Market Failure And Government Intervention Essay Research

Market Failure And Government Intervention Essay, Research Paper


This essay will examine the concept of market failure and the measures that governments take remedy the failure of the market.

The concept of perfect market allocation of resources was in W. Baumol’s (1988,631), view largly theroretical. Baumol believed that economic models relied upon the concept of the invisible hand first discussed by Adam Smith. In these models, the perfectly competetive economy was able to allocate resources efficiently, without the need for market intervention by outside agents, including governments. However, there were significant weaknesses in these models particuarly in the area of ensuring equity of acess, social objectives and in the provision of public goods.

Ensuring equity of acess, meeting social objectives and providing public goods.were considered the main reasons why the public sector provided goods. Why governments intervened in the market was due mainly to charactoristics of the market place. If the market place was to function efficiently, several conditions needed to exsist, including,

* Freedom of choice

* Certainty of demand

* Miniminal externalities

* Excludability

In addition to these prerequisites, the perfect market required perfect consumer and supplier information, no rent seeking behaviour and no moral hazard existed. If these conditions were not met, market mechanisms would fail to produce the efficient allocation of resources.

P. Groenewegen (1990,2) argued that governments intervened in the market place with the,

… Public sector… being engaged in the providing sevices (and in some cases goods) whose scope and variety are determined not by the direct wishes of the consumers, but by the the decisions of government bodies.

This view implies that governments intervene for many reasons, including the redistributional and stablisation functions. While market failure is one reason for intervention, other considerations, including questions of equity and social justice determined the nature and the extent of government intervention. This point was expanded upon by Groenewegen (1990,2) who argued that the extent of market intervention in the supply, distribution and redistibution of goods and services are not dictated by purly political and ideological considerations, other considerations may play a role including the failure of the market in certain instances to ensure efficient, equiable allocation of resources.

Another reason why governments intervened in the market place was to ensure the provision of public goods. Public goods are generally comodities that are socially desiralbe but cannot be financed through the private sector. The reason for this is that,

A public good is a comodity or service whose benefits are not depleted by an additional user and for which it is generally difficult or impossible to exclude people from its benefits, even if they are unwilling to pay for them. (Baumol, 1988,639)

Baumol’s definition of a public good highlighted two distinct properties, excludibility and depletability, however, there are very few goods that are totally non-excludable or totally non-depletable.

Groenewegen (1990,2) argued that a distinction needed to be made between the public provision and the public production of goods, if government intervention in the economy is to be understood. Goods may be produced in the public sector and sold in the market place, while privately produced goods may be provided by the public sector. Groenewegen argued that why some goods were supplied by the private sector and others by the public sector was a complex issue whose anwser was not soley determined by political imperitives. One of the primary reasons for government intervention was the absence of the perfect market for many socially important groups.

If there is a potential for the market to fail governments will attempt to intervene. The type and the extent of intervention will depend upon a number of factors. The reason for this in Groenewegen’s (1990,13) view was that while the provision of goods with a high degree of public good charactoristics was a government function, the fuction of government was not confined soley to the provision of these goods, other factors including, institutional, political, and economic chioces were also important.

One product that can be provided both publically and privately and whose provision demonstrates how a market can fail, is health care. The provision of health care has been a major issue for all governments within the last fifty years, with the arguements for private, as opposed to public provision remaining a major issue on the political agenda.

Le grand (1992,44 ) believed that one of the major differences between health care and other commodities was the imbalance between the knowledge of the supplier and the knowledge available to the consumer,which is termed Inperfect Information. S. Sax (1990,149) argued that consumers have little knowledge or information about the diagnostic and treatment processes involved, while providers held a large amount of knowledge. Le Grand (1992,45) argued that if market was to allocate health care, the market would fail, as consumers would seek to form long term relationships with providers. These relationships have the effect of limiting the requirement for competition between providers of health care, as consumers do not possess the information nor the incentive to ’shop around’ for health care services.

Health care, unlike other commodities is subject to uncertainty of demand by consumers. An individual is generally unable to predict when they may require health care, thus making planning or provision for the purchase of care difficult. The market has a mechanism for coping with this uncertainty, namely insurance. Health insurance has two specific difficulties associated with it’s provision these being, moral hazard and adverse selection. Both have the potential to lead to the failure of the market system and therefore have direct policy implications.

‘The main function of an insurance contract is to reduce the risk faced by the person who buys it.’ (Besley ,1988,151) If an insurance scheme is to be efficient it requires perfect information and risk minimisation on the part of the insurer and the insured. In the area of health this may not be the case due to the concept of Moral Hazard. Moral hazard occurs when the individuals incentive to maintain good health is deminished or the existence of the insurance causes the individual and the provider to over utilise health care services. Adverse selection occurs when the insurance provider is unable to determine the level of risk it faces due to imperfect information being provided by the insured individual. Both have the potential to cause the market in health care to fail. Because the cost of premiums rise, the ‘ratio of bad risks to good risks amongst the insured will rise ‘( Le Grand, 1992,44) This leads to those individuals with a percieved lower risk abandoning insurance.

The dismantling of the universal Medibank system of health insurance and the introduction of private health insurance resulted in many younger people opting out of insurance which produced stains upon the system.. The net result of this was a partial market failure which led to the development of severe inequities in access to health care.

A feature of health care that may create problems for market allocation is that it has external’ benefits or externalities (Le Grand 1992,46)

Externalities are a major reason why goverments intervene in the market place. Externalities occur when a third party who is not involved in the decision to consume is affected by it, either as a cost or a benefit. Externalities have, to a large extent, been the major imperative of government health care reforms. The provision of free universal immunisation programmes which significantly improved the health of the population as a whole, is one example where governments have used a subsidy to achieve a community benefit. Due to the market’s inability to cope with the problems of exteralities, governments have in Buamol’s view, found it appropriate to intervene in the market through the application of taxes and subsidies, thus paying producers for the benificial exteralities and charging for the negetive exteralities.

It is arguable that externalities are a major factor in questions of equity. In addressing the health care issues of the lower socio-economic groups, Enough to make You Sick, How Income and Environment Affect health. National Health Research Paper No 1 September 1992, made continual references to the fact that the health of an individual was dependant upon the health of the community, and visa-versa.

Monopolistic competiion is a further reason for the intervention of governments in the market place. Monopoly (or oligoply) production has the potential for the misallocation of reasources or the distortion of market mechanisms through the fixing of wrong prices.

Govenments have attempted to address the failure of the market place through several stratagies


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