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Market Failures and Government Responses

In the economy, a perfectly competitive market is where there are no giants or monotony within the market. Perfect market firms are referred to as price takers because they do not influence the set prices. Since many companies are producing similar products, the price is set along the equilibrium. One advantage is that the cost of production and transportation is much easier.

Buy such a market exists only in theory. Most of the markets produce imperfect outcomes, which can be corrected by a change in the incentive structure or reallocation of resources. Imperfect market outcomes lead to market failure.

A market failure explained

To correct a market failure, it is first important understanding of what it is and how it happens. The simplest understanding of this concept would be a market that fails to attain the standards of “a perfect competition in the general equilibrium of economics.” It can be easily identified in most markets if not all.

Think of it this way, that price equilibrium is a changing target; now all sellers and buyers in the market can be liked to sprinters in a race, except that the finishing like is not constant – it keeps shifting left, right, up and down. 

Another good example is a situation where economic participants are not proper incentivized to push the market towards more convenient results. This is the basis of academic literature.

During the period of 2008/2009, the world faced the most significant economic recession. Consumers were forced to change their consumption behaviors in ways they would never have imagined. They focused on choosing whatever was more relevant and leaving out most of their normal expenditures due to budget constraints. Things were better in developed countries like the USA, where unemployment funds from the government shielded some.

Such a situation shows in detail how market failure can negatively affect an economy when there is a non-optimal allocation of resources. All the opportunities for input resources (social costs of manufacturing goods or services) used in the production process are not minimized. The result is poor management of funds and wastage of resources. 

Consider, for instance, the minimum wage policy. This law has been under discussion and arguments for the longest time. It puts wages beyond the prevailing market-clearing wage to raise market wages. To some critics, higher salaries will compel employers to take in less number of minimum wage employees that before the act was passed. And this meant an increase in the unemployment of these workers. The situation forged social costs that led to market failure. 

What causes market failures?

Another critical aspect of economic failure is what causes. First, we have already seen that markets fail when goods and services are inefficiently allocated. Note that price mechanisms are among the most critical aspect of a healthy economy. It determines both production and consumption. Hence, where the price mechanism fails to consider all the benefits and costs involved in an entire cycle of a product, a market failure is inevitable. The market will not produce socially optimal goods.

As stated above, the nature of the modern economy does not permit for perfectly competitive markets. The result becomes many barriers to entry and exit of firms into markets. As such, most markets are not successful and require some kind of intervention to keep them going. Here are some other reasons why a market may fail.


An externality can be defined as an effect of a third party, which is normally initiated by availing a specific good or services. There are positive externalities, which is the positive spillover benefited from products. For example, a public education system may impact only schools and their students, but an educated society will stretch positive effects on the whole community. A negative externality is a negative spillover impact from a third party. For example, constant smoking in public may affect the health of people, even those who don’t smoke.

Environmental policies 

One of the significant global goals is to sustain the environment. This means the government has to review the economic impact of the economy on the environment along the line of sustainable development. Markets that seem to affect the environment may not be allowed to continue.

Scarcity of public goods

Even with an increase in consumption, the cost of production for public goods remains constant. A lighthouse, for instance, has a cost of production that does not change no matter the number of ships that use it. Under the production of public goods is a threat to the economy. 

Limited merit goods

The underproduction of what is known as merit goods also threatens markets. These are goods from the private sector that the society believes may be under-consumed. Sectors like healthcare, education, sports center, and many such are considered merit goods. 

Too many demerit goods

Demerit goods are goods the society believes to be over-produced and used. They usually come from negative externalities. Goods such as alcohol, cigarette, drums, and related products fall under demerits goods. In other words, they don’t have value to society, yet they are overly products.

Wrong use of monopoly power

A monopoly can be a great way to save a failing firm. Consider, for instance, a situation where the government may pass an act to give one firm monotony to supply a specific product. In an imperfect market, there are output restrictions to maximize profits. 

Government Interventions in Market Failures

A perfectly competitive market is a scenario used in defining what an ideal market should be. Market failure can be corrected by letting consumers and competing producers shift the market toward equilibrium. Due to the limitation of human knowledge and universal effects, attaining such is almost impossible.

In the modern economy, markets play a vital role in sustaining growth and development. Hence policy experts and economists constantly try to find possible policies and rules for compensating market failures. Things like tariffs, punitive or redistributive taxation, trade restrictions, disclosure mandates, price ceiling, and other economic-related distortions are mooted to rectify unsatisfactory outcomes.

To other economists, the market is obviously imperfect. Bu y market failures are not appropriately framed. They say it is not about whether market failures and perfect competitions have a relation. Instead, it is about the relationship between market performance and other human triggers.

Milton Friedman, FA Hayek, and other free-market economists have recognized that a market is the only known discovery prices that can adequately adjust to inefficient changes. They argue, therefore, that interference from regulatory rules can cause deterioration rather than improve these inefficiencies. 

Despite these arguments, there are several actions that can be adopted to try and rectify the issues. Note that market failure can justify government interventions.

Controlling monopolies

A government can control a monopoly power in the market by imposing restrictions to trade practice legislation anti-monopoly acts. Monopolies lead to unfair competition. The government can remove such competition, prevent price discrimination, and fix prices to meet competitive prices.

Also, a government can use taxation and price laws to deescalate all monopoly pricing structures. A price ceiling can be used to pull down monopoly pricing to an equal level. To do this, authorities may set up commissions that fix the price of monopoly products, setting it below the monopoly price. 

Another way could be through taxation. For instance, authorities can levy taxes in lumpsum without considering the monopolist’s output. This can be done through proportional output, where buy taxable quantity rise with input increase. In either case, the aim is to pull down the monopoly to a competitive level. 

Using external factors

As Pigou suggests, social control approaches can be employed together with subsidies and taxes to create a perfect allocation of resources in relation to different externalities. Interference from the government can include can using an external diseconomy for removing by a divergence between social and private expenditure and benefits. If, for instance, a firm owner is moving out of a residential area, the government can ask them to the extent to appropriate facilities. In case of any external diseconomy of consumption, the government can implement laws banning loudspeakers, except if permitted. 

Let’s step back a bit:

- Externalities are spill-off impacts originating from production and consumption were there no compensation.

- They are beyond the borders of market transactions.

- They can initiate market failures if the price mechanism does not consider costs and benefits.

- Externalities can either be positive or native

Pigou continues by encouraging governments to grant subsidies to each product unit. This move would encourage the manufacture of products bearing positive externalities. Since consumers want to maximize their satisfaction by tax concession, this move will encourage them to buy more goods and services. Seller fears producing where negative externalities face, and consumers are discouraged from buying because of levies.

If the government, for example, imposes a tax on families living a specific area,s they can be able to compensate a smoke emitting factory for relocation. Hence, subsidies and taxes can create a bridge between social and private expenditures and profits. 

Another standard measure involves the utilization of externalities in production. For example, companies in oil production can create over-pumping and over drilling. But if they merge, they can ensure more efficient extraction.

Production of more public goods

Public goods are not availed in the free market, because they are non-rivaled and non-excluded. Privates and only public authority cannot provide them. And the benefits that come from them cannot be divided. Rather, the government makes people share the costs of these utilities to improve them. For instance, each person can be charged an equal part of the maximum amount they can pay, discouraging them from forsaking the product. But they must fix the proportion to cover the whole production cost. The government can produce special public goods, like defense. Or, it can buy private firms that meet the relevant production guidelines.

Returns to scale increment 

There are largely different opinions regarding the role of governments in market failures, regarding increasing returns to scale. To some, the governments need to nationalize industries that work under decreasing costs, hence overproducing. But may disagree with this, arguing government intervention only makes things worse. To others, it would be better if the private sector manufactured products while the government handles price and tax regulation in order to balances costs and profits.

- Indivisibles.

The case of indivisibility in goods and services is a matter for different entities. It includes various persons, like paved roads, traffic lights e.t.c. Local authorities, including civil corporation – all which have to be spent on maintenance and repairs. The costs, in this case, will come from residents of the area where they are located, and who use them.

- Property right and coarse theorem.

In any case, property rights give rise to external situations. It seeks to answer the questions of ownership, use, the rights of people, and transfer processes. And because of this, individuals can prevent anyone from imposing a cost on them. Such include all public properties.

Perhaps distributing wealth from the rich to the poor could be another solution. But the issue of changing property rights, more than just extending ownership, has to be handled. Hence, that would not be a possibility.

A government could charge for damages or compensate for them. But they will have to deal with low-value products as well. The government may again seek legal advice for monetary damages arising from externalities. For instance, Ronal Coase, a British economist, suggested that a market failure from property rights can be easily handled through mutual understanding among parties. 


In the wake of 2009, no one was ready for the extension of the Global financial crises that started in autumn 2008. The world was not sure whether it could grow into the Great Depression. But after twelve months, there was an expression of the Great Recession returning. The worst, then, seemed to be over. The US government was largely applauded by private economists for its response. However, there were some remedies enacted that seem to haunt the global economy ever since. Even though the crisis did not send the world back to historical times, it contracted economies in many countries. The ripple effect of the crisis went beyond finances. But it was clear market failures can greatly affect an economymarket failure, and government interventions are necessary. 

Author: James Hamilton

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