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4 Types Of Market Failures That Require Government Intervention

This is part 1 of a 3-part series on the theoretical underpinnings of governance and policymaking.

09/02/2017 12:28 PM IST | Updated 10/02/2017 9:22 AM IST
Rupak De Chowdhuri / Reuters

"There are two things you don't want to see being made—sausage and legislation. They're both messy. Often you have no idea what's in the end product. And what goes into the process is, well, not for the faint-hearted."— Otto Van Bismarck

Such sayings/idioms, even though amusing on the surface, betray an undeniable and fundamental fault with how we as governments continue to create policies and govern. The problems facing our policymakers and the potential solutions are well-known, although as they say, the devil lies in the implementation; more often than not the real quagmire of all policy and governance failures can be traced to the foundational issue of improper implementation.

There are three fundamental questions to be asked before the process of policymaking initiates:

1. When is government intervention needed?

2. How to navigate the terrain of political economy?

3. How to improve state capacity to execute policies and schemes?

When is government intervention needed?

The government is the entity that wields the maximum power to pursue multiple objectives for the welfare of society. No one doubts the importance of a well-oiled state machinery; however, unbridled state intervention raises reasonable doubts on its need and requirement in the various situations concerned.

Four market failure categories cover the areas where intervention by the government is required and the provision of services and goods cannot be left to the forces of free markets.

In the realm of economics, there exists the concept of "laissez faire". In plain speak, laissez faire is a system where the incentives of private players to provide services are not shaped by government interventions and all economic activities can take place without being encumbered by coercive measures such as tariffs, subsidies and taxes. Laissez faire was defined by the following three axioms that were proposed by economist Adam Smith in 1776:

  • The Invisible Hand: The notion that an individual's efforts to maximise her own gains in a free market benefits society even when her ambitions have no benevolent intentions.
  • Advantage of Competition: Natural competition amongst private entities, instead of closely controlled state companies and organisations, fosters better and cheaper product development for the end consumer
  • Dynamics of Supply and Demand: The producers of good in a free market will produce enough to meet the demands of the consumers and this potential equilibrium will rationalise and modulate the prices in an economy.

The idea of laissez faire is a powerful one; one that injects innovation, energy and dynamism into an economy for it prevents the meddlesome state from resorting to desultory means of imposing and structuring licensing paraphernalia, like the Fabianis-tic policies that India witnessed during the license-raj era and which looks set to return with the inefficacious demonetisation rollout. However, as beautiful a concept laissez faire is, its limitations and failures in fostering crony capitalism and in imposing a distinct lack of focus on the welfare of the underprivileged are well documented and tested.

This then begs the fundamental question of when the state should react and respond to these failures of the free market. These market failures can be, summarily, divided into four categories:

1. Negative externalities identified by the exploitation of the commons

A negative externality is the cost borne by a tertiary player in the system due to the actions of the primary and secondary players. Let us consider the case of people suffering from respiratory diseases due to pollution spewing vehicles on the roads:

  • Assuming that all the people who are using vehicles to aid their transportation process are within limits of plausible rationality; each person then seeks to maximise her benefits associated with travelling in a private vehicle. These benefits include: comfort, savings on account of time, status in the society, among other things.
  • Given that these people are rational beings, each person performs the following mental calculation: Is the usage of a vehicle for the purposes of transportation benefitting me?
  • She generally has the following answers in mind: The positive component is the array of benefits associated with usage of a vehicle; The negative component is the pollution caused due to the vehicle.
  • However, the person justifies her usage of a vehicle by way of the argument that the negative externalities produced due to her actions are shared amongst different stakeholders, whilst the positive benefits are accrued by her only.

Such instances which involve exploitation of the commons require immediate interventions by the state.

The road rationing experiment tried out by the Delhi government to reduce air pollution is an example of a relatively successful state intervention.

2. Market forces of capitalism resulting in concentration of power

As described above, the single-minded pursuance of laissez faire often gives rise to crony capitalism which is usually identified by monopolistic and oligopolistic markets.

This gives rise to a system where there is a concentration of power among a few instead of dispersion of power in the hands of many. This results in distortions in the market economy, causing exploitation of the needy and the poor.

This again requires intervention by the state to regulate markets by way of rules, laws and policies which aim to safeguard the interests of the people.

Adnan Abidi / Reuters

3. Asymmetry of information

Markets usually produce the end consumers with varied choices of products and services, whose quality and/or reputation is hard to know, in advance.

This results in information asymmetries where the consumer goes in blind, oblivious to the quality of the service that he is utilising, argued George Akerlof. Example: a patient visits a doctor for a routine examination, but he has no knowledge of the reputation and credibility of his professional medical practice

The government needs to remove these asymmetries and ensure proper information dissemination to the citizens on the availability of cogent information. Example: The government of India, through the Medical Council of India (MCI) empanels doctors and medical institutions after a rigorous vetting process, which signals the credibility of the practitioner concerned to the citizen.

4. Provisos for non-rival and non-excludable goods

In the field of micro-economics, the following matrix of the categories of service provided in a market is followed:

Pranav Jain

Thus, it is incumbent upon the government to provide for and intervene in systems and market failures which involve non-rival and non-excludable goods

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With this we have answered our question of: When is government intervention needed? These four market failure categories comprehensively cover the areas where intervention by the government is required and the provision of services and goods cannot be left to the forces of free markets.

The second article of this series will answer the questions of how to navigate the terrain of political economy and how to improve state capacity to execute policies and schemes. The third article will look at potential solutions to simplify and strengthen the supply chain of ideation, policy creation and its cogent implementation.

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