Tools of intervention of Govt. In Market Failure

Government Intervention: Fiscal Measures

Taxes and Subsidies

• The use of taxes and subsidies to correct externalitieso Externalities occur when some of the costs or benefits associated with

production or consumption of goods and services spill over onto third parties.

– the optimum size of a tax

baber.mba@gmail.com

Q1O

MC = S

DP

Co

sts

and

be

nef

its

Quantity

Using taxes to correct a market distortion

O

MC = S

DP

MSC

Co

sts

and

be

nef

its

Quantity

External cost

Q1Q2

Social optimum

Using taxes to correct a market distortion

Q2

MC

Q1O

P

Co

sts

and

be

nef

its

Quantity

Optimum tax = MSC – MC

MC = SMSC

D

Using taxes to correct a market distortion

• The use of taxes and subsidies to correct externalities– the optimum size of a tax– the optimum size of a subsidy

Government Intervention: Fiscal Measures

Taxes and Subsidies

O

DP

MC = S

Q1

Co

sts

and

be

nef

its

Quantity

Using subsidies to correct a market distortion

O

MSC

DP

Q1

External benefit

Co

sts

and

be

nef

its

Quantity

MC = S

Q2Social optimum

Using subsidies to correct a market distortion

MC

O

P

Q2Q1

Co

sts

and

be

nef

its

Quantity

Optimum subsidy

= MC – MSC

MSCMC = S

D

Using subsidies to correct a market distortion

• The use of taxes and subsidies to correct for monopoly

– use of lump-sum taxes

• Advantages of taxes and subsidies

– Considered the most effective way of solving underconsumption as it is easily implemented

– Leaves space for market forces to interact

– Provision of revenue for the government

• Disadvantages of taxes and subsidies

– infeasible to use different tax and subsidy rates

– lack of knowledge

Government Intervention: Fiscal Measures Taxes and Subsidies

Provision of Public Goods

A public good is a good/service which is

– Non-rivalrous – its benefits are not depleted by an additional user• MC = 0, for allocative efficiency, P = MC = 0• Public goods have to be provided at no charge

– Non-excludable – impossible (or difficult) to exclude people from its benefits

• ‘Free rider’ problem arises – no one will pay for what he can get free

• Private firms will not provide public goods (unable to charge for consumption)

• Public goods, therefore, have to be provided by the government

• Examples of public goods include streetlamps and public libraries

• Note: a private good is one that is both rivalrous and excludable – automobiles, clothing, food etc.

Provision of Public Goods• Direct provision of goods and services

– the provision of public goods

– the need to evaluate costs and benefits of publicly provided goods

– there is a need to produce merit goods (which are naturally underconsumed) at low prices or for free due to four reasons

• Social justice: they should be provided according to need and not ability to pay

• Large positive externalities, for example in the provision of free health services helps to contain and combat the spread of disease

• Dependants are subject to their guardians decision which are not necessarily the best, therefore the provision of services like free education and dental treatment is needed to protect dependants from uninformed or bad decisions

• Ignorance: The problem of imperfect information makes consumers unaware of the positive externalities and benefits that arise from consumption

Nationalization And Expansion of public sector

• Nationalization refers to the public (governmental) ownership of certain firms to provide goods or services sold in the market, that is, public corporations engaged in commercial activities. Governments often take over natural monopolies to prevent monopoly pricing and examples include public utilities.

• Advantages:– Consumers protected from high prices– Ensuring social costs and benefits are taken into account

when production decisions are made• Disadvantages:

– No profit motive may lead to nationalized enterprises being allocatively inefficient

Promotion Of competition

Effective competition in properly regulated markets can deliver lower prices, better quality goods and services and greater choice for consumers.

Competition can create strong incentives for firms to be more efficient and to invest in innovation, thereby helping raise productivity growth.

Policy makers should aim to protect and promote competition in markets in order to capture the benefits of markets for consumers and society as a whole.

However, markets if not adequately regulated can potentially harm consumers.

Drives firms to improve their internal efficiency and reduce costs.

Cost minimisation allows firms to deliver the same goods and services to consumers, but at lower prices. This will attract a greater number of consumers and the firm will gain a larger market share.

Provides incentives to firms to adopt new technology. • Early adoption of technology and/or new techniques

and processes helps firms minimise their costs.

Provides incentives to firms to invest in innovation. • Investment in innovation allows firms to improve the quality of their

existing products and/or develop new products and services to better suit the changing needs and preferences of consumers.

Reduces managerial inefficiency. • Competitive pressures from other firms and new entrants lead firms to

look for better, more efficient ways to organise their business. Lack of effective competition could lead firms and managers to operate with inefficient business models and technology as firms are unlikely to lose profits.

Promotion Of competition

Government determines how Market outcomes are to be limited.

Output regulation: Government sets quotas or Limits the amount of output that can be

provided by participants in a market.Examples: prohibition of bogus cures

Price regulation: Government sets price controls either as minimum or maximum

prices that can be charged in a market.Examples: price controls on drugs

standards regulation: Government sets limits on the characteristics of a product or

serviceExamples: FDA regulations on advertising & quality

Control of price and output

More or Less Intervention?

• Drawbacks of government intervention

– shortages and surpluses

– poor information

– bureaucracy and inefficiency

– lack of market incentives

– shifts in government policy

– lack of freedom for the individual