Lesson Explainer: Market Failure and the Role of the Government Economics • Third Year of Secondary School

In this explainer, we will learn how to identify different types of goods and the role of the government in fulfilling certain human needs due to market failure.

Let us begin by understanding what is a free market. Recall that, in economics, a household is a group of one or more individuals who own the factors of production, and a firm is an organization that produces new goods and services by consuming the factors of production owned by the household. The firms are motivated to produce goods and services as long as they are profitable, and individuals receive income from the firms by providing factors of production they own. Interaction between households and firms is the driving force of a free market, which is an economic system where these entities can pursue their self-interest without the control and regulations of the government. While it may appear that a free market can lead to an efficient system, there are many inefficiencies inherent in a free market as we will discuss in this lesson.

For instance, consider how education services would be allocated in a free market economy. In this case, the firms would be private schools that consume the factors of production, such as teachers and school buildings, and produce educational services in exchange for tuition payments from the consumers. However, tuition payments are often not affordable for many families, which would mean that a large portion of the population would not be educated. The lack of consumption of educational services by the general population means that the amount of human resources in the economy would not grow at a suitable rate. This can be considered as wasted resources due to inefficiencies of the free market.

Since the firms in a free market are motivated by profits to produce goods and services, they will not commit to the production process unless they can receive financial compensation from their consumers. In order to motivate the firms in a free market economy to produce goods and services, it must be possible, and practical, to prevent unpaying individuals from consuming them. For instance, they will not produce goods such as streetlights and services such as national defense, since it would not be practical to keep unpaying consumers from receiving their benefits. This leads to a characteristic of goods and services known as excludability.

If it is possible and practical to prevent others from consuming certain goods, the firms can then charge consumers fees in exchange for their access to these goods and services; hence, if the firms in a free market can profit from such transactions, they will be motivated to produce such goods and services. On the contrary, firms in a free market do not have incentives to produce goods and services that are not excludable because it is not possible or practical to charge fees for their consumption.

For most goods and services, it may be possible but not practical to prevent others from using them. For instance, to prevent a nonpaying individual from enjoying security in a neighborhood due to the provision of police services, we would have to expel that individual from the neighborhood. While it is possible to do so, this would not be practical. The extent to which the prevention is practical can be connected to the profitability of such endeavors. For instance, it may be practical to prevent consumers from using a bridge by building toll gates at the entrance, but it may not be practical or cost-effective to prevent individuals from consuming large public parks by building fences along their entire perimeters.

In our first example, we will consider the excludability of goods and services.

In the previous example, we considered the excludability of goods and services. The excludability of goods and services such as education, houses, apples, and private roads gives firms in a free market economy an incentive to produce them. From this list, we note that the owner could easily sell the benefit of using their private road to additional individuals without degrading the service to existing users. This leads to another characteristic of goods and services known as rivalry in consumption.

Whether or not they are excludable, some goods and services can easily be shared among many individuals without reducing their benefits to other consumers. For instance, many people can enjoy the benefits of national defense without reducing its benefits for others, which makes national defense nonrivalrous. To an extent, people can also share access to a bridge or a public park without causing much inconvenience to others, which makes these goods nonrivalrous. However, when more and more people are accessing these goods simultaneously, their benefits may be reduced for all involved. In this sense, a bridge or a public park is only considered nonrival until it becomes too congested. On the other hand, a house is a rival good since allowing others to live in the same house would reduce its benefits for the original occupants.

The characteristics of excludability and rivalry in consumption are used to classify goods and services into different types.

Private goods are goods and services that are both excludable and rivalrous. In other words, others can be prevented from consuming private goods (excludable), and sharing these goods with others reduces their benefits (rivalrous). Private goods are often owned by individuals or private firms, which explains their name, but this is not true for all private goods. For example, houses, food items, and cars are private goods because they are excludable and rivalrous, and these goods are generally owned by individuals. Electrical services are also an example of private goods, since they are excludable and rivalrous, but they are usually owned by utility companies or by local governments rather than the end users of the service. The defining characteristics of private goods are their excludability and rivalry rather than their private ownership.

Public goods are goods and services that are both nonexcludable and nonrivalrous. In other words, others cannot be prevented from consuming them (nonexcludable), and sharing them with others does not reduce their benefits (nonrivalrous). Examples of public goods include public parks, national defense, and streetlights. Since public goods are not excludable, the firms in a free market are not motivated to produce them. They are called public goods because, being nonexcludable, they can be used by the public in general.

Artificially scarce goods, also known as club goods, are goods and services that are excludable but nonrivalrous. In some references, these are also known as public but excludable goods since others can be prevented from consuming them (excludable), while sharing them with others does not reduce their benefits (nonrivalrous). Examples of artificially scarce goods include private roads, digital books, and satellite television services. Individuals can be excluded from consuming these goods, which enables the firms to charge consumers fees to access them. While the availability of these goods and services is almost unlimited and it does not cost the firm extra to extend their benefits to others, restrictions on accessing these goods and services make them artificially scarce.

We have seen that excludability and rivalry in consumption can be used to classify private goods, public goods, and artificially scarce (or club) goods. While we will not discuss this in detail, goods such as public fishing ponds are nonexcludable but rivalrous. Such goods are known as common goods, or common resources. The table below summarizes these classifications.

Externality is another characteristic of goods and services that concerns the secondary, or societal, effects of their consumption in addition to their primary, or individual, satisfaction of needs. If the secondary effects are benefits, then the goods have positive externalities. If the secondary effects are harmful, then the goods have negative externalities.

Merit goods are goods and services whose consumption creates additional benefits for the society; hence they carry positive externalities. For instance, there are direct benefits for the student when consuming educational services, such as satisfying the individual’s need for learning and improving employment opportunities. However, society as a whole also benefits from the increased availability of employable, educated human resources, which will help produce economic growth. These societal benefits of consuming merit goods are their positive externalities. On the other hand, demerit goods such as cigarettes have negative externalities, since cigarette smoking has harmful health effects on nearby individuals.

Let us consider the model used to provide some merit goods and services, as well as their positive externalities. For instance, the provision of educational services in a purely free market economy is not optimal because many families cannot afford to pay private school fees. The nation’s economy would miss out on the benefits of educating all of its potential workforce. Likewise, healthcare services deliver many positive externalities by improving the health and fitness of people and their availability for work, as well as providing health education and vaccinations to reduce the spread of infectious diseases. Benefits to society may exceed costs if the model of provision of such goods and services is extended beyond a purely free market system.

Merit goods are similar to private goods in the sense that they are often excludable and rivalrous. For instance, it is possible to exclude a patient from receiving a healthcare service, and when one patient is being treated by a doctor, it prevents another patient from receiving the treatment from the doctor simultaneously, which makes it rivalrous. In this sense, healthcare services can also be categorized as private goods, as well as a merit goods. However, merit goods are not characterized by their excludability and rivalry but by their positive externalities. Their positive benefits to society make the consumption of merit goods very appealing.

In our next example, we will classify different types of goods and services.

We have discussed different types of goods depending on their excludability, rivalry, and externalities. A free market fails to deliver certain types of these goods efficiently, which leads to market failure.

Recall that efficiency in economics is measured by the amount of wasted resources during their allocation. In other words, market failure means that, without the government’s help, households and firms will end up wasting a lot of resources through their economic activities.

One example of market failure is the inadequate production of public goods, such as public streets and national defense. The following are reasons often given for the failure of a free market to produce an adequate supply of public goods.

• Firms in a free market do not have the internal motivation to produce public goods. While public goods are necessary for the society, it is not the responsibility of a specific individual or a firm to produce them in a free market.
• The firm producing the public good must bear its cost entirely. Although the public good is shared with others in the end, they do not share the expenses.
• A public good is not excludable, so its producer cannot prevent others from benefiting from it. This also means that a firm cannot charge the consumers of the good fees to make profits. Hence, the firms in a free market will not produce public goods since it is not profitable to do so.
• An individual can consume a public good that others have produced without bearing any of its cost. In economics, this is known as the free rider problem. For instance, nonexcludable goods and services such as a lighthouse or national defense suffer from the free rider problem, since individuals can enjoy their benefits without incurring any of their costs. Hence, there is no incentive for any individual to produce them.

Another type of market failure is the underconsumption of merit goods in a free market. Underconsumption means that if we rely only on the firms for the production, the consumption of these goods will not reach an optimal level for the society. We noted that merit goods, such as healthcare and education, are often excludable, which means that the firms in a free market are motivated to produce them. However, the firms will only produce these goods and services as long as they are profitable. We can observe this in our society today, as private schools and hospitals are often not accessible to many individuals. If they were the sole producers of these merit goods, education and healthcare services would be severely underconsumed in that economy.

To understand why the underconsumption of merit goods leads to an inefficient economy, recall that merit goods are characterized by their positive externalities. We noted that educational services have the positive externalities of increasing the available human resources in the economy and that healthcare services have the externalities of preventing widespread illnesses that could severely cripple the economy. If merit goods are underconsumed, then resources, for instance, human resources, will be wasted in the end.

Hence, the two types of market failure associated with different types of goods, introduced earlier, are the inadequate production of public goods and the underconsumption of merit goods. Besides the production of goods and services, there are other areas where a free market fails to be efficient, as we will discuss below. A government can intervene in the economy to address various inefficiencies of the free market. Let us consider additional types of market failure and the role of the government in an economy.

• The government intervenes to efficiently allocate public and merit goods. We have noticed that, in a free market, public goods are not adequately produced and merit goods are underconsumed. The firms in a free market will not produce public goods, and the individuals in a free market will not consume merit goods at an optimal level. The government can produce public and merit goods by using revenues collected from households and firms in the form of taxes and fees. In doing so, the consumers of these resources indirectly contribute to the costs and they can share the benefits. For instance, the government can fund the construction of a bridge by charging the consumers a fee, and it can fund national defense by using tax revenues collected from its citizens.
  The government can use its sovereign authority in the form of regulations to allocate public and merit goods more efficiently. For instance, a regulation can require private hospitals to employ only nationally certified doctors to perform surgeries, and it can also prohibit the consumers of public parks from destroying the scenery. Furthermore, since the government wants more merit goods to be consumed, it can require the citizens to consume them. For instance, many countries require their citizens to receive education up to a certain level so that their labor factor of production will be enhanced. Also, while healthcare policy is a multifaceted issue with various approaches in different countries, most countries have regulations to encourage healthcare services’ consumption: some countries provide a public healthcare system through tax revenues, while other countries provide subsidies for individuals in poverty to obtain health insurance.
• The government intervenes to achieve economic stability and growth. In a free market, prices of goods and services are determined by the interactions between the producers and the consumers. However, these interactions often lead the prices of goods and services to fluctuate wildly. The failure of a free market to achieve economic stability can cause serious societal issues such as unemployment and inflation. Unemployment refers to the societal problem where individuals seeking to provide their labor factor of production cannot find opportunities. To address the problem of unemployment, the government can itself provide the opportunities to consume their labor, or it can provide subsidies for the firms to encourage additional job openings. Inflation is caused by a continual increase in the prices of goods and services over a long period of time. In order to address inflation, the government can intervene by ensuring a stable growth in production, since a sufficient supply of goods and services would stabilize the prices of these items. Additionally, the government bears the responsibility of stabilizing the value of the national currency against foreign currencies.
  In addition to stabilizing the economy, the government is also responsible for achieving the nation’s economic growth, since a free market is driven by profits of individual firms rather than the overall economic growth. For economic growth to take place, firms need to invest in capital goods, which requires money. Firms obtain the necessary funds for investment from the financial market. Hence, ensuring the existence of good conditions in the financial market is an important role of the government, which encourages and supports economic growth. Another way the government can promote economic growth is by directly providing work for its citizens or encouraging firms to create new jobs by providing subsidies.
• The government intervenes to achieve equity. One of the most apparent failures of a free market is the widening income gap between the wealthy and the poor. While the unequal distribution of wealth in itself does not mean that a free market is inefficient in allocating its resources, large income gaps do lead to inefficiencies in the form of lost economic opportunities for the poor. In economics, equity refers to equal opportunities for individuals, regardless of their wealth, gender, race, age, or religion. The government’s allocation of public and merit goods is one example of a government intervention to achieve economic equity, but it is often insufficient on its own to satisfy the broader needs of a society. The government often needs to create additional regulations to achieve equity. For instance, the government can set regulations to ensure diversity in job recruitment, and it can provide subsidies to provide housing for the homeless. Improved equity conditions will lead to an increased utilization of human resources, which makes the economy more efficient.

In our next example, we will consider the role of the government in addressing various market failures.

We have discussed different types of market failure and how the government can intervene to address these issues. Let us turn our focus to capitalism, which is the most prominent economic system today. Three pillars of capitalism are known as private ownership, profit motive, and market mechanism.

Private ownership, or private property, is the defining characteristic of a capitalist economy. It refers to the rights of individuals in the economy to own tangible resources, such as factors of production, as well as intangible properties, such as financial instruments and intellectual rights. Private ownership allows an individual to own a firm that can produce goods and services. The privately owned firm returns all its profits as the owner’s income.

Profit motive means that the production of goods and services is driven by the firm’s profits. Each firm in the economy operates to maximize its profit from the goods and services it produces. Having many firms participating in an economy in this manner creates free competition between them, which makes the economy more efficient.

Market mechanism refers to the process through which the prices of goods and services are determined by the producers and the consumers. The firms in the economy compete with one another to produce goods and services and to maximize profit, while the consumers in the economy will purchase them at the lowest available price. The amount of goods and services the firms are willing to produce at a given price is called the supply, while the amount of goods and services the consumers are willing to purchase at a given price is called the demand. Supply and demand interact with each other through the market mechanism, resulting in the market price (also known as the equilibrium price) as well as the quantity to be produced.

We will consider the pillars of capitalism in our next example.

Private ownership, profit motive, and market mechanism work together to motivate the producers and consumers to participate in a capitalist economy. Driven by these pillars of capitalism, firms in the economy can produce goods and services very efficiently if the conditions are right. For this reason, the government often shifts some of its responsibilities of the allocation of public and merit goods to privately owned firms through privatization.

The public sector refers to the government-owned production enterprises in an economy. For instance, the national military, power grids, and public schools are parts of the public sector. On the other hand, individual-owned production enterprises, that is, firms, comprise the private sector. Using these terms, privatization is defined as the transfer of the factors of production from the public sector to the private sector. Let us consider different forms of privatization.

• Privatization of ownership is a type of privatization where the government-owned factors of production are sold to individuals who will transfer them to the private sector. This sale can be of the whole enterprise, including the ownership of all factors of production involved in which case, the private sector will fully control the production process afterward. However, the sale is more often for a partial ownership of the enterprise, using financial products like stock shares. While an individual with these shares can benefit from the profits from the production, the public sector remains in control of the enterprise.
• Privatization by outsourcing is when the government uses the private sector to produce goods and services in exchange for financial compensation. The government uses legal contracts to mediate outsourcing. Contracts specify the production responsibilities for the private sector as well as the financial compensation for the goods and services it delivers.
• Privatization of management is a transformation of the management style in the public sector to resemble that of the private sector. In the private sector, the appointment and termination of positions are driven by efficiency, and rewards and penalties are often used to motivate the workers. The public sector can improve its efficiency by adopting this management style. This type of privatization differs from other types of privatization, since the government maintains the full ownership of the factors of production.
• Privatization by deregulation is when the private sector is allowed to participate in a production process that used to be solely conducted by the government. This is often achieved by removing legal barriers of entry, which is called deregulation. Deregulation improves efficiency by providing an environment where many firms can compete against one another, as well as against the public sector, in the production of goods and services. The competition between providers can lead to innovation and the development of more efficient and cost-effective ways of producing or delivering the goods and services. The government can achieve deregulation by allowing any firms to participate, or it can grant special permits to a few qualified firms to participate.

Privatization does not lead to a reduced role of the government, but it leads to the redistribution of the government’s role in the economy. Transferring the responsibility of the production process lessens the burden on the government, allowing it to better tend to its other tasks such as regulating the private sector and preventing market failures. We can also note a few other benefits of privatization. The revenue received from privatization of ownership can be used to fund other enterprises in the public sector. Also, since the private sector is driven by profit, the free competition between the firms will improve the efficiency of the economy.

In our final example, we will consider different forms of privatization.

Let us finish by recapping a few important concepts from this explainer.