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The Role Of Public Policy In Market Failure Economics Essay

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When market fails, public policy may remedy the problem and increase efficiency. In connection to the above statement, discuss the implications of implementation of the different forms of public policy.

Market failure is defined as a phenomenon in which the price system fails to operate efficiently, creating a problem for society. In economic term, we can say that Pareto optimality has not been reached. Vilfredo Pareto (1906) defined pareto optimality as a situation which happens when economic resources and output have been allocated in such a way that no-one can be made better off without sacrificing the well-being of at least one person. In other words, we can use the concept of market equilibrium to explain that market failures happen when there is too little or too many resources used in a production of goods or services. For example, the decision to build two schools and one library will only be taken if the marginal social benefit (MSB) exceeds the marginal social costs (MSC). In general, market failures occur due to imperfect competition in a country, the existence of externalities and public goods. Government can play an essential role to remedy these problems.

Externality is the uncompensated impact of one person's actions on the well-being of a bystander (Mankiw, 2007). There are two types of externalities, such as positive externality and negative externality. Education is a type of positive externality as it creates better educated leaders and decreases the crime rates in a country. While an example of negative externality would be air pollution from the cars or industries as it affect's people's breathing. Nowadays, some competitive markets may still fail to operate because they encounter externalities. Both buyers and suppliers have ignored their actions when deciding how much to demand and supply, therefore it eventually caused the market equilibrium inefficient.

Imperfect competition economics the market situation that exists when one or more of the necessary conditions for perfect competition do not hold (Collins English Dictionary, 2003). It causes allocation of resource inefficient which results in market failure. This usually happens when there is no competition among both producers and consumers, and the producer can raise the price of a good or service at any amount they want, without having to worry about losing their customers. The firm overcharges the price of a good above its cost and reduce the production of a good and services. Unemployment rate eventually will increase as the firm doesn't need to hire so many labours to produce so little goods. Therefore, we can say that market failures happen the resource is not allocated efficiently. In this case, government needs to remedy this problem to achieve efficiency.

Several public policies will be implemented in order to overcome market failures. In general, public policy is defined as a system of laws, regulatory measures, courses of action, and funding priorities concerning a given topic (Kilpatrick, 2010). Examples of public policies such as price controls, corrective taxation, subsidies, and regulations could be taken to correct market failures. Government can use market based policies to overcome externalities, such as command and control policies, corrective taxes and subsidies.

One of the command and control policies is legislation. Legislation can set standards that force firms to clean up their emission as a condition of remaining in business (Tucker, 2008). One of the advantages of setting regulation is that the firm doesn't have to pay as compared to subsidy. Assuming legislation is implemented to correct the market failure of pollution by alloy industries. When suppliers are forced to follows to rules set by government, such as spending on appropriate equipment using the pollution-control, the supply curve will shift leftwards from S1 to S2. This is because an extra cost of the equipment spent by producers is added to the production cost of alloy. Therefore, legislation has caused market equilibrium to change from E1 to E2, causing the industry to operate efficiently. In this case, market failure of alloy industries can be avoided.

In addition, negative externality could also be cured by levying tax on producers for each of the unit of goods sold. For example, let's suppose that alloy factories produce pollution. For each unit of alloy produced, a certain amount of gasses and pollutants enter the atmospheres. It is no doubt that the government have the rights and ability to impose tax by collecting money from an individual, organisation or group and by subsidizing to the needy people.

The graph above shows social cost of producing alloy without taxation. It can be seen that the marginal social costs is higher compared to marginal private cost and the equilibrium quantity of alloy, QMarket, is larger than the social optimal quantity, QOptimal. By using tax to solve a negative externality, it involves internalizing the costs as it allows buyers and sellers to take account of their external behaviours when making decisions. With the existence of taxation, alloy producers will tend to make a wiser decision on how much to supply because the tax would make them to pay for extra cost.

Based on the graph above, we can see after the tax is set by government, it has affected the marginal private cost to increase. Therefore, alloy producers would produce the socially optimal quantity of alloy. However, the marginal private benefits will always be equal to marginal social benefit because there is no externalities affect the consumers.

Besides, the government could remedy market failure by reducing market participants to internalize externality. In order to move the market equilibrium closer to the social optimum, positive externality could be cured using subsidy. For example, consider the market of AIDS vaccination. With subsidy, government would make payment for the consumers who want to get vaccinated. When consumers get to vaccine for free, they demand more. Therefore, the demand for AIDS vaccination will increase, shifting rightwards from D1 to D2. This will then make the equilibrium price and equilibrium quantity efficient where it will be achieved at E2. To sum up, government can internalize negative externality by taxing on a particular good and by subsidising to positive externality.

There are two types of price controls in the market, which are price ceiling and price floors. Price ceiling can be defined as a legally set maximum price a seller can charge. Price floor can be defined as a legally set minimum price a seller can be paid. To prevent market failures, government will either set price ceiling or price floors, depending on what kind of situations happen in the market. An example of imposition of price ceiling would be rental control. For instance when government imposes rent ceiling, consumers will demand more because they realize that they can rent at a lower price. In contrast, supplier will supply lesser. This is because suppliers realize that they are not charging the same price as before causing them to drop out of the market. Here we can see that shortage will happen because quantity demanded exceeds quantity supplied. Therefore the suppliers must ration the scarce goods among the customers. The price of rental control will eventually cause supply and demand to meet therefore an equilibrium is formed.

To sum up, when market failures happen, it is indeed important for government to implement different types of public policies to remedy it. Government could solve externalities by using tax and subsidy, and they could also use legislation to solve the market for vaccination. However in my opinion, not all public policies are effective. I would say taxation is the most crucial ones as compared to other public policies. Take subsidy for example, This is because it gives greater efficiency, and it also allows a greater flexibility. Therefore, with all these public policies, government's revenue can be increased and the economic efficiency can be enhanced, therefore, market failures will be avoided.


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