GOVERNMENT INTERVENTION TO CORRECT MARKET FAILURE

GOVERNMENT INTERVENTION IN THE CASE OF DEMERIT GOODS

• Demerit goods are goods which are believed to be socially undesirable. Examples of demerit goods are cigarettes, alcohol, intoxicating drugs etc. The consumption of demerit goods imposes significant negative externalities on the society as a whole and therefore the private costs incurred by individual consumers are less than the social costs experienced by the society. 
• The production and consumption of demerit goods are likely to be more than optimal under free markets. The price that consumers pay for a packet of cigarettes is market determined and does not account for the social costs that arise due to externalities.
•  In other words, the marginal social cost will exceed the market price and overproduction and over- consumption will occur, causing misallocation of society's scarce resources. (Refer Figure 2.2.1 in unit 2). 
• However, it should be kept in mind that all goods with negative externalities are not essentially demerit goods; e.g. Production of steel causes pollution, but steel is not a socially undesirable good.

The generally held argument is that consumers overvalue demerit goods because of imperfect information and they are not the best judges of welfare with respect to such goods. The government should therefore intervene in the marketplace to discourage their production and consumption. How do governments correct market failure resulting from demerit goods?

• At the extreme, government may enforce complete ban on a demerit good.
• e.g. Intoxicating drugs. In such cases, the possession, trading or consumption of the good is made illegal.
• Through persuasion which is mainly intended to be achieved by negative advertising campaigns which emphasize the dangers associated with consumption of demerit goods.
• Through legislations that prohibit the advertising or promotion of demerit goods in whatsoever manner.
• Strict regulations of the market for the good may be put in place so as to limit access to the good, especially by vulnerable groups such as children and adolescents.
• Regulatory controls in the form of spatial restrictions e.g. smoking in public places, sale of tobacco to be away from schools, and time restrictions under which sale at particular times during the day is banned.

Imposing unusually high taxes on producing or purchasing the good making them very costly and unaffordable to many is perhaps the most commonly used method for reducing the consumption of a demerit good. 

• For example, the GST Council has bracketed four items namely, high end cars, pan masala, aerated drinks and tobacco products into demerit goods category and therefore these would be taxed (with a cess being added on to the basic tax) at much higher rates than the top GST slab of 28 per cent.
• However, there are various limitations for government to succeed in producing the desired optimal effects in the case of demerit goods. There are many practical difficulties in imposing taxes.
•  In order to impose a tax which is equivalent to the marginal external cost, the governments need to know the exact value of the marginal external cost and then ascribe accurate monetary value to those negative externalities. In practice, this is extremely difficult to do.

The government can fix a minimum price below which the demerit good should not be exchanged. The effect of such minimum price fixation above equilibrium price is shown in the figure below:

Figure 2.3.5

Outcomes of Minimum Price for a Demerit Good

• Free market equates marginal private cost with marginal private benefit (point B) and produces an output of a demerit good Q at which marginal social benefit (MSB) is much less than marginal private benefit (MPB).
•  At this level of output, there is a divergence (BC) between marginal private benefit (MPB) and marginal social benefit (MSB). The shaded area represents loss of social welfare. If the government determined minimum price is P1, demand contracts and the quantity of alcohol consumed would be reduced to Q1. At Q1level of output, marginal social benefit (MSB) is equal to marginal social cost (MSC) and the quantity of alcohol consumed is optimal from the society’s point of view.
• The demand for demerit goods such as, cigarettes and alcohol is often highly inelastic, so that any increase in price resulting from additional taxation causes a less than proportionate decrease in demand. Also, sellers can always shift the taxes to consumers without losing customers.
• The effect of stringent regulation such as total ban is seldom realized in the form of complete elimination of the demerit good; conversely such goods are secretly driven underground and traded in a hidden market.

GOVERNMENT INTERVENTION IN THE CASE OF PUBLIC GOODS

• We have seen in the previous unit that public goods which are non excludable is highly prone to free rider problem and therefore markets are unlikely to get established. Direct provision of a public good by government can help overcome free-rider problem which leads to market failure. The non-rival nature of consumption provides a strong argument for the government rather than the market to provide and pay for public goods.
•  In the case of such pure public goods where entry fees cannot be charged, direct provision by governments through the use of general government tax revenues is the only option.
• Excludable public goods can be provided by government and the same can be financed through entry fees. A very commonly followed method is to grant licenses to private firms to build a public good facility.
•  Under this method, the goods are provided to the public on payment of an entry fee. In such cases, the government regulates the level of the entry fee chargeable from the public and keeps strict watch on the functioning of the licensee to guarantee equitable distribution of welfare.
• Certain goods are produced and consumed as public goods and services despite the fact that they can be produced or consumed as private goods. This is because, left to the markets and profit motives, these may prove dangerous to the society. Examples are scientific approval of drugs, production of strategic products such as atomic energy, provision of security at airports etc.

PRICE INTERVENTION : NON MARKET PRICING

• Price controls are put in place by governments to influence the outcomes of a market. Very often, there is strong political demand for governments to intervene in markets for various goods and services on grounds of fairness and equity. 
• Price intervention generally takes the form of price controls which are legal restrictions on price. Price controls may take the form of either a price floor (a minimum price buyers are required to pay) or a price ceiling (a maximum price sellers are allowed to charge for a good or service). Fixing of minimum wages and rent controls are examples of such market intervention.
• Government usually intervenes in many primary markets which are subject to extreme as well as unpredictable fluctuations in price.
•  For example in India, in the case of many crops the government has initiated the Minimum Support Price (MSP) programme as well as procurement by government agencies at the set support prices. The objective is to guarantee steady and assured incomes to farmers. In case the market price falls below the MSP, then the guaranteed MSP will prevail. The following diagram will illustrate the effects of a price floor. 
• Nevertheless, mere announcement of higher support prices for commodities, which are not effectively backed up by procurement arrangement, does not serve the purpose of remunerative levels of prices for producers.

Figure 2.3.6

Market Outcome of Minimum Support Price

When price floors are set above market clearing price, suppliers are encouraged to over-supply and there would be an excess of supply over demand. At price `150/ which is much above the market determined equilibrium price of ` 75/, the market demand is only Q1, but the market supply is Q2.

When prices of certain essential commodities rise excessively, government may resort to controls in the form of price ceilings (also called maximum price) for making a resource or commodity available to all at reasonable prices. For example: maximum prices of food grains and essential items are set by government during times of scarcity. A price ceiling which is set below the prevailing market clearing price will generate excess demand over supply. As can be seen in the following figure, the price ceiling of ` 75/ which is below the market determined price of  ` 150/leads to generation of excess demand over supply equal to Q1-Q2.

Figure 2.3.7

Market Outcome of Price Ceiling

With the objective of ensuring stability in prices and distribution, governments often intervene in grain markets through building and maintenance of buffer stocks. It involves purchases from the market during good harvest and releasing stocks during periods when production is below average.

GOVERNMENT INTERVENTION FOR CORRECTING INFORMATION FAILURE

• For combating the problem of market failure due to information problems and considering the importance of information in making rational choices, the following interventions are resorted to:
• Government makes it mandatory to have accurate labeling and content disclosures by producers. For example: SEBI requires that accurate information be provided to prospective buyers of new stocks.
• Public dissemination of information to improve knowledge and subsidizing of initiatives in that direction.
• Regulation of advertising and setting of advertising standards to make advertising more responsible, informative and less persuasive.

GOVERNMENT INTERVENTION FOR EQUITABLE DISTRIBUTION

• One of the most important activities of the government is to redistribute incomes so that there is equity and fairness in the society. Equity can be brought about by redistribution of endowments with which the economic agents enter the market.
•  Some common policy interventions include: progressive income tax, targeted budgetary allocations, unemployment compensation, transfer payments, subsidies, social security schemes, job reservations, land reforms, gender sensitive budgeting etc.

 Government also intervenes to combat black economy and market distortions associated with a parallel black economy. Government intervention in a market that reduces efficiency while increasing equity is often justified because equity is greatly appreciated by society.

The discussion above is far from being comprehensive; yet it points toward the numerous ways in which governments intervene in the markets. However, we cannot be sure whether the government interventions would be effective or whether it would make the functioning of the economy less efficient. Government failures where government intervention in the economy to correct a market failure creates inefficiency and leads to a misallocation of scarce resources occur very often. Government failure occurs when:

•  intervention is ineffective causing wastage of resources expended for the intervention.
• intervention  produces fresh and more serious problems

There are costs and benefits associated with any Government intervention in a market, and it is important that policy makers consider all of the costs and benefits of a policy intervention.