Market Failure and the Role of Government Overview

Introduction

The need for government intervention is typically in response to some sort of market failure. That is, sometimes markets do not function the way we believe they should or they do not produce efficient outcomes. In such cases, the government may be needed to intervene and correct for the market failure. In this module, we will consider several types of market failures and the steps the government may take in response. In addition, you will become familiar with general arguments in favor of and in opposition to government intervention.

Essential Questions

1. What are the conditions of allocative and productive efficiency?
2. What are market failures?
3. What are typical tools the government can use to correct for market failures?
4. What are public goods? Why are they sometimes necessary?
5. How can government policies impact income distribution and allocative efficiency?
6. What means can the government use to regulate natural monopolies?

Key Terms

Click here to download the key terms document for this module.

Market Failure – refers to the inability of the free market to allocate resources efficiently.

Imperfect Information – categorizes a situation in which parties to a transaction have different information.

Externality – a spillover effect on a third party not involved directly in the market transaction.

Positive Externality – a situation in which parties not directly involved in a transaction receive some benefit from the transaction.

Negative Externality – a situation in which parties not directly involved in a transaction incur some sort of cost from the transaction.

Marginal Private Cost – the cost to a firm of producing a good or service.

Marginal Social Cost – the marginal private cost plus any external costs that result from the production of the good.

Marginal Private Benefit – the additional satisfaction received by an individual as a result of the consumption of a good.

Marginal Social Benefit – the marginal private benefit plus any external benefits that result from the consumption of a good.

Public Goods – goods that are both non-rival and non-excludable.

Free Rider – a term used to describe an individual that receives the benefit of a good without incurring any cost for that good.

Poverty Line – a guideline set and adjusted by the Bureau of Labor Statistics that establishes the minimum level of income deemed necessary to survive in a country.

Herfindahl-Hirschman Index (HHI) – a commonly used measure by the Department of Justice as it seeks to determine market concentration in the face of merger; the greater value of the HHI the closer to being a monopoly.

Progressive Tax – a type of tax where the proportion of income paid in taxes rises as income rises.

Regressive Tax – a type of tax where the proportion of income paid in taxes decreases as income rises.

Proportional Tax – a type of tax where the proportion of income paid in taxes is constant no matter the level of income.

Subsidy – a government transfer, either to consumers or producers, on the consumption of production of a good

Fair-return Pricing – a strategy used by the government to regulate monopoly pricing; price is set equal to ATC.

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