Skip to main content

INSIGHTS BLOG > Role of Government – Part 4: Address Market Failures

Role of Government – Part 4: Address Market Failures

Written on 30 August 2012

Ruth Fisher, PhD. by Ruth Fisher, PhD

In Part 3: Promote a Civil Society, I discussed the role government should play in society that would improve upon anarchy or autarchy from a social standpoint. What I proposed is that government provide laws and infrastructure to enforce accountability and justice – both civil and criminal -- for the people and establish and protect property rights.

After government has facilitated a civil society, the next step would be for government to facilitate an efficient economy, that is, provide rules and infrastructure that encourage the efficient allocation of resources among the population’s producers and consumers. What I mean by efficient allocation of resources is one that maximizes the total social welfare of the population.

I wrote a draft of this section, and as I was re-reading it for edits, I kept falling asleep, because it was SO dry and textbook-like. What appears below is a rewrite that attempts to provide very dull information in as informal and conversational a way as possible. We’ll see how I do.

A free market situation is like a bazaar in which everybody is able to do as he pleases – buy and sell whatever – with no restrictions on who can buy or sell what or how much he can charge.

As an aside, even though many people talk about the US as if we had free markets, this is actually not the case. Government regulations touch most every type of transaction that occurs, through such means as information disclosure (labeling) laws; minimum quality standards, health standards, and safety standards; and/or anti-discrimination or equal opportunity laws, to name a few. And with every law comes a costs to suppliers – called compliance costs – which comes in the form of having to use accountants, attorneys, and other consultants and advisors to help them make sure (or prove) they are conforming with all the laws and regulations imposed by government.

Back to free markets. Free markets are not necessarily as chaotic or as user-unfriendly as they might seem. Think about the products and services you buy. If you’ve bought a product more than once, it’s because you tried it the first time, and you liked it, so you went back for seconds, thirds, and fourths. Most sellers have to be able to sell their products again and again to the same customers, otherwise they run out of customers to sell to and they can’t make enough money to survive. And for people to buy their products again and again, the products must be good; otherwise they would lose their customers to other, better suppliers.

Of course, in the free markets, suppliers try to sell their goods by undercutting the prices of (or offering better quality than) other suppliers. Some suppliers are, in fact, able to supply the same or similar products as other suppliers at lower prices, because they have some sort of advantage over the other suppliers. For example, Internet suppliers don’t have to pay the rent and other overhead costs that brick-and-mortar suppliers do. In these cases, the low-cost = low-priced supplier will generally eventually win out. Consumers win because they get the same product at a lower price (but perhaps with fewer associated amenities), the resources that used to go to the bricks-and-mortar stores will find some other place to be used, and so society as a whole ends up better off.

It is true that in some cases the low-priced suppliers are able to charge lower prices than everyone else because they are cutting corners on quality to save costs. Sure, some buyers only care about price, and those buyers may continue to buy from the cheapest suppliers, even though their products aren’t as good as the other, more expensive products out there. However, as long as enough people care about quality to pay a higher price for it, the higher quality − but more expensive − suppliers can continue to sell their better products at higher prices and survive the presence of the low-priced supplier.

Now, think about a new product you had to buy that you had never bought before. What did you do? If you’re like most people, you probably asked someone you trust who had bought a similar product recently about their experience. Or maybe you went online and searched out posted reviews of the different products available. The point is, you were able to find reasonably trustworthy information to help guide your purchase. Publicly available user feedback (also known as seller reputation) helps keep the quality of products available for sale above some minimum level. Sure, there are duds out there, but those suppliers don’t usually last that long, especially in the US, where buyers can SUE suppliers of faulty or defective products. There are also cases in which competition leads to a race to the bottom, where the market ends up with only the lowest-priced suppliers who supply only low quality products. But this isn’t always the case.

So you see, in free markets, when buyers and sellers are free to transact as they please, the market generally imposes discipline (with respect to price and/or quality) on sellers. As a result, sellers cannot continue to cheat buyers of their products indefinitely, and good quality and novelty is usually rewarded. In economic lingo, this situation is called a competitive equilibrium. And the Fundamental Theorems of Welfare Economics say that competitive equilibria are efficient, in that they tend to end up with all buyers and sellers as a whole being as satisfied as possible.

Now, I say the market generally imposes discipline on sellers, because there are some exceptions -- certain occasions when free markets do not impose discipline on either buyers or sellers. These situations are called market failures. Market Failures can occur in four basic situations: when supply and demand of goods and services involve (i) asymmetric information, (ii) externalities, (iii) public goods, and/or (iv) non-competitive market conditions.

When there are market failures, government intervention may be able to help buyers or sellers end up better off than they would otherwise be by helping to address the market failure.


1. Asymmetric Information

Market transactions involve asymmetric information when either the buyer or, more likely, the seller has more information than the other party, leaving the uninformed party at a disadvantage. Some specific examples of transactions involving asymmetric information include:

  • Pharmaceutical companies have more information about the risks and side-effects of new medications than do prospective doctors or patients
  • Used car sellers have more information about the quality and history of their cars than do prospective buyers
  • Company management has more information about the financial situation and future prospects of their company than do prospective investors

When transactions involve asymmetric information, free markets will not necessarily lead the more informed parties (that is, the parties with private information) to divulge “enough” information to the other, less-informed parties. In these cases, the outcome may not end up being efficient, that is, in the examples above, doctors may prescribe drugs that are too risky or too fraught with side effects for certain patients, buyers may end up paying too much money for used cars that end up being lemons, and investors may unwittingly invest in financially unhealthy businesses.

There are three types of government intervention than can help minimize inefficient outcomes associated with asymmetric information. First, the government can force companies to release information that they might not otherwise make public to help other parties make informed decisions. For example, the government requires pharmaceutical companies to list all the potential risks and side effects they’ve discovered during tests and trials when selling medications to doctors and patients. The government also requires public companies to release all relevant financial information to potential investors.

Second, government can put the legal liability for damages on the party involved in a transaction who may have private information. This will force the knowledgeable party to make a “better” investment in preventing damages than they might otherwise. For example, automobile makers are liable for any accidents that their vehicles cause if the accident is due to faulty parts, design, or construction. Putting this liability on the auto manufacturers forces them to increase the quality of their car parts, designs, and construction to levels they might not otherwise achieve, so as to avoid having to pay for too many accidents.

Third, government can make insurance available in other cases when citizens face undue risks, such as for acts of nature, (unexpected) health problems, automobile accidents in which manufacturers aren’t liable, etc.


2. Externalities

Market transactions involve externalities when the transactions also end up affecting other people who are not directly involved in the transactions.

Suppose you live on a city block and you decide to plant a few plants and flowers in your front windowsill. Every time you catch a glimpse of your leafy plants and lovely flowers, you smile with satisfaction and enjoyment. And so does your neighbor, who can see your windowsill garden from her window next door. And so do many of the pedestrians who walk by your home every day. In other words, your garden is creating joy, not just for you (private benefits) but also for other members of your neighborhood (social benefits), which means your action of planting the garden created a positive externality.

When deciding how much time, effort, and expense to put into your garden, you only consider the counterbalancing enjoyment you yourself get from your plants. Your neighbors, who see your garden at all hours of the day, would like you to spend a bit more time, money, and effort to create a bigger garden, but you can’t justify the costs, since you’re only home a few hours a day to enjoy it.

On the other hand, if your neighbors were to contribute some of their time and money to help you with your garden, you would gladly use the extra resources to enhance your garden. With your neighbors’ help, you’re able to capture some of the value you’re creating for your neighbors, so you will expand your garden. Without your neighbors’ help, however, you don’t capture any of that extra value, so you have no incentive to build a bigger garden.

More generally, when buyers and sellers are negotiating a transaction, they generally consider only how the transaction will affect themselves (that is, they consider the private benefits and costs of the transaction), and not how the transaction might affect other, uninvolved people (that is, any additional social benefits and costs the transaction provides). The result is that “too many” transactions occur from a social standpoint when the deals involve negative externalities, because the parties don’t suffer and therefore don’t count the extra costs they impose on others. Similarly, “too few” transactions occur from a social standpoint when the deals involve positive externalities, because the parties don’t gain anything from the extra benefits they provide for others.

When market transactions involve externalities, government intervention can help decrease the size and/or frequency of transactions that provide negative externalities by taxing the parties to the negotiation, say, by the amount of costs the negotiations incurs on others. In economic lingo, taxes will help align private and social costs.

Similarly, government intervention can help increase the size and/or frequency of transactions that provide positive externalities by subsidizing the parties to the negotiation, thereby helping to better align private and social benefits.

An example we’re all too familiar with, government currently taxes gasoline at the pumps to encourage drivers to drive less in an effort to help decrease automobile pollution. At the same time, government also subsidizes public transportation to encourage people to use buses and trains instead of cars.


3. Non-Competitive Markets

There are certain types of products or services whose supply and/or demand under free market conditions will end up with either producers or consumers having market power (i.e., undue leverage) over the other party. These non-competitive markets generally fall into one of three categories: (i) natural monopoly, (ii) barriers to entry, or (iii) too few market players.

i. Natural Monopoly

Consider the provision of railroad services. The first entrant into a new market must lay a set of railroad tracks, which is obviously a very costly endeavor. Once the tracks have been laid, the owner is able to provide railway services to all people in the area. If a new supplier of railroad services wanted to enter the market, he would have to lay a second set of tracks parallel to the first. And assuming the first entrant was able to service all demand in the area on the original set of tracks, then not only would the second set of tracks be costly, but they would also be wasteful from a social standpoint, because the second set of tracks would simply duplicate the first, without providing any additional (social) benefits. The money used to construct the second set of tracks could provide more value to the community, say, by providing taxi service from the railway stations to local points of interest.

Markets like railways that are prone toward natural monopoly are those in which two conditions both hold. First, market entry by suppliers requires large, up-front, set-up costs. And second, one supplier alone in the market can supply a significant part of the market’s demand. In many natural monopoly settings, there is the additional characteristics that having multiple suppliers in the market at the same time, duplicating each other’s large, up-front set-up costs, may be considered wasteful from a social standpoint because the extra set of infrastructure doesn’t provide any (or enough) real benefits to society to warrant their costs.

Many products or services that are supported by physical, virtual, or intangible networks fall into this category.

In the case of natural monopoly, government intervention can often improve social welfare, especially if other alternatives to the product or service provided by the natural monopolist don’t exist. In these cases, government will generally grant a (local) monopoly to the supplier (i.e., prevent further entry by other suppliers), set a cap on the price the monopolist can charge for his products and services, and require that the supplier supply all demand for his product or service.

ii. Barriers to Entry

The second category of non-competitive markets is markets that contain barriers to entry. These are markets that have a limited number of suppliers in the market, generally due either to limited access to a scarce resource necessary to supply the product or service (e.g., intellectual property) or to certification or permitting requirements (e.g., doctors, lawyers, taxi drivers, etc.). Because the number of suppliers is limited they will be able to charge buyers high prices.

In fact, though, in most cases, the barriers to entry have actually been created by the government in the first place, to serve another purpose – grants of intellectual property encourage new innovation and certification establishes minimum standards of quality. And in these cases, any ability by suppliers to charge consumers high prices is a secondary, and often expected, effect of the original government intervention, where it has been determined that the pain associated with the high prices is less than the larger benefits to society associated with the original goal of the intervention (encourage innovation or establish minimum quality standards). Of course, over time, things may change, and the markets might get to a point in which the costs outweigh the benefits. As per my guideline #2 in Part 2: Guidelines for Government Intervention, government intervention should either have an initial time limit built into the intervention or the intervention should be reviewed regularly to make sure the benefits continue to outweigh the costs as times change.

iii. Too Few Market Players

The third category of non-competitive markets is markets that contain only a few buyers (e.g., government) (called monopsony or oligopsony) or, more likely, only a few sellers (called monopoly or oligopoly). Markets with too few players to generate competition generally involve specialty items for which there is limited demand. And obviously, with only a few buyers or only a few sellers, the few buyers or few sellers can pretty much dictate terms to the countering parties.

The cases of oligopsony or oligopoly are too uncommon and/or idiosynchratic to have general guidelines for intervention.


4. Public Goods

The last case of markets in which there is often market failure is that of public goods. Wikipedia defines public goods as follows:

In economics, a public good is a good that is both non-excludable and non-rivalrous in that individuals cannot be effectively excluded from use and where use by one individual does not reduce availability to others. Examples of public goods include fresh air, knowledge, lighthouses, national defence, flood control systems and street lighting.

That paragraph makes me laugh, especially the thought of some poor shmo putting up a street light on a busy road and trying to extract payment from every pedestrian and vehicle that passes by.

The non-excludible and non-rivalrous nature of public goods generally makes it unprofitable for private suppliers to provide them, because private suppliers would not be able to capture enough of the value they would be providing society – that is, there would be too many free riders – to make the endeavor profitable. However, the benefits gained by society from having many public goods tend to outweigh their costs of supply. So, it usually falls upon government either to subsidize provision of the goods by private suppliers or to provide the goods itself, where the optimal form of funding is to tax the potential beneficiaries.

Most national (critical) infrastructure falls into the category of public goods, which is why government tends to be the one who supplies it. According to a 2004 CRS Report for Congress: Critical Infrastructure and Key Assets: Definition and Identification,

…the meaning of “critical infrastructure” in the public policy context has been evolving for decades and is still open to debate…

The American Heritage Dictionary, defines the term “infrastructure” as

The basic facilities, services, and installations needed for the functioning of a community or society, such as transportation and communications systems, water and power lines, and public institutions including schools, post offices, and prisons…

The growing threat of international terrorism in the mid-1990s renewed federal government interest in infrastructure issues. Unlike the previous period, which was focused on infrastructure adequacy, federal agencies in the 1990s were increasingly concerned about infrastructure protection. This concern, in turn, led policy makers to reconsider the definition of “infrastructure” in a security context.

The CRS Report provides the following chart containing items that have been classified as being part of the critical infrastructure at some time in the recent past:

In an attempt to make more sense of what’s included here, I added a category classification to each type of infrastructure and resorted the table by that category:


What the classification by category shows is that most goods or services necessary for ensuring people’s basic needs – water, food, health, safety, energy, transportation and communication, money, industry, continuity of services, and education – are included in government’s list of critical infrastructure, which makes sense.

Public goods that are not explicitly included in the above list of critical infrastructure are The Commons: Air/environment, Waters (rivers, lakes, oceans), and Federal lands (parks, forests, etc.). However, the government has clearly intervened – notably through the EPA – in managing The Commons.

To conclude, where free markets lead to competitive equilibria, outcomes are efficient, and so no government intervention can improve social welfare. However, in those cases where free markets are characterized by some market failure  asymmetric information, externalities, public goods, and/or non-competitive market conditions – then some form of government intervention may increase social welfare above that achieved by free markets.

With this ending to Part 4, I conclude the driest and most boring part of my blog series on The Role of Government in Society.  The next entry should be much more interesting. Theoretically.

Continue to Part 5.