Why governments step into markets

Overview

Governments intervene to stabilise prices in agricultural and commodity markets, raising revenue a genuine reason for intervening in some markets and socially optimum level of output mean.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why does the presence of a negative production externality give a government a reason to act in a market?

   Model answer

   A negative production externality means part of the cost of producing the good falls on third parties, so marginal social cost lies above marginal private cost. Firms set output where private cost meets private benefit, which is to the right of the point where social cost meets social benefit. The market therefore over-produces, and the units between the two output levels generate more cost to society than benefit. That gap between the market outcome and the social optimum is the welfare loss a government tries to remove.

2. 2

   Trace the chain that runs from a marginal external cost of £3.00 per unit to over-production in a market.

   Model answer

   Each unit imposes £3.00 of cost on people outside the transaction. The firm bears only its private cost, so its supply curve sits £3.00 per unit below marginal social cost. Equilibrium is found where private supply crosses demand, at a price that is too low and a quantity that is too high. Between the market quantity and the social optimum, marginal social cost exceeds marginal social benefit on every unit. The sum of those excesses is the welfare loss, and it grows the larger the external cost is.

3. 3

   Why can a private market not supply a good that is both non-excludable and non-rival?

   Model answer

   Non-excludability means a firm cannot stop people who have not paid from consuming the good, so consumers have every incentive to free ride and wait for someone else to buy it. Non-rivalry means one person's consumption does not reduce what is left for others, so the marginal cost of an extra user is zero and charging a positive price is inefficient anyway. With no way to collect revenue, no profit-seeking firm will supply the good, and the market provides none of it. Government provision funded from taxation is the usual answer.

4. 4

   A market is clearly imperfect. Why does that not, by itself, prove that intervention will raise welfare?

   Model answer

   The case for intervening rests on a comparison of two imperfect outcomes, not on the market falling short of a textbook ideal. Intervention has its own costs: administration and enforcement, the opportunity cost of the revenue used, distorted price signals, and unintended behaviour such as evasion or relocation. A government also lacks the information to set the instrument at exactly the right level. Intervention is justified only where the expected gain from moving output towards the social optimum exceeds those costs; otherwise the cure is worse than the disease.

5. 5

   Why do governments intervene in the market for a merit good such as childhood vaccination?

   Model answer

   A merit good is under-consumed relative to the social optimum, partly because consumers undervalue the private benefit and partly because consumption creates external benefits for others. With vaccination, a vaccinated child is less likely to pass infection to people who are not vaccinated, so marginal social benefit lies above marginal private benefit. Left to itself the market sets output where private benefit meets supply, below the optimum. Intervention through free provision, subsidy or information aims to raise consumption towards the level at which social benefit meets social cost.

6. 6

   How does an information failure on the part of consumers create a case for intervention?

   Model answer

   Efficient choice assumes consumers know the true costs and benefits of what they buy. Where they do not, demand reflects perceived rather than actual benefit, so the market clears at the wrong quantity. Consumers who underestimate the long-run harm of a demerit good buy too much of it; those who underestimate the benefit of training or insurance buy too little. Because the failure lies in what people know, intervention can be aimed at the cause, by requiring labelling or publishing comparable data, rather than at the price.

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