SOPHIA will be down Thursday, May 24, 2018 at 3:00 AM (CDT) for a little housecleaning. We are sorry if this causes you any trouble. The outage should last less than 2 hours.

Online College Courses for Credit

3 Tutorials that teach Details on Regulatory Intervention and Market Failure
Take your pick:
Details on Regulatory Intervention and Market Failure

Details on Regulatory Intervention and Market Failure

Author: Kate Eskra

This lesson provides examples of regulatory intervention and market failure.

See More
Fast, Free College Credit

Developing Effective Teams

Let's Ride
*No strings attached. This college course is 100% free and is worth 1 semester credit.

29 Sophia partners guarantee credit transfer.

312 Institutions have accepted or given pre-approval for credit transfer.

* The American Council on Education's College Credit Recommendation Service (ACE Credit®) has evaluated and recommended college credit for 27 of Sophia’s online courses. Many different colleges and universities consider ACE CREDIT recommendations in determining the applicability to their course and degree programs.



Source: Image of Negative Externality Graph created by Kate Eskra, Image of Positive Externality Graph created by Kate Eskra

Video Transcription

Download PDF

Hi, welcome to economics. This is Kate. This tutorial is called Details on Regulatory Intervention and Market Failure. As always, my key terms are in red, and my examples are in green.

So in this tutorial we'll be talking about how markets fail whenever there's an inefficient allocation of goods and services. I'll talk with you about the various causes of market failures. And then we'll talk about how government regulation attempts to address some of these market failures, but unfortunately sometimes it can make the outcome even worse. And we'll talk about some of the various causes of government failures.

So we know that in most cases free markets function so, so well. That's because in the free market system, producers have this profit motive to get us what we want, at prices that we are willing to pay. And so generally speaking, without any government intervention, free markets produce the best outcome.

And we can see that when we conduct welfare analysis. We see that in the free market system it's allowing for trade to occur between buyers and sellers. Consumer and producer surplus is the biggest it can be, showing that we and producers are better off. And there's no dead weight loss to society.

However, what this tutorial is about is the times when a market does fail. And sometimes the market fails to produce the efficient allocation of goods and services. And that's what we refer to as a market failure.

So market failure is a situation where the free market does not create an optimal situation between those demanding a good or service, and those supplying a good or service. Market failures can be addressed through government intervention.

So why is it that markets fail? Well, typically they're going to fail when preferences aren't aligned, or in some cases, involving decision making. And these are the different areas that we're going to be talking about now.

So I'll start with information asymmetries. This is when information is not equally available to all parties. There's a lack of complete transparency. And it's going to result in the people who do have full information having a major advantage.

OK. So I don't know about you, but this has definitely happened to me. Have you ever regretted a purchase because you didn't realize what you were getting? Or what you were getting yourself involved in?

My mom, for example, bought a car years ago that's definitely a lemon. She thought she was getting this great deal on it, but time, and time, and time again, it has needed extremely expensive repairs. So had she known that going into it, she wouldn't have spent the amount of money that she thought was a really great deal.

There are also many products out there that make grandiose promises and then we find out that that's just not the case, and we overpaid for it. So whenever we don't have this full information about what we are buying, the market price that we paid does not fully reflect the true benefits, and the true cost of that good.

Then we have non-competitive markets as another reason for government failure. This is where markets where price setting, or the quantity supplied, occurs without interaction between suppliers and demanders. There's a lack of competitive forces here, and the free market is not the basis for trading.

So when we're talking about non-competitive markets, we're talking about the opposite end of the spectrum from perfect competition. And so public utility companies are the one example I came up with here. These are generally natural monopolies, and if you think about it, they don't face any competition. So they are complete price makers. They get to choose what price they charge.

And let's think about a public utility company like your electricity company. When the power goes out, are they going to restore power eventually? Absolutely. Otherwise people would be just up in arms.

But what incentive do they have to do that extremely quickly? What incentive do they have to provide us with the best quality, at prices that we are really willing to pay? They don't have as much of an incentive nearly as a more competitive market structure.

OK. Now we have principal-agent problems. This is when a principal party cannot trust or motivate the agent party to conduct business that is not self-serving.

So one area where this is sometimes studied, is in companies. As companies grow into these really, really large corporations, sometimes they have these principal-agent problems. Their managers, even the management of their company, starts to become less attached to the company as it becomes so big. And they can sometimes start making self-serving decisions that are really not in the best interest of the company. Either to benefit them in their own department, or to benefit them individually.

This was a personal example I came up with. Have you ever questioned whether your doctor is recommending that you take a certain medication or even have a certain surgery? Is that necessarily what's best for you? Or is it that something that's generating income for him or for her? So that would be another example of a pretty serious principal-agent problem.

OK. Now we have externalities. An externality is when the effects of a good or service go to a third party. Someone who's not involved in that market or transaction. And these can be either negative or positive.

So negative externalities are costs of a good or service to a third party. They involve things like pollution, secondhand smoke, or if you have just a really annoying neighbor who has a very messy front yard, or he's very noisy and you can't sleep at night. Those things are not your fault, yet you're paying essentially the cost of them.

And here's a graph that shows what is going to be the result here. You can see that the cost to the individual is much less than the cost when we consider all of the cost to society, now including you.

So if this is the cost for one person to pollute, there's actually a much higher cost of that pollution that other people have to end up paying for or they've received that negative externality of it. And so because these full costs aren't realized, you can see that it's overproduced here at Q star. And the price is at P star. When in fact the price should be higher and it should be produced less.

In the case of the positive externality, here's the graph for that. Now we have the benefits going to a third party. And so these are things like flu vaccines or environmental clean-up.

If you get a flu vaccine, sure that benefits you. But don't I also benefit from you getting that flu vaccine? Because if I choose not to, well, now I can't get the flu from you because your vaccinated against it. So the benefits are much higher than are realized. And in that case, it's going to be under-produced. OK? So the price could be higher and it could be produced much more, if in fact, we realize the full benefits to society.

All right. Finally we have public goods. A public good is a good that is considered both non-rivalrous and non-exclusive. And this was the subject of a different tutorial. But there are two criteria for public goods. Like we said, they are non-rival and they are non-excludable. That helps more if I explain it through an example.

So national defense is something that everybody enjoys the benefit of. And that's non-rival. We all enjoy it at the same time. And we are not able to exclude people from enjoying the benefits of it. Even if they don't pay taxes, they still enjoy the benefits of national defense.

Public parks are another type of public good. And because there is no way to exclude free riders from enjoying these, there's little incentive for private markets to provide them.

OK. Now we come to government regulation. So often this is suggested to address some of the market failures we just talked about. Because any regulation is going to take place through a political process, we know that those processes are imperfect.

So what is in society's best interest? Is the question here. These political processes, unfortunately, can sometimes lead to government failure. Which is where a government intervention results in increased in efficiency in the allocation of goods and services. Which is exactly what we did not want.

Here again we see principal-agent problems. Where politicians and government bureaucrats seek to maximize their own utility. If you think about the goal of a politician, it's very short term to get reelected and please their constituents in any way that they can.

The goal of a bureaucrat might be to maximize the size of his or her budget. And so their goals are often going to conflict with what's best for our country. Their goals can be very self-serving, and really not good for the rest of us.

Moral hazard can happen here when government programs, for example, to help struggling citizens and firms, sometimes takeaway really important incentives in the free market. And so very generous welfare programs can create disincentives for people to get out there and seek jobs. When we subsidize producers we can create a disincentive for these firms to become more efficient. And they can also prevent others from entering the market with the subsidies.

Information failures can also occur. So how is it that businesses decide how much to produce the quality of their product? What price charged? They take signals from us, the buyers.

Does the government really know what type of jeans you want? Or what you're willing to pay for shoes? Without the information available that is in private markets the government can't effectively determine the optimal quality and quantity of goods and services the way that the private markets can.

And so the goal of any government regulation is to reduce market failures, but we need to understand that it might be worse than the market failure itself, unfortunately.

So here's what we went over in this tutorial. You can take a look at it.

Thank you so much for listening, have a great day.

Notes on "Details on Regulatory Intervention and Market Failure"

Terms to Know


The effects of a good or service to a third party; can be negative or positive.

Market Failure

A situation where the free market does not create an optimal situation between those demanding a good or service and those supplying a good or service.  Market failures are addressed through government intervention.

Government Failure

A situation involving government intervention that results in increased inefficiency in the allocation of goods and services.

Information Asymmetries

When information is not equally available to all parties; lack of complete transparency.  This results in an advantage to those individuals having full information.

Non-Competitive Markets

Markets where price setting (or quantity supplied) occurs without interaction between suppliers and demanders.  Lack of competitive forces; free market is not the basis for trading.

Principal-Agent Problems

When a principal party cannot trust or motivate the agent party to conduct business that is not self-serving.

Public Goods

A good that is considered both non-rivalrous and non-exclusive.