Correcting Market Failure - The Role of Government

Market failure happens when the price mechanism fails to allocate scarce resources efficiently (A.K.A. Allocative Inefficiency).

Policies to counter market failure: (First 3 are known as Command & Control Policies)

1) Regulation:

• Rules & laws put in place to influence the behaviour of firms. E.g. to increase firm's costs & hence decrease their output, hopefully to the Social Optimum, thus internalizing the externality.
• Corrects the market failure of over-consumption & over-production as a result of -ve production externalities, -ve consumption externalities & demerit goods.

Strengths:

• Quick to implement
• Full weight of the law behind it.
• If accurate, can internalise the externality.
• Fines are a deterrent.

Weaknesses:

• Cost & problems of enforcement.
• How to set appropriate standards.
• No incentive for improvement once standards have been set.
• Obtaining international agreement.
• Policy may not raise revenue.
• May lead to a black market.
• Gvnmt. failure.

2) Indirect Taxation:

• A tax initially paid by firms but passed on to the consumer. The intention is to influence consumer's decisions through changes in price. The higher price leads to a contraction in demand. 
• Corrects the market failure of over-consumption & over-production as a result of -ve production externalities, -ve consumption externalities & demerit goods.

Strengths:

• The tax can be set at a high level to deter consumption (contraction of demand).
• Any tax revenue collected can be hypothecated to pay for things such as research into cancer treatments.

Weaknesses:

• Can adversely affect firms.
• Can unfairly affect some members of society (e.g. poor).
• If the demand is inelastic the tax will yield more…