25 3.2 – MARKET FAILURES

3. MARKET FAILURES

Market failures occur when there is an inefficient allocation of goods and services by the free market. Governments often use market failures as a rationale for intervening in economic activity: “Put simply, governments act when markets fail to achieve the conditions that justify their use” (Stewart Hedge & Lester, 2008). According to Weimer and Vining (2017), market failures occur due to one of four reasons: public goods, externalities, natural monopolies, and information asymmetry.

Figure 3.1: National defense is a public good.

Source: U.S. Army Attribution: Thomas Cieslak License: Public Domain

One of the most important actions governments can take involves the provision or protection of public goods. Public goods refer to the common goods enjoyed by everyone in society (Samuelson, 1955). Public goods cannot be limited to only those individuals who choose to pay for them because they are naturally available to all. Clean air, streetlights, and public roads are examples of public goods. National defense exemplifies a pure public good. One person can benefit from national defense without reducing the benefit another person receives. Similarly, one cannot be excluded from the benefits national defense provides.

Public goods cannot be provided or ensured by the market (private sector) due to two of their unique characteristics: non-exclusion and joint consumption, also referred to as non-rivalrous (Samuelson, 1954). Non-exclusion describes the inability to prevent individuals from enjoying a public good. Joint consumption describes the ability of one person to consume a public good without precluding others from enjoying it. This phenomenon is referred to as non-rivalrous, since the market cannot exclude those who do not pay for a public good from enjoying it. Because exclusion is impossible, the market also cannot ensure a profitable return if they were to provide a public good (Schneider and Ingram, 1997).

Government actions protecting public goods occured in the U.S. federal government’s passage of the Clean Air Act of 1970 (an amended version of earlier air pollution acts from the 1950s and 1960s). This legislation vastly expanded federal and state government’s power to regulate air pollutants from stationary and mobile sources. The federal and state government’s subsequent regulation of air pollution in the U.S. has served to dramatically reduce dangerous pollutants in the air. Clean air is a public good that can only be protected by government action. Services that are not generally provided by the market involve those in which profits are impossible to ensure. Since clean air is nonexclusive (you cannot stop individuals from breathing clean air) and involves joint consumption (my breathing clean air does not stop you from breathing it), the private sector has no incentive to make any attempts at providing it. Although some companies have tried, it is difficult to profit by selling clean air.

Government actions to protect clean air, water, public lands, and other natural resources are considered vital due to the inability of other actors in the policy process to protect them. As described in Hardin’s article (1968) The Tragedy of the Commons, commonly held resources (“common pool resources”) must be protected by government actions. If individual and private sector actors were allowed to consume or abuse publicly owned natural resources without government regulations, those natural resources would be depleted and unavailable to future generations. The federal government’s passage of the National Environmental Policy Act (NEPA) of 1970 exemplifies government action to protect common pool resources. The act requires all government projects to consider their possible impact on the environment. Environmental impact statements are required before any federal government project, or projects involving federal funding, can take place. Most state governments have subsequently enacted their own versions of NEPA to provide protections for common pool resources that could not be provided by the private sector.

Conversely, a private good is both rivalrous and excludable. A pure private good is one that is privately owned and, once consumed, cannot be consumed by another. A coffee from Starbucks is a prime example of such an item. The person who bought the coffee is not required to share and, once they consume the coffee, it cannot be consumed again. Some private goods are not pure private goods; instead, they are considered toll goods. Toll roads, for example, exclude motorists who are unable or unwilling to pay the toll. However, one motorist’s consumption, or use, of the road does not prevent another motorist from using the same road. Similarly, some public goods are not pure public goods. These goods are not excludable but are rivalrous. Public fisheries, including rivers, lakes, and streams, are open to the public, but consumption of the fish is limited if catching and eating too many fish would deplete the population, the act of catching and releasing a fish would not apply to this scenario.

Table 3.1: Public vs. Private Goods.

Source: Original Work Attribution: Keith Lee License: CC BY-SA 4.0

Externalities (Stigler, 1961) refer to effects resulting from a produced good that are not the intent of production. One example is the effect on a local economy when a major sporting event takes place, such as the Super Bowl, the NBA playoffs, or the Master’s golf tournament. Businesses not directly related to or responsible for the event will still benefit from the occasion due to visitors frequenting their establishments. This type of spillover effect is considered a positive externality since the effect benefits the community. Conversely, a negative externality includes water and air pollution created by coal-fired power plants. The power plants provide a service to the community, but the service comes at a price beyond the monthly power bill. Air quality and water quality are reduced, and profit-maximizing firms do not have an incentive to expend resources to limit their environmental impact. Government intervention is required to address this failure by setting restrictions on how much pollution can be generated and fining firms for exceeding established limits.

Natural monopolies (Baumol, 1970) can occur when start-up costs are high, thereby making it impractical for multiple firms to provide a service. Examples include public utilities, such as water, sewer, and gas services. Utilities require infrastructure to provide the resource, which is a costly endeavor. Furthermore, having multiple water, gas, or sewer lines is not practical considering the complexity of pipeline networks. The government generally intervenes to provide the utility or, at a minimum, negotiates prices to ensure citizens are not excluded by being priced out of the resource.

Lastly, information asymmetry (Akerlof, 1970) occurs when a firm possesses knowledge that the consumer does not. For example, prescription drug providers know about adverse side effects due to drug testing and would benefit from not disclosing this information. However, the Federal Drug Administration (FDA) requires prescription drug companies to provide sufficient information to protect the consumer. Consider the work that government agencies do to protect the public and ensure that consumers have the information they need to make choices about food products. Non-GMO food labels, grading meat packages, warning labels on cigarettes and alcoholic beverages: the government requires companies to place these labels on products because, otherwise, the food packaging industry is unlikely to disclose negative information to consumers. These are all examples of market failures that resulted in government intervention.