Market Failure and Government Failure

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Market Failure and Government Failure


The current state of economy, the growing role of state regulation, and the dynamism of the processes require rapid and appropriate response to the changes that are taking place. In these circumstances, the importance of studying the nature of government and market failure is growing.

Currently, government regulation of the economy is and has been implemented in all states of the world, including the developed countries. There cannot be an effective market economy without an active regulatory role of the government. The world science often uses the theory of market failure in justifying the necessity of government interference in the economy. Recognizing the obvious advantages of the market economy over the command economy, economic science is forced to admit that the market system cannot cope with a number of issues or solve them efficiently enough, leading to a market failure. Moreover, weak regulatory role of the government may lead to a government failure. Therefore, both market and government institutions are not perfect and have their flaws. Government failure and market failure are the inevitable results of their own imperfections and the key concepts towards deeper understanding of the nature and objective functions of the microeconomic policy.

Market Failure

Market failure is a situation in which the market mechanism is not able to provide the optimal allocation, and efficient and equitable use of resources. According to the theory of market failure, the economic role of the government lies in the correction of such “failures” (McConnell, 2009). World experience of the last decade has shown that the almost complete abandonment of the socio-economic development processes and the provision of unrestricted freedom to market forces by the government regulation have led to a deep crisis. This experience has also proved that the unregulated market cannot solve problems of economic and social development, including the creation and maintenance of infrastructure facilities. Each type of market failure involves a certain type of government intervention.

Manifestations of market failure include:

  • Market ignoring the external effects of a problem;
  • Disinterest of the market in the production of public goods;
  • Concentration and monopolization of production;
  • Unemployment, inflation, and macroeconomic instability;
  • Market indifference to the problem of social justice;
  • Impossibility to achieve a breakthrough in the field of basic science and technology, as well as a deep restructuring of national economy through market mechanisms;
  • Excessive differentiation of regions in the country (Dolfsma, 2013).

An example of adverse external effects is the activity of the chemical industry. Negative externalities formed as a result of its operation lead to the fact that such types of production as agriculture, forestry, fishery, and recreational facilities are suffering significant losses. The diagram (Fig. 1) shows that the market does not perceive the negative externalities, so the resources are marketed in excessive quantities (expressed in the form of Qe > Qo), and the price is lower than the optimal (Po > Pe). It appears that consumers receive false information, and this, in turn, is the reason why substitutes of chemical industry, secondary raw materials, and stronger and more durable materials are not used. Therefore, consumers lose confidence in the whole industry, which results in a market failure.

D - the actual demand curve; S - the actual supply curve; T - external costs (spillover costs or uncompensated costs); St - supply curve, including the spillover costs; Qe - the real equilibrium volume of production; Qo - optimal output; Pe - the equilibrium price; Po - the optimal price.

Another example of market failure is the private clinics, where doctors may deliberately offer clients more expensive and less effective treatments in order to maximize their own profits. In this case, the problem can be solved if the government starts supervising the production of such goods, as well as passes laws on consumer protection, advertising, insurance of bank deposits, and so on.

A striking example of the next market failure is the capital and insurance markets. In the capital markets, private companies do not want to invest money in small business loans, foreign trade, mortgage, as well as college education. The insurance market has a problem of rejection of insurance coverage against property loss from flooding, diseases of older people, fluctuations in market prices for agricultural products, etc. The government tries to intervene in the situation through compulsory statutory instruments. Here, one should mention the complementary markets problem, which in some cases is solved again by government. Therefore, in most cases, government is the guarantor of the mitigation and neutralization of market failure.

Laws that allow one to regulate the behavior of economic agents play a huge role in the governmental influence on the economic and social development. An exact legal framework, which was created by the early transition to market relations, helped mitigate to some extent many negative effects of today’s market. At the current stage, the essence of government regulation lies not in the complete dismantling of the old system, but in creating of a more effective system to regulate the economy in light of experience (Funnell, Jupe, & Andrew, 2009).

First of all, creation of such an effective system of regulation entails conducting a number of activities:

  • Improvement of the financial system, transition to the indicative methods;
  • Creation of conditions for adaptation and subsequent development of unprofitable and low-profit enterprises;
  • Implementation of the structural adjustment for the entire economic sector of the country, introduction of the latest technological advances, new technologies, enhancement of resource saving (McConnell, 2009).

However, there is no reason to believe that the intervention of the government in economic life is something positive by its very nature because there are so-called government failures, and they are no less important than market failures. The government failures are quite well researched, including rigorously proved fact that some of them are not fundamentally eliminable.

Government Failure

The absence of perfect and complete markets leads to a market failure. Similarly, failures of government arise from the shortcomings of non-market mechanism which deals with harmonizing the private costs and benefits of policy makers with the costs and benefits of society as a whole. At the same time, the possibility to create a non-market mechanism which would be able to function without failures is no stronger than the prospects to provide the conditions for perfect competition always and everywhere.

Microeconomic policies intended to compensate for market failures are usually expressed through delegation of legislative or administrative powers to various government bodies, agencies, in order to allow them to produce specific non-market products which are designed to “fix” these failures. With a certain degree of conditionality, these products can be divided into four types. The first type is regulating services (e.g., fines for environmental pollution, licensing of television and radio broadcasts, quality control of food and drugs, etc.). The second type comprises purely public goods (defense, fundamental scientific research). The third type is represented by quasi-public goods, such as education and health service. The fourth type is management of the transfer payments, which include social security, social subsidies, etc (Dolfsma, 2013). The value of these products is taken into account when calculating the gross national product of the country just as the value of resources spent on its creation (Funnell, Jupe, & Andrew, 2009).

However, the big drawback of these microeconomic policies is inequality in getting information. People with high incomes and well-organized lobby groups are informed better than any other men or group of men. Consequently, they maximize their profits getting political rent. Inequality in obtaining information is associated with a phenomenon that is present in the system of representative democracy and called rational ignorance. This term means the avoidance of individuals from participation in the voting and electing process if the benefits they will receive in case of a favorable outcome are lower than costs associated with participation in the voting process (McConnell, 2009).

Another reason of government failure is government officials, which seek to win votes in the next election in pursuit of their private interest and take such decisions that will help them achieve this, the so-called populist decisions. Such decisions usually do not meet the criteria of economic efficiency. Moreover, political figures pursue their personal interests, like all normal people, and these personal interests may at some point exceed their duty as public officials.

Incompatibility in the time of adoption of certain decisions, which lead to another government failure, should also be noted. For example, a politician promises to increase social spending before the election, cut taxes. and implement many other similar activities that will help him get the support of the voters. However, populist promises are proclaimed today, and their implementation after the elections is often delayed. Sometimes, directly opposite solutions are taken, which lead to a decrease in material well-being of the population. Therefore, the incompatibility in time means that the activities optimal from the standpoint of the government today may not be optimal in the future, especially after the economic agents have already responded to the announced election promises and formed their expectations (McConnell, 2009).

Bureaucratic monopoly is another cause of government failure. It is a property of bureaucracy, which means that a bureaucrat is the only one who is capable of determining the production extent of certain goods, the bearing of certain government spending. The state creates duplicate and oppositional bodies in order to reduce the monopoly power of bureau, but then, the society suffers the loss for maintenance of such oppositional bodies and also due to the wrong decisions of these bodies (McConnell, 2009).

The government failures are not subjective mistakes of officials. The essence of the government failure lies in some underperforming tendencies generated by the structure of the government institutions. It may be different, but never perfect. Here is a complete analogy with the market failures which result not from the mistakes of entrepreneurs but from one or another market condition, like in the chemical industry example, that leads away from maximizing the efficiency. The government, as well as the market, operates without failures only in rare and very special cases. Hence, each situation needs to be resolved using such measure of government intervention, in which the gain from the overcoming market failure would not overlap a loss from the government failure. This is a typical optimization problem, which, in each case, must be addressed in specific conditions. Moreover, there is no universal solution. Even private, non-generic solutions for such problems offered by economic science are not perfect.


The real economy is characterized by situations where market failures and government failures manifest themselves simultaneously. Moreover, weakening of one’s influence is possible only through weakening of another’s influence. The ideal solutions are rare in practice. Options that involve active government intervention help overcome market failures, but they are often associated with government failures. Such a dialectical understanding of government and market failures can facilitate political decision-making. In any case, unacceptable options based on overly optimistic assessment of government or market opportunities drop despite their being most attractive.

Therefore, government failure and market failure are the inevitable results of their own imperfections. However, the concepts of market and government failure help realize that the government is a very imperfect tool, and in many cases, even an unwanted one, and its services should only be used in cases of exhaustion of market possibilities, after all pros and cons have been considered. Summarizing, it can be said that the government and the market should interact in order to increase their efficiency and reduce losses of society, but the question of the extent of their interaction in each separate case should be resolved through a careful analysis of economic losses and damages from such interaction.