Market Failure and Public Policy

The potential of market failure is a phenomenon that is commonly considered in a free market economy. When a market fails, it is the task of economists and policy makers to find the reasons for such failures, while the government is expected to intervene in a manner that is targeted towards mitigating the effects of market failure. Theorists appear to disagree somewhat regarding the exact way in which such intervention should take place, but it is commonly conceded that the government should have some role in mitigating market failure.

Market Failure and Public Policy

According to Janusz Mrozek (1999, p. 411), markets fail because of a violation of efficiency. The author holds that all market transactions can be classified according to an efficiency rule: it is either efficient or inefficient. The efficiency rule determines the extent to which marginal benefits to society equal or exceed marginal costs. This efficiency is often influenced by private-decision rules. When the efficiency rule is then violated, the government can improve the efficiency of the economy by altering individual markets. Mrozek emphasizes that the efficiency rule should be applied by considering a unified view of markets and how they operate, with an all-inclusive consideration of the various elements involved. In this way, the most efficient solution can be found to mitigate market failure.

Zerbe and McCurdy (1999, p. 561) refer to efficiency as market transactions that are optimal in operating price; they are costless. Failure to achieve costless transactions, or transactions at less than cost, means that market failure occurs. The authors also point out however that this tends not to occur in the real world, and that costs occur whenever transactions take place. Externalities and market failures therefore occur to some degree whenever transactions occur. These authors then consider market failure and its definition in more specific terms than Mrozek. According to the authors, markets fail as a result of various elements: the market fails to produce public goods; it produces externalities; gives rise to monopolies; disenfranchises other parties by means of asymmetries in information; or by undesirable income distributions. According to the authors, these are all forms of externalities; in other words, they are nonmonetary effects and were not considered during the decision-making process. Externalities, as mentioned above, take place when transactions are in progress.

According to Zerbe and McCurdy (1999, p. 561), a degree of market failure is inevitable when concluding a transaction. However, some market failures are significant and require government attention.

The Role of Government

According to Mrozek (1999, p. 412), governments have more issues than only efficiency to consider in terms of potential market failure and policy issues. Furthermore, the government will only view market alterations as desirable in terms of efficiency when private decision rules are improved in the process. There are therefore certain constraints upon the ability of governments in making an intervention effort in terms of market failure. These constraints can for example include: political constraints; bureaucratic constraints such as limited information; and distortions that arise from taxation viewed as necessary to support policy issues. The government is therefore not always able to intervene in market failure issues.

The government's role in market failure is generally seen as one in which unique power or coercion is applied to overcome cost barriers. When the government is therefore able to intervene, it can regulate prices in such a way to mitigate the causes of market failure.

When the government does intervene, externality problems need to be the point of focus. Governments can for example correct such problems by means of changing private marginal benefits or costs (Mrozek, 1999, p. 416). Private decision rules are then modified I this way to match the efficiency rule. These private decision rules can include mandates, taxes, subsidies, and tradable permits. It is also possible that certain institutions, such as property rights backed by a legal system, can internalize externalities. In such cases, governments can provide these with features like torts and liability in order…