The Critical Role of Government in Addressing Market Failures

Economically, a market failure is when there is an inefficient distribution of goods and services in the free market - in contrast to an optimally functioning market wherein the vectors of supply and demand are in equilibrium. A market failure is achieved when there is a dramatic skew in the law of supply and demand, with a critical component of market failures is inefficient resource allocation. Inadequate resource allocation is principally sparked by self-serving actions enacted by individuals within free markets. A conglomerate of these self-satisfying transactions will eventually generate less than optimal economic circumstances. These small actions echo further than you may think and have unfavorable outcomes such as monopolies, externalities, and information asymmetry.

Similarly to every other human-induced condition, market failure requires government intervention and rehabilitation. Governments must intervene in market failures, because market failures harm both consumers and the overall economy. Government intervention helps correct these market failures by implementing regulations, taxes, subsidies, or providing public goods to ensure fair, efficient, and equitable outcomes. To delve deeper into the dynamics of market failure and understand its underlying causes, let's explore the types of market failure:

Monopoly Power

One type of market failure is monopoly power, or instead when one player in an industry has significant authority over a particular market. Microsoft, for instance, is a monopoly because it dominates its market niche of consumer electronics to such an extent that it has significant power and influence over the entire market.

Although the game of Monopoly - involving toppling down your friend's economic empires may seem fun - in the real world, this sort of absorption is dangerous to the market as it leads to higher prices that consumers have to pay, reduced choices for consumers, less innovation, heightened barriers to entry, and most frightening of all political influence wherein monopolistic business imprints itself in government policies and regulations to its advantage.

When monopolies rise to dangerous heights, the government brings them down with many approaches. The government chiefly uses some of the below legislative policies to control monopolies:

❖ Antitrust Regulation - a regulatory policy that enacts and enforces antitrust laws to prevent monopolies from forming or breaking up existing ones. One instance of an antitrust regulation is the Sherman Act. An act that "outlawed all contracts, combinations, and conspiracies that unreasonably restrain interstate and foreign trade," according to the Department of Justice. Regulation and Price Controls- When a natural monopoly exists (e.g., fuel and utilities), the government takes it upon itself to regulate prices and services so that trade is fair, reasonable, and all, to prevent excessive pricing and abuse of their market power.

❖ Competition Policy- When monopolies seemingly start to form, governments will encourage new entrants and innovators into the space by implementing policies geared explicitly towards more inclusion and competition. They may reduce the barriers to entry, support startups, and push a competitive market space.

❖ Breakup of Monopolies - As famously in the case of AT&T, where the company grew dramatically and took up a significant market share to the point that it was even known as Ma Bell - signifying its dominance in the telephone services industry- the government intervened, and required it to break up into smaller companies making the seven baby bells in the process.

Consumption Externalities

Smoking is disgusting. It destroys a person from the inside out and even has the gall to affect others on a second level. This is an example of a negative externality. Externalities occur when the production or consumption of a good or service affects third parties who are not directly involved in the transaction and those whose interests are not considered in the market price. Smoking is a negative externality because it imposes significant health crises on smokers and non-smokers. Health crises lead to increased healthcare expenses and debt for even the non-smoker. These costs are not accounted for by the people who smoke, which leads to the inefficient allocation of resources and a market failure.

Education, on the other hand, is not totally gross, but that isn't what makes it a positive externality; it is that it generates benefits that are enjoyed by others in society because, typically, the amount of education you receive dictates your income and higher income means you are more taxable and those tax dollars go into public commodities such as roads, parks, and more school or in other words things used up by the general public. In instances of externalities, governments will impose regulations to address them. They chiefly employ two methods, of which one is the imposition of subsidies or taxes.

When governments witness goods or activities with negative externalities within a free market, such as smoking, the government can impose taxes or fees to internalize the external costs. For example, they may raise taxes for cigarette companies, encouraging cigarette producers to reduce the negative externalities by reducing production or adopting cleaner technologies. Oppositely, for goods or activities with positive externalities like education, the government can provide subsidies to encourage their consumption or production, thereby promoting the benefits.

Information Asymmetry

Information asymmetry is when one party in an economic transaction has ample and superior knowledge to use to their benefit. Information asymmetry can lead to adverse effects on the market.

Two of the foremost examples of information asymmetry are in the following cases: Adverse Selection: According to Investopedia, "Adverse selection occurs when one party in a negotiation has relevant information the other party lacks." In these situations of information asymmetry, individuals or firms with better information about a product or service may selectively participate in transactions that benefit them while avoiding less favorable ones. For instance, a prospective car buyer is interested in a beautiful, shiny red car (I don't know much about cars, sorry for my inability to paint a vivid picture of a dazzling vehicle for you), there's a sketchy used car salesman with the cunning smile and reeking of cheap cologne who possess an abundance of information on the history of the car, the accidents, the miles, everything and although the prospective buyer can inquire about the cars information the car salesman will be at an advantage because of his superior knowledge potentially leading to the sale of low-quality vehicles at high prices.

Information asymmetry also presents a moral hazard. A moral hazard is where one party may take on more risk or behave recklessly because they know the other party is less informed. This can occur when borrowers take on excessive risk because lenders cannot fully assess the borrower's genuine risk profile. Now, let's refer back to the prospective car buyer who is excited to buy a car because he knows he has an above-average credit score, but he needs to inform the dealership of his propensity to gamble and pay off debt slowly and ineffectively.

The government also steps in to mitigate information asymmetry and promote equity. Historically, they have used the following policies:

❖ Mandatory Disclosure and Transparency: they’ve required businesses and individuals to provide comprehensive and accurate information about their products, services, and financial dealings. For instance, we have SEC financial reporting requirements for publicly traded companies and nutritional labeling on food products.

❖ Consumer Protection Laws: Governments have Enacted and enforced laws that protect consumers from fraudulent or deceptive practices. These laws include regulations against false advertising, product misrepresentation, and unfair business practices.

❖ Licensing and Certification: Moreover, governments have established licensing requirements and certification programs for certain professions and industries. This ensures that practitioners meet specific standards and qualifications, reducing information asymmetry for consumers. For example, licensing is common in healthcare and legal professions.

In essence, government intervention is essential for mitigating market failures, ensuring that markets work for the benefit of society as a whole, and promoting economic efficiency and fairness. As we delve deeper into the dynamics of market failure and its underlying causes in, it becomes evident that the government's regulatory and policy roles are indispensable in maintaining well-functioning markets.

If push comes to shove - by the end of this you’ll have learnt at least two things: smoking is seriously horrible for you and others, and sketchy car salesmen with pungent cologne can probably over-sell you a vehicle. If you’ve been able to retain slightly more than just that - stay strapped in with more in-depth analysis arriving in the coming weeks!