The actions of government are helpful in resolving market failure. Market failure results from the absence of the incentives that encourage economic agents to allocate resources efficiently. When markets fail, the social costs of allocating resources using the market mechanism are greater than the social benefits, and since private actors have no invective to correct this anomaly, the government has to step in and correct the market so that it yields better outcomes.
Some of the reasons markets fail include externalities, inadequate provision of public goods, under-provision of merit products, over-production of demerit products, and the abuse of monopoly power (Acemoglu & Verdier, 2000). Externalities are the ways in which the production of certain goods and services either benefits or harms third parties. Positive externalities are the beneficial spillover effects of the production of a certain good or service, whereas negative externalities are the harmful effects that accrue to third parties as a result of the production of certain goods or services. An example of a positive externality is public transport.
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An efficient, privately owned public transport system takes private cars off the roads, thus reducing traffic congestion and air pollution. The market mechanism cannot leverage the positive externalities to enhance the benefits to the third parties, and this means the government plays an instrumental role in enhancing positive externalities. For instance, when the government offers subsidies to the private providers of public transport and allocates public resources such as roads for the exclusive use of the firms offering public transport services, it encourages increased provision of the public transport, thus enhancing the positive externalities.
Negative externalities, on the other hand, are the harmful, spillover effects of producing certain goods and services. For instance, when the environmental protection laws are weak, locating an industrial zone in an area may result in environmental pollution because the firms in this zone emit harmful gases into the atmosphere and discharge raw effluent into water bodies. Environmental pollution makes the communities residing in the industrial zone worse off. Since the polluting firms benefit more from avoiding pollution than they do from polluting the environment, it is not in their interest to conserve the environment. Thus, it becomes appropriate for the government to step in and raise the costs of polluting the environment in order to change the incentives of the industrial firms.
Public goods have a free rider problem that results from the fact that people who do not incur the costs of providing them still benefit as much as those who bear the costs of their provision do (Stiglitz, 2010). The free rider problem discourages the allocation of private capital to seemingly unprofitable but essential public goods and services, and to correct this problem, the government needs provide these goods. The under-production of merited products reflects the problem inherent in allowing the exclusive use of private capital to provide public goods; such use means that only the people who can afford these services consume them, and if many people cannot afford them, these services will remain under-produced.
When the government intervenes to correct the over-production of unmerited goods, it does so by, among others, imposing sin taxes and limiting the ability of firms to produce these goods. Overall, government actions are helpful in preventing markets from allocating resources in socially inefficient ways. Even though government action may produce undesirable effects such as an increase in the cost of market transactions, the potential adverse effects outweigh the benefits, and this means there is a strong case for government involvement in the markets. What people need is not less government action, but ways to minimize the unintended costs of this action.
