Theory of Public Finance (GE)
market failure
Presented by:
Divyanshi 22/51038
Dhwani 22/51079
Niti 22/51072
Prerna 22/51079
Riya 22/51087
overview of market failure
Market failure refers to a situation defined by an inefficient distribution of goods and
services in the free market. In an ideally functioning market, the forces of supply and
demand balance each other out, with a change on one side of the equation leading to
a change in price that maintains the market's equilibrium. In a market failure, however,
this balance is disrupted.
When markets fail, the individual incentives for rational behavior do not lead to
rational outcomes for the group. In other words, each individual makes the correct
decision for themselves, but those prove to be the wrong decisions for the group as a
whole
six basic market failures
1. Imperfect Competition
2. Public goods
3. Externalities
4. Incomplete markets
5. Imperfect information
6. Unemployment and other macro-economic
disturbance
Understanding Market Failures
and Government Intervention
Ideal Market Conditions Strategic Behaviour of Firms
Under perfect conditions, markets ensure Firms may engage in strategic behaviour to limit
Pareto efficiency, benefiting competition, further
all parties involved exacerbaune marker failure
Negative Externalities Role of Government
Markets frequently overproduce Governments intervene to define
nerative externalites, such as property rights, enforce contracts
pollution, leading to societal dissatisfaction. and ensure marker emiciency.
Underproduction of Public good Competition and Market failure
Markets tend to underproduce
essential public poods like arts and The lack of pertect competition
research, which require government creates market tailures.
support necessitating government intervention
failure of competition
Failure of competition refers to situations in which markets deviate from the ideal of perfect
competition, leading to inefficient outcomes that can result in market failure. In perfect competition,
many small firms exist, none of which can influence market prices, and resources are allocated
efficiently. When competition fails, this efficiency breaks down, leading to potential welfare losses.
For markets to result in Pareto efficiency, there must be perfect competition; that is, there must be a
sufficiently large number of firms that each believes it has no effect on prices. However, in some
industries-supercomputers, operating systems and chips for PCs, aluminum, cigarettes, and greeting
cards, for instance-there are relatively few firms, or one or two firms have a large share of the market.
When a single firm supplies the market, economists refer to it as a monopoly; when a few firms supply
the market, economists refer to them as an oligopoly.
In all these situations. competition deviates from the ideal of perfect competition, in which each firm is
so small that it believes there is nothing it can do to affect prices. It is important to recognize that under
these circumstances, firms may still seem to be competing actively against each other, and that the
market economy may seem to "work" in the sense that goods are being produced that consumers seem
to like.
failure of competition
Common causes of the failure of competition include:
Monopoly: A single firm dominates the market, allowing it to set higher prices and restrict output,
reducing consumer welfare. This lack of competition leads to inefficiency, as prices exceed marginal
costs.
Oligopoly: A few firms control the market, which can lead to collusion or strategic behavior. Firms may
set prices above competitive levels or restrict output, resulting in higher prices for consumers and
reduced efficiency.
Monopolistic Competition: In this form of competition, firms produce slightly differentiated products,
and each firm faces a downward-sloping demand curve. Although firms compete, the market may not
achieve full efficiency due to excess capacity or markups over marginal cost.
Natural Monopoly: In industries where high fixed costs and economies of scale make it more efficient for
a single firm to supply the entire market (e.g., utilities), competition is naturally limited. This can lead to
market failure without regulation.
Barriers to Entry: High barriers, such as large capital requirements, patents, or regulatory hurdles, can
prevent new firms from entering the market. This limits competition and allows incumbent firms to
maintain high prices and profits, leading to inefficiencies.
Public goods
What Are Public Goods?
Public goods are items or services that are available to everyone in society. The market either doesn’t provide them, or if
it does, it provides too little.
Examples: National defense, street lighting, lighthouses.
Key Features of Public Goods:
Non-excludability: You can’t stop anyone from using them, even if they don’t pay. Once available, everyone can benefit.
Example: If a lighthouse is built, any ship passing by benefits from its light.
Zero Marginal Cost: Adding more people doesn’t increase the cost of the good.
Example: Defending one extra person in the country doesn’t cost extra for the military.
Why the Market Fails to Provide Public Goods:
Free-Rider Problem: People benefit without paying, so private companies don’t want to produce these goods.
Example: A private company won't build a lighthouse because all ships, even those who don't pay, will use it.
Underproduction: If provided by private companies, they only focus on their own benefit, not the benefits to everyone.
Example: A large shipowner may only build enough lighthouses for their own ships, ignoring other ships that need
Why Governments Step In:
Governments often step in to provide public goods because they are necessary for society, but the
market doesn’t supply enough.
Government's Role: Ensure that everyone has access to these goods, like building more lighthouses or
providing national defense.
Inefficiency Without Government:
Without the government, society wouldn’t have enough public goods like clean air, parks, or national
defense because private companies would find them unprofitable.
Everyday Examples:
Street Lighting: No one pays directly for street lights, but everyone benefits when walking or driving at
night.
National Defense: The military protects the entire country, and you can’t exclude anyone from that
protection.
Externalities
Externalities occur when the actions of one person or company impact others, either positively
or negatively.
Example: A factory polluting the air (negative externality) or someone planting a beautiful
garden that benefits the neighborhood (positive externality).
1. Two Types of Externalities:
Negative Externalities: When someone’s actions harm others without them being compensated.
Example: Air and water pollution from factories, which negatively affect the health and environment of
others.
Positive Externalities: When someone’s actions benefit others, but the person doesn’t get rewarded for it.
Example: A homeowner who fixes up their house, raising the property value for the entire
neighborhood.
Why Externalities Lead to Inefficiency:
In negative externalities, people or companies don’t bear the full cost of the harm they cause, so
they continue harmful activities.
Example: If car owners don't pay for the pollution they cause, more cars will be on the road,
increasing pollution levels.
In positive externalities, people or companies don’t get the full reward for the benefits they
provide, so they do less of these good activities.
Example: Without rewards for creating parks, people won’t invest in making public spaces
beautiful.
Role of Government:
Governments often intervene to reduce negative externalities (like pollution control) and
encourage positive externalities (like providing incentives for green energy).
Example: Without government rules, pollution would be too high because businesses wouldn’t
voluntarily stop harming the environment.
Incomplete Markets
What Are Incomplete Markets?
Incomplete markets occur when private companies fail to provide goods or services, even though people are
willing to pay for them.
Example: Lack of affordable health insurance or loans despite demand.
Why Markets Fail:
Risk: Companies avoid offering products in risky areas, like disaster insurance.
Profit: Businesses may not find it profitable, even if people are willing to pay.
Impact on Society:
Essential services like insurance or loans are unavailable, causing economic gaps and inequalities.
Role of Government:
The government steps in to provide services like health insurance or loans when private markets fail.
Insurance and Capital
Markets
1. Failures in Insurance Markets:
Private insurance markets often fail to cover key risks, like bank failures and natural disasters.
The government set up programs like the FDIC (Federal Deposit Insurance Corporation) in 1933 to insure
bank deposits after the Great Depression and provides flood insurance where private companies won’t.
After the 1967 urban riots, private insurers refused to offer fire insurance in inner cities, leading the
government to intervene.
2. Government Insurance Programs:
Crop insurance is provided to farmers when private markets fall short.
Unemployment insurance helps individuals during job loss.
The introduction of Medicare in the 1960s helped the elderly secure health insurance, which private
markets were not offering.
3. Inflation Protection for Investors:
Since 1997, the government has issued Treasury Inflation-Protected Securities (TIPS) to safeguard
investors from inflation.
4. Capital Market Interventions:
In 1965, the government guaranteed student loans to increase access to
education loans, which private markets weren’t providing sufficiently.
Due to high profits and excessive interest rates by private lenders, the
government became a major provider of student loans.
Programs like the Export-Import Bank and Small Business Administration provide
loans to small businesses and those involved in international trade, addressing
the issue of restricted access to credit in these sectors.
ASYMMETRIC INFORMATION
AND ENFORCEMENT COSTS
1. Asymmetric Information occurs when one party has more knowledge about a product, service,
or transaction than the other. This imbalance often leads to inefficient market outcomes,
contributing to market failure. Two common examples of market failure due to asymmetric
information are adverse selection and moral hazard.
Adverse Selection: This occurs when buyers or sellers with better information exploit that
knowledge to their advantage. For example, in insurance markets, individuals with higher risk are
more likely to purchase insurance, while those with lower risk might avoid it due to higher
premiums. The insurer cannot fully assess the risk, leading to a pool of insured individuals with
disproportionately high-risk profiles, causing the insurer to either raise premiums or exit the
market entirely. This situation can cause missing markets, where no insurance product is offered
at all.
Moral Hazard: This arises when one party's behavior changes after entering into a contract
because they are shielded from the consequences. For instance, after purchasing insurance, a
person may take more risks because they know they are covered. This leads to higher costs for
insurers and potential misallocation of resources, as insurers cannot monitor all actions of their
clients, contributing to inefficiencies in the market.
2. Enforcement Costs:
Enforcement costs refer to the resources needed to ensure that parties adhere to contracts or
laws. When these costs are high, it can lead to incomplete contracts or ineffective regulations,
further exacerbating market failures.
Contract Enforcement: In many markets, enforcing contracts (such as loan agreements or
product warranties) requires legal or monitoring resources. If these enforcement costs are too
high, firms may either avoid entering into contracts or pass the cost onto consumers. In cases like
labor markets, enforcing contracts for wages, working conditions, or benefits can be expensive,
leading to exploitation or inefficiencies when compliance is low.
Regulatory Enforcement: Governments and institutions attempt to correct market failures
through regulation (e.g., environmental regulations, safety standards, etc.), but enforcement is
costly. When governments or regulators face high enforcement costs, non-compliance by firms
or individuals can undermine the intended market corrections. This results in continued
inefficiency, as firms may choose to ignore regulations that are not well enforced, perpetuating
externalities like pollution or unsafe products.
3. Examples of Market Failure Due to Asymmetric Information and Enforcement Costs:
Health Insurance: Asymmetric information is particularly problematic in health insurance markets.
Insurers struggle to accurately assess the health risks of individuals, leading to adverse selection,
where only the sickest individuals opt for coverage. This raises premiums for everyone,
potentially driving healthy individuals out of the market and reducing access to affordable
insurance.
Financial Markets: In capital markets, lenders face difficulties in assessing the creditworthiness of
borrowers, leading to higher interest rates to compensate for the unknown risk. As a result,
creditworthy borrowers may be deterred from borrowing, while high-risk borrowers dominate
the market, leading to adverse selection. Moreover, enforcement of loan repayment is costly,
especially for unsecured loans, adding to the inefficiency.
Environmental Markets: Enforcement costs are high when it comes to environmental regulations.
For example, ensuring firms adhere to pollution controls or emission caps involves costly
monitoring and penalties. If enforcement is weak, firms may ignore the regulations, leading to
market failure in the form of unchecked pollution, a classic example of a negative externality.
COMPLEMENTARY MARKETS
Suppose all individuals enjoy only coffee with sugar. Assume, moreover, that
without coffee there is no market for sugar. Given that sugar was not
produced, an entrepreneur considering whether to produce coffee would not
do so, because he would realise that he would have no sales.
Likewise. given that coffee was not produced, an entrepreneur considering
whether to produce sugar also would not do so, since she too would realise
that she would have no sales. If, however, the two entrepreneurs could get
together, there would be a good market for coffee and sugar.
Each acting alone would not be able to pursue the public interest, but acting
together they could.
information
failures
A number of government activities are motivated by imperfect information on
the part of consumers, and by the belief that the market will supply too little
information. For instance, the Truth in Lending Act requires lenders to inform
borrowers of the true interest rate on their loans. The Federal Trade Commission
and the Food and Drug Administration have adopted several regulations
concerning labelling, disclosure of contents, etc.
Opponents of regulations on information disclosure contend that they are
unnecessary the competitive market provides incentives for firms to disclose
relevant information), irrelevant (consumers pay little attention to the
information the law requires firms to disclose), and costly, both to the
government that must administer them and to the firms that must comply with
the regulations. Proponents of these regulations claim that, though they are
sometimes difficult to administer effectively, they are still critical to the
affected markets.
The private market will often provide an inadequate supply of information,
just as it supplies an inadequate amount of other public goods. The most
notable example of government activity in this area is the National Weather
Service.
In fact, much economic activity is directed at obtaining information, from
employers trying to find out who are good employees, to lenders trying to
find out who are good borrowers, investors trying to find out what are good
investments, and insurers trying to find out who are good risks. Later, we
shall see that information problems lie behind several government
programs.
For instance, many of the problems in the health sector in general and
health insurance markets in particular can be traced to problems of
information.
unemployment
Unemployment can be a reason for market failure because it represents an
inefficient allocation of resources, particularly labor. Market failure occurs
when the free market, left to operate on its own, fails to allocate resources
efficiently, leading to outcomes that are not socially optimal.
most economists take the high level of unemployment as prima facie
evidence that something is not working well in the market.To some
economists high unemployment is the most dramatic and most
convincing evidence of market failure
Wasted Resources (Labor)
Unemployment means that workers who are willing and able to work cannot find
jobs. This is a misallocation of a crucial resource (labor) because the economy is not
using its available workforce productively. The potential output from these workers is
lost, leading to underproduction and lower economic growth.
Inequality and Social Welfare
High unemployment rates often lead to income inequality, which can reduce overall
societal welfare. The market's inability to provide sufficient employment opportunities
leads to wealth concentration in fewer hands, reducing economic mobility and overall
social welfare.
In sum, unemployment leads to market failure when the free market does not create
enough jobs or distribute labor resources efficiently, leaving people who want to work
without opportunities. It often requires government intervention (such as fiscal stimulus,
retraining programs, or social safety nets) to correct these inefficiencies.
INFLATION
Inflation can contribute to market failure in several ways:
1. Uncertainty: High inflation creates uncertainty about future prices, leading
consumers and businesses to postpone spending and investment decisions. This can
reduce overall economic activity.
2. Resource Misallocation: When prices rise unevenly, it can distort signals in the market.
Businesses may over-invest in sectors experiencing price increases while neglecting others,
leading to inefficiencies.
3. Income Redistribution: Inflation can disproportionately affect different income groups.
Fixed-income households may struggle as their purchasing power declines, leading to
increased inequality and social tension.
4. Menu Costs: Businesses may face costs associated with frequently changing
prices, which can lead to inefficiencies and reduced competitiveness.
5. Interest Rate Volatility: Central banks often respond to inflation with interest rate
changes, which can create volatility in financial markets, affecting borrowing and
investment.
6. Wage-Price Spiral: Workers demand higher wages to maintain their purchasing
power as inflation rises. This can lead to further inflation, creating a cycle that is hard
to break and destabilises the economy.
Overall, while moderate inflation can be a sign of a growing economy, high or
unpredictable inflation can lead to significant market distortions and failures.
REDISTRIBUTION AND MERIT GOODS
Even if the economy were Pareto efficient, though, there are two further arguments for
government intervention.
The first is income distribution: the fact that the economy is Pareto efficient says nothing about
the distribution of income; competitive markets may give rise to a very unequal distribution, which
may leave some individuals with insufficient resources on which to live. One of the most important
activities of the government is to redistribute income.
The second argument for government intervention in a Pareto efficient economy arises from
concern that individuals may not act in their own best interests. It is often argued that an
individual's perception of his or her own welfare may be an unreliable criterion for making welfare
judgments. Even fully informed consumers may make “bad” decisions. Individuals continue to
smoke, for instance, even though it is bad for them, and even though they know it is bad for them.
Goods that the government compels individuals to consume, such as seat belts and
elementary education, are called MERIT GOODS
PATERNALISM & LIBERTARIANISM
The view that the government should intervene because it knows what is in the best
interest of individuals better than they do themselves is referred to as
PATERNALISM
In contrast to the paternalistic view, many economists and social philosophers believe
that the government should respect consumers' preferences. Though there may
occasionally be cases that merit a paternalistic role for the government, these
economists argue that it is virtually impossible to distinguish such cases from those that
do not. And, they argue, that once the government assumes a paternalistic role, special
interest groups will attempt to use government to further their own views about how
individuals should act or what they should consume.
The view that the government should not interfere with the choices of individuals is
sometimes referred to as libertarianism.
CAVEATS
There are two important caveats to economists' general presumption against government paternalism.
The first concerns children. Someone—either the parents or the state—must make paternalistic decisions
on behalf of children, and there is an ongoing debate concerning the proper division of responsibility
between the two. Some believe that children were the property of their parents, arguing that parents
alone should have responsibility for taking care of their children. Most argue, however, that society has
certain basic responsibilities, such as, for instance, to ensure that children receive at least an education,
and that parents do not deprive their children of needed medical care or endanger them physically or
emotionally.
The second caveat concerns situations in which the government cannot, at least without difficulty, commit
itself to refrain from helping individuals who make poor decisions. For instance, individuals who do not
save for their retirement become a burden on the government; this provides part of the rationale for Social
Security. In other instances, individuals fail to take appropriate precautions because no one is willing to
allow them to bear the full costs.
Government accordingly imposes regulations, or at least encourages precautionary behavior. Individuals,
for example, who neither buy earthquake insurance nor build homes to withstand an earthquake may, in
the long run, become a burden on the government when an earthquake strikes. The government finds
itself compelled to act compassionately, even if the individual's burden should be borne by that individual.
two perspectives on the role
of government
Normative Analysis
The fundamental theorems of welfare economics are valuable because they clearly define a role for the
government. In the absence of market failures and merit goods, the government’s primary responsibility
is managing the distribution of income and resources, as the private sector ensures that resources are
used efficiently. However, in the presence of significant market failures—such as imperfect competition,
imperfect information, incomplete markets, externalities, public goods, and unemployment—markets are
unlikely to be Pareto efficient. This suggests a need for government intervention, but with two key
conditions.
First, it must be demonstrated that intervention could make someone better off without making anyone
worse off, achieving a Pareto improvement.
Second, it must be shown that the political processes and bureaucratic structures in a democratic
society are capable of addressing the market failure and realizing this improvement. When information
is imperfect and costly, both the government and private firms face similar challenges, and the costs of
setting up government programs, such as public insurance, must be weighed against their potential
benefits.
Normative Analysis
Recent research has identified cases where, despite no informational or cost advantage over
private markets, government intervention could theoretically lead to Pareto improvements.
However, the existence of such policies does not automatically mean that government action is
desirable.
To assess whether government intervention will effectively address market failures, it is essential
to consider how real-world governments operate. In the 1960s, it was common practice to
identify market failures and propose government programs to achieve Pareto improvements,
assuming that intervention was justified.
When these programs failed, the blame was often placed on bureaucratic inefficiency or political
interference. However, even if bureaucrats and politicians act with integrity, the inherent nature
of government structures may explain why these interventions often fall short. Public programs
designed to address market failures are implemented through complex political processes in
democracies, not by idealized or perfectly benevolent governments.
Positive Analysis
The market failure approach to understanding the role of government is primarily normative,
providing a framework for identifying when government intervention is necessary, though it is
tempered by considerations of government failure.
This approach has become popular, with many programs justified on the grounds of addressing
market failures, though this justification may often be rhetorical. In reality, there can be a significant
gap between a program's stated objective—such as addressing market failures—and its actual design.
For instance, while political rhetoric may highlight the failure of markets to insure small farmers
against price volatility, government agricultural programs may, in practice, transfer income to large
farmers.
To truly understand the political forces at play, it is often more revealing to examine how programs
are designed and implemented than to rely on their stated goals. Some economists argue that focus
should be placed on positive analysis—describing the consequences of government programs and the
political processes—rather than normative analysis, which concerns what the government should do.
Nonetheless, discussions about the government’s role are a vital part of the political process in
modern democracies. Moreover, studying institutional arrangements that shape public decision-
making can help design systems that better reflect broader public interests, rather than catering
solely to special interests.
Thank You
