Market Failure Why the government regulates markets

Why do governments regulate markets?

Most economists believe that, for the most part, deregulated, competitive markets provide a more efficient allocation of the economy’s scarce resources than other government controlled methods.

However, when markets fail to maximise welfare or operate in a away then seems unfair, governments step in to prevent or correct the market failure by regulating prices or the behaviour of consumers, producers.

Market failure

Market failure occurs when markets do not maximise welfare. The term ‘deadweight loss’ is used to describe the shortfall in welfare caused by market failure. There are a number of reasons for markets failure:

  • Monopoly Power (lack of competition)
  • Information gaps or one-sided information
  • Merit and demerit goods
  • Externalities
  • Markets which are non-rival and or non-excludable

Cause of market failure: Monopoly Power

Red = consumer surplus; orange = producer surplus; blue = deadweight loss.

Dealing with monopoly power: Possible government responses

  • Encourage competition e.g. through trade liberalisation
  • Ensure markets are contestable (open to new entrants)
  • Discourage harmful mergers and acquisitions
  • Regulate behaviour, e.g. trough price controls
  • Public ownership (so prices can be controlled)

Evaluation of these measures

  • Public ownership can lead to government failure
  • Need for case-by-case approach due to complexity of each situation
  • Regulations have to be enforced

Cause of market failure: Information Gaps

Without full information consumers can’t judge the marginal benefit they will get from a product.

For example:

  • Genetically Modified crops - what dangers, if any, do they present?
  • Insurance - what is the risk of experiencing a problem?
  • Second hand cars - is the car a lemon?

Merit and Demerit Goods

Merit goods

According to the view of society when people are left to make up their own minds without a nudge they may under-consume some products

Merit goods are under- consumed because there are information gaps or information is ignored. In many cases merit goods provide benefits indirectly for other people as well (see section on positive externalities later)

Demerit goods

According to the view of society when people are left to make up their own minds without a nudge they may over-consume some products.

De-merit goods are over- consumed because there are information gaps or information is ignored. In many cases de-merit goods impose costs indirectly on other people as well (see section on negative externalities later)

Possible solutions

  • Provide information / educate / encourage change
  • Legislate or regulate use
  • Subsidise merit goods
  • Tax demerit goods

Evaluation of measures

  • Short-term cost for long-term gain (e.g. saving for a pension)
  • Size of subsidy / tax (estimating size of costs / benefits)
  • Enforcement of regulation (e.g. cycle helmets)
  • People may still ignore information (e.g. binge drinking)

Cause of market failure: Externalities

Externalities are side-effects, or spin-off effects, experienced by bystanders or third parties as a result of someone else's consumption or production. The externalities can be harmful or negative or they can be beneficial or positive.

  • Negative consumption externality: Harm experienced as a result of someone else's consumption (e.g. passive smoking)
  • Positive consumption externality: Benefits received as a result of someone else's consumption (e.g. flu vaccination)
  • Negative production externality: Harm experienced as a result of someone else's production (e.g. pollution)
  • Positive production externality: Benefit received as a result of someone else's production (e.g. research and development)

Cause of market failure: Non-rival and/or non-excludable products

Private good: Rival and excludable

No problems arise. People gain property rights when they buy a Cherry Ripe. No one else can buy that Cherry Ripe. Consumption can only be shared as a result of the generosity of the owner.

Public goods: Non-rival and non-excludable

Non-rival products:

  • One ship seeing the light does not stop other ships seeing it as well.
  • One ship can share the consumption or benefits of the light with another ship

Non-excludable products

  • Free-riders - some ships would use the light but not pay
  • No property rights
  • Lighthouse owners could not exclude ships from seeing the light.

NOTE: Quasi-public goods: There are many ‘public goods and services’ that could, to some extent, be supplied by the free market (street lights, freeways). These can be called quasi- public goods.

Common Access Resources: Non-excludable, rival when over-used

The common resource is treated as a free good (not clear who owns them and who should be paid) as if it is not relatively scarce and there is no opportunity cost.


‘Commons’ = resource shared by group of people with no clear property rights (no one owns them so no one has to be paid for their use or looks after them)

If there is free access and unrestricted demand for a finite resource, the resource is ultimately doomed because of over-exploitation.

It is in a person’s self-interest to exploit the resource in the short run, even though, if everybody behaves selfishly, in the long run the resource will run out.

Natural Monopolies or Club Goods: Excludable but non-rival

Natural monopolies

Due to the combined effect of economies of scale (e.g. high fixed costs) and market size, some services need to be provided by a single firm. These single providers are called natural monopolists.

Club Goods

People pay to ‘join the club’ because they can be excluded. Extra consumers do not reduce benefit of existing consumers (non-rival)


  • Taxation, subsidy
  • Direct provision
  • Legislation and regulations
  • Setting up parallel markets
  • Education / information


Created By
Andrew Tibbitt


Created with images by RoDobby - "brown coal energy garzweiler"

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