The market system is not perfect, and sometimes there are economic inefficiencies that arise from the existence of monopoly power in imperfectly competitive markets, from externalities, and from the existence of public goods. It is believed that if individuals are left to pursue their own self-interest, they will be led, as if by an “invisible hand,” to act in a manner that maximizes society’s well-being. Of course, free markets will maximize the gains from trade only under a particular set of conditions. “Market failure” refers to all those instances where the conditions required for markets to be efficient are not satisfied.
If the market fails, then there is some allocation of resources, that could, in principle, result in at least one person being made better off without someone else being made worse off. In other words, when the market fails, the gains from voluntary exchange have not been fully exhausted, and so it follows that the free market has not maximized the value of economic activity. In these situations, the government intervenes to correct the market failure. One area of market failure is often seen with the externalities of merit and demerit goods.
Sometimes people do not realize, or ignore the costs, of doing something related to their consumption of these goods that have negative externalities. When there becomes an over consumption of these goods in the free market, the government then intervenes to reduce demand. One example of this is seen with smoking. After the public became aware of the negative health effects of tobacco usage, there was a time when cigarette consumption was still on the rise. Finally, the government intervened and placed higher taxes on the tobacco companies, and required that they discontinue their marketing strategy with advertising commercials on television.
The government’s action was to respond to the market failure with demerit goods. Alternatively, sometimes the government’s response to market failure is due to the public not realizing the true benefit of a merit good, so in a free market there will be an under consumption of these goods, which often have positive externalities. One example of this occurs when the public has not received education of the benefit of a particular vaccination, in which case, the government intervenes to correct the market failure occurring with the merit good of health care. The government also intervenes when there area of market failure is in public goods.
Generally, a private firm will provide a good or service if it can earn a normal profit. Market failure occurs when a socially desirable good or service, whose social benefits exceed its social costs, is not provided because firms would find it unprofitable to do so. For example, when the nation was developing its road system, a private firm or firms may not have been able to raise sufficient capital to build a private interstate highway system. Similarly, a private urban rail system may not be able to attract sufficient ridership and charge sufficiently high fares to be profitable.
In such cases, the government can increase economic welfare by financing socially desirable services like roads and public transit that would not be supplied by the private sector. Thus public production of these activities is correcting a market failure in public goods. Many economists and policy makers believe that the presence of market power constitutes a rationale for government intervention. The standard argument offered is as follows: market power on the part of suppliers results in “under production” of goods. Therefore, government should intervene to force producers to produce the “right” amount and thus, maximize social welfare.
Government intervention to correct for market power takes many forms, one of them being that the government takes total control. In other instances, production continues to take place under private ownership, but some control is relinquished to public regulators who can influence the amount the firm charges and the amount it produces. One example of this is when the government appoints an organization through which the state regulates the behavior of private telecommunications firms to correct the market failure in monopoly.