GOVERNMENT INTERVENTION TO CORRECT MARKET FAILURE

Introduction:

• In the previous unit, we have seen that under a variety of circumstances the market and the price system fail to achieve productive and allocative efficiency in an economy. As such, it should be construed that the existence of a free market does not altogether eliminate the need for government and that government intervention is essential for the efficient functioning of markets.
•  The focus of this unit will be the intervention mechanisms which governments adopt to ensure greater welfare to the society and the probable outcomes of such market interventions. 
• Government plays a vital role in creating the basic framework within which fair and open competitive markets can exist. It is indispensable that government establishes the ‘rule of law’, and in this process, creates and protects property rights, ensures that contracts are upheld and sets up necessary institutions for proper functioning of markets.
•  For achieving this, an appropriately framed competition and consumer law framework that regulates the activities of firms and individuals in their market exchanges should be in place.

We have seen in the previous unit that the major reasons for market failure are market power, externalities, public goods, and incomplete information. Before we go into the details of government intervention, we shall try to have a quick glimpse of the forms of government intervention.

GOVERNMENT INTERVENTION TO MINIMIZE MARKET POWER

• As we are aware, market power—exercised either by sellers or buyers— is an important factor that contributes to inefficiency because it results in higher prices than competitive prices. In addition, market power also tends to restrict output and leads to deadweight loss. Because of the social costs imposed by monopoly, governments intervene by establishing rules and regulations designed to promote competition and prohibit actions that are likely to restrain competition. These legislations differ from country to country. 
• For example, in India, we have the Competition Act, 2002(as amended by the Competition (Amendment) Act, 2007) to promote and sustain competition in markets. The Antitrust laws in the US and the Competition Act, 1998 of UK etc are designed to promote competitive economy by prohibiting actions that are likely to restrain competition. Such legislations generally aim at prohibiting contracts, combinations and collusions among producers or traders which are in restraint of trade and other anticompetitive actions such as predatory pricing.
•  On the contrary, some of the regulatory responses of government to incentive failure tend to create and protect monopoly positions of firms that have developed unique innovations. For example, patent and copyright laws grant exclusive rights of products or processes to provide incentives for invention and innovation. 
• Policy options for limiting market power also include price regulation in the form of setting maximum prices that firms can charge. Price regulation is most often used for natural monopolies that can produce the entire output of the market at a cost that is lower than what it would be if there were several firms. If a firm is a natural monopoly, it is more efficient to permit it serve the entire market rather than have several firms who compete each other. 
• Examples of such natural monopoly are electricity, gas and water supplies. In some cases, the government‘s regulatory agency determines an acceptable price, so as to ensure a competitive or fair rate of return. This practice is called rate-of-return regulation. Another approach to regulation is setting price-caps based on the firm’s variable costs, past prices, and possible inflation and productivity growth. 

GOVERNMENT INTERVENTION TO CORRECT EXTERNALITIES

• As you may easily recall, freely functioning markets produce externalities because producers and consumers need to consider only their private costs and benefits and not the costs imposed on or benefits accrued to others. Governments have numerous methods to reduce the effects of negative externalities and to promote positive externalities.
•  We shall first examine how government regulation can deal with the inefficiencies that arise from negative externalities. Since the most commonly referred negative externality is pollution, we shall take it as an exemplar in the following discussion. 

Government initiatives towards negative externalities may be classified as:

1. Direct controls that openly regulate the actions of those involved in generating negative externalities, and 
2. Market-based policies that would provide economic incentives so that the self- interest of the market participants would achieve the socially optimal solution. 

• Direct controls prohibit specific activities that explicitly create negative externalities or require that the negative externality be limited to a certain level, for instance limiting emissions. Production, use and sale of many commodities and services are prohibited in our country.
•  Smoking is completely banned in many public places. Stringent rules are in place in respect of tobacco advertising, packaging and labeling etc.
• Governments may pass laws to alleviate the effects of negative externalities. Government stipulated environmental standards are rules that protect the environment by specifying actions by producers and consumers.
•  For example, India has enacted the Environment (Protection) Act, 1986. The government may, through legislation, fix emissions standard which is a legal limit on how much pollutant a firm can emit. The set standard ensures that the firm produces efficiently. If the firm exceeds the limit, it can invite monetary penalties or/and criminal liabilities. The firms have to install pollution-abatement mechanisms to ensure adherence to the emission standards. 
• This means additional expenditure to the firm leading to rise in the firm’s average cost. New firms will find it profitable to enter the industry only if the price of the product is greater than the average cost of production plus abatement expenditure. 
• Another method is to charge an emissions fee which is levied on each unit of a firm’s emissions. The firms can minimize costs and enhance their profitability by reducing emissions. Governments may also form special bodies/ boards to specifically address the problem: for instance the Ministry of Environment & Forest, the Pollution Control Board of India and the State Pollution Control Boards. 
• The market-based approaches–environmental taxes and cap-and-trade – operate through price mechanism to create an incentive for change.
•  In other words, they rely on economic incentives to accomplish environmental goals at lesser costs. The market based approaches focus on generation of a market price for pollution. This is achieved by: 

1. Setting the price directly through a pollution tax 
2. Setting the price indirectly through the establishment of a cap-and-trade system. 

• The key to internalizing an externality (both external costs and benefits) is to ensure that those who create the externalities include them while making decisions. One method of ensuring internalization of negative externalities is imposing pollution taxes. The size of the tax depends on the amount of pollution a firm produces.
•  These taxes are named Pigouvian taxes after A.C. Pigou who argued that an externality cannot be alleviated by contractual negotiation between the affected parties and therefore taxation should be resorted to. These taxes, by ‘making the polluter pay’, seek to internalize external costs into the price of a product or activity. 
• More precisely, the tax is placed on the externality itself (the amount of pollution emissions) rather than on output (say, amount of steel). For each unit of pollution, the polluter must choose either to pay the tax or to reduce pollution through any means at its disposal. Tax increases the private cost of production or consumption as the case may be, and would decrease the quantity demanded and therefore the output of the good which creates negative externality. The proceeds from the tax, some argue, can be specifically earmarked for projects that protect or enhance environment. 

The following figure illustrates the market outcomes of pollution tax.

Market Outcomes of Pollution Tax 

• When negative production externalities exist, marginal social cost is greater than marginal private cost. The free market outcome would be to produce a socially non optimal output level Q at the level of equality between marginal private cost and marginal private benefit. (Since externalities are not taken into account, marginal private benefit would be contemplated as marginal social benefit). 
• When externalities are present, the welfare loss to the society or dead weight loss would be the shaded area ABC. The tax imposed by government (equivalent to the vertical distance AA1) would shift the cost curve up by the amount of tax, prices will rise to P1 and a new equilibrium is established at point B, where the marginal social cost is equal to marginal social benefit. Output level Q1 is socially optimal and eliminates the whole of welfare loss on account of overproduction. 

However, there are problems in administering an efficient pollution tax.

• Pollution taxes are difficult to determine and administer because it is difficult to discover the right level of taxation that would ensure that the private cost plus taxes will exactly equate with the social cost. If the demand for the good is inelastic, the tax may only have an insignificant effect in reducing demand. 
• The method of taxing the polluters has many limitations because it involves the use of complex and costly administrative procedures for monitoring the polluters. 
• This method does not provide any genuine solutions to the problem. It only establishes an incentive system for use of methods which are less polluting. 
• In the case of goods which have inelastic demand, producers will be able to easily shift the tax burden in the form of higher product prices. This will have an inflationary effect and may reduce consumer welfare. 
• Pollution taxes also have potential negative consequences on employment and investments because high pollution taxes in one country may encourage producers to shift their production facilities to those countries with lower taxes. 
• The second approach to establishing prices is tradable emissions permits (also known as cap-and-trade). These are marketable licenses to emit limited quantities of pollutants and can be bought and sold by polluters. Under this method, each firm has permits specifying the number of units of emissions that the firm is allowed to generate.
•  A firm that generates emissions above what is allowed by the permit is penalized with substantial monetary sanctions. These permits are transferable, and therefore different pollution levels are possible across the regulated entities. Permits are allocated among firms, with the total number of permits so chosen as to achieve the desired maximum level of emissions. By allocating fewer permits than the free pollution level, the regulatory agency creates a shortage of permits which then leads to a positive price for permits.
•  This establishes a price for pollution, just as in the tax case. The high polluters have to buy more permits, which increases their costs, and makes them less competitive and less profitable. The low polluters receive extra revenue from selling their surplus permits, which makes them more competitive and more profitable.
•  Therefore, firms will have an incentive not to pollute. India is experimenting with cap-and-trade in the form of Perform, Achieve & Trade (PAT) scheme and carbon tax in the form of a cess on coal. 

The advantages claimed for tradable permits are:

• The system allows flexibility and reward efficiency 
• It is administratively cheap and simple to implement and ensures that pollution is minimised in the most cost-effective way 
• It also provides strong incentives for innovation. 

Consumers may benefit if the extra profits made by low pollution firms are passed on to them in the form of lower prices. 

The main argument in opposition to the employment of tradable emission permits is that they do not in reality stop firms from polluting the environment; they only provide an incentive to them to do so. Moreover, if firms have monopoly power of some degree along with a relatively inelastic demand for its product, the extra cost incurred for procuring additional permits so as to further pollute the atmosphere, could easily be compensated by charging higher prices to consumers.

The two interventions mentioned above i.e. pemits and taxes make use of market forces to encourage consumers and producers to take externalities into account when planning their consumption and production. In other words, the polluters are forced to consider pollution as a private cost.

• We shall now look into the case of positive externalities. As we are aware, subsidies involve government paying part of the cost to the firms in order to promote the production of goods having positive externalities.
•  This is in fact a market-based policy as subsidies to producers would lower their cost of production. What would be the outcome of government intervention through subsidy? A subsidy on a good which has substantial positive externalities would reduce its cost and consequently price, shift the supply curve to the right and increase its output. A higher output that would equate marginal social benefit and marginal social cost is socially optimal 

The effect of a subsidy is shown in the following figure.
                            Effect of Subsidy on Output

• A Pigouvian subsidy equal to the benefit of externality (S=E) is granted by government to the producer. The output level post subsidy is Q* which equates marginal social benefit with marginal social cost. This is socially optimum level of output. 
• In the case of products and services whose externalities are vastly positive and pervasive, government enters the market directly as an entrepreneur to produce and provide them.
•  For example, fundamental research to protect the futuristic technology interest of the society is, in most cases, funded by government as the market may not be willing to provide them. Governments also engage in direct production of environmental quality.
•  Examples are: aforestation, reforestation, protection of water bodies, treatment of sewage and cleaning of toxic waste sites. 

GOVERNMENT INTERVENTION IN THE CASE OF MERIT GOODS

• Merit goods are goods which are deemed to be socially desirable and therefore the government deems that its consumption should be encouraged. Substantial positive externalities are involved in the consumption of merit goods. Left to the market, only private benefits and private costs would be reflected in the price paid by consumers.
•  This means, compared to what is socially desirable, people would consume inadequate quantities. Examples of merit goods include education, health care, welfare services, housing, fire protection, waste management, public libraries, museum and public parks. 
• In contrast to pure public goods, merit goods are rival, excludable, limited in supply, rejectable by those unwilling to pay, and involve positive marginal cost for supplying to extra users. Merit goods can be provided through the market, but are likely to be under-produced and under-consumed through the market mechanism so that social welfare will not be maximized. The following diagram will show the market outcome for merit goods. 

In the absence of government intervention, the output of the merit good would be Q where the marginal private cost (MPC) is equal to marginal private benefit (MPB). The welfare loss to the society due to under production and under consumption is the shaded area (ABC). On account of considerable positive externalities, the optimal output is Q* at which marginal social (MSC) cost is equal to marginal social benefit (MSB). This is a strong case for government intervention in the case of merit goods.

The additional reasons for government provision of merit goods are:

• Information failure is widely prevalent with merit goods and therefore individuals may not act in their best interest because of imperfect information. 
• Equity considerations demand that merit goods such as health and education should be provided free on the basis of need rather than on the basis of individual’s ability to pay. 
• There is a lot of uncertainty as to the need for merit goods E.g. health care. Due to uncertainty about the nature and timing of healthcare required in future, individuals may be unable to plan their expenditure and save for their future medical requirements. The market is unlikely to provide the optimal quantity of health care when consumers actually need it, because they may be short of the necessary finances to pay the market price. 
• The possible government responses to under-provision of merit goods are regulation, subsidies, direct government provision and a combination of government provision and market provision. Regulation determines how a private activity may be conducted. For example, the way in which education is to be imparted is government regulated. Governments can prohibit some type of goods and activities, set standards and issue mandates making others oblige.
•  For example, government may make it compulsory to avail insurance protection. Compulsory immunization may be insisted upon as it helps not only the individual but also the society at large. Government could also use legislation to enforce the consumption of a good which generates positive externalities. E.g. use of helmets, seat belts etc. 
• The Right of Children to Free and Compulsory Education Act, 2009 which mandates free and compulsory education for every child of the age of six to fourteen years is another example. A variety of regulatory mechanisms may also be set up by government to enhance consumption of merit goods and to ensure their quality. 

When governments provide merit goods, it may give rise to large economies of scale and productive efficiency apart from generating substantial positive externalities and overcoming the problems mentioned above.