How governments attempt to correct market failure

When the forces of market fail to allocate resources efficiently, the government may attempt to intervene to correct the market failure. There are several ways in which government can intervene in the market:

Type of Intervention How it works Strengths Weaknesses
Taxation Reduces supply and therefore increases price, to discourage production /consumption of a good that has negative externalities. Works through the price mechanism. Easy to understand. Can be expensive to collect. Difficult to know the correct level of tax to set, as it should equal the external costs (= difficult to measure). Ineffective if PED is inelastic, as tax will have to be very high to reduce equilibrium quantity. Can be regressive.
Subsidy Increases supply and therefore reduces price, to encourage production /consumption of a good with positive externalities. Works through the price mechanism. Easy to understand. Expensive for government — incurs an opportunity cost. Difficult to know correct subsidy to provide as it should equal external benefits. Producers may pocket the money and not increase supply.
State Provision Government directly provides a good or service, funded through tax revenue, in order to provide goods which have positive externalities or are public goods. Increases fairness of access to services such as healthcare and education, which have many positive externalities attached. Without Government provision, public goods wouldn’t be provided. Trustworthy provided with common standards. Expensive for Government — incurs opportunity cost. State monopoly can result in inefficiency (eg through bureaucracy etc). Difficult to maintain consistent standards.
Buffer Stocks Government purchases commodities if a floor price is reached and sells commodities if a ceiling price is reached. Ensures fair income for producers and fair prices for consumers.
  • storage is expensive
  • transport to and from storage is expensive
  • it works only if goods are non-perishable
  • it is nearly impossible to ensure that the amount kept in storage will equal the amount required for release in the future to lower prices
Regulation Government imposes rules regarding the production, sale or use of a good/service, and backs this up legally by fines/ prison sentences etc. Aims to tackle negative externalities. Easy to understand and often easy to monitor/police. Expensive to monitor/police. Firms may ignore fines if they are not large enough. Can be anti competitive. Often difficult to ‘pin the blame’ on the appropriate person, therefore unfair.
Pollution Permits An efficient amount of pollution is agreed, and a corresponding number of permits released — these can be traded amongst firms so that low polluters can sell to high polluters and make a profit. Aims to tackle negative externalities. Uses the market mechanism, therefore efficient. Requires little Government intervention, therefore cheap to run. Difficult to set correct amount of pollution and therefore right number of permits.
Extended Property Rights Aims to identify who is responsible for paying for external costs, therefore reducing negative externalities. The economist Ronald Coase argued that it didn’t matter whether the producer or the consumer took responsibility — either would be an efficient outcome. Once property rights are allocated, no more Government intervention needed in theory, therefore cheap. Difficult to allocate property rights when they have never existed before. Some property rights cannot be allocated, eg carbon emissions cause global warming, but no-one ‘owns’ the world and it would be
politically undesirable for this to happen.

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