campaigns for specific diseases like Tuberculosis (DOTS program pic) are provided by the government. This is useful in two ways.
One, private provision of health facilities will leave out the poor, which is anti-welfare. Secondly, health is a public good. If I suffer from TB and do not get treated, then I can spread the virus to others. This is a case on negative externality, as my neighbour can suffer from the disease that was transferred to him without his approval or knowledge. Even I do not know when and how the disease was transmitted to him. This is especially true for viral infections and air borne diseases.
Thus we see that the role of government is very pervasive and wide, which explains why the government has a role in most activities that happen around us. This spread of the government around us is based on market failures that are common in any market economy. In many cases the nature of the good itself creates the failures, which must not go uncorrected. The correction of these market failures leads the government to take different roles in an effort to improve welfare of society.