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Regulatory Intervention and Market Failure

Regulatory Intervention and Market Failure

Author: Kate Eskra

This lesson will explain regulatory intervention and market failure

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Hi. Welcome to economics. This is Kate. This tutorial is called 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 talk about why it is that markets fail and when they fail. We'll look at how externalities are one of the biggest reasons that cause market failure, and we'll talk about both positive and negative externalities. And finally, you'll understand that government regulation does attempt to address market failure, but unfortunately sometimes it can make the outcome worse.

OK, so first of all, we know that in most cases free markets function really, really well, and that's because producers have this profit motive to get us what we want at prices that we are willing to pay. So generally speaking, unregulated, free markets with no government intervention are going to produce the best outcome, and that will maximize our overall welfare as a society. When we allow the free market to function on its own, it allows for trade between buyers and sellers, and when it reaches equilibrium, both consumers and producers are better off, there's no dead weight loss, we can do that whole welfare analysis thing where we see how big consumer and producer surplus are.

So generally speaking, that's the best way to go. But unfortunately, sometimes a market fails to produce the efficient allocation of goods and services for various reasons, and in that case, we call this a market failure. So market failure is defined as 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 generally addressed through government intervention.

So one of the biggest reasons why markets can fail is due to something we call externalities. And these are either costs or benefits that-- they're put onto a third party who isn't really participating or has nothing to do with that particular market. OK, so as a definition, here's your externality-- the effects of a good or service to a third party, and they can be negative or positive. We'll look at both.

I think, honestly, these come to light a lot better when we talk about examples. So let's look at some examples of negative externalities. This is where a third party has to absorb the cost of a good or service. For example, pollution. Have you ever been driving behind a truck that is just emitting all kinds of fumes? You are in essence paying for that pollution. You have to experience it, and you have nothing to do with that company or that market or that truck driver. But you're stuck behind it.

Secondhand smoke is the same thing. When you're a non-smoker, and you have to be around it. And then I don't know if you've had this experience, but I know I have, where you are subjected to either very noisy neighbors or messy neighbors or neighbors who leave their smelly trash out or something like that. You are the third party paying the cost of somebody else or something else.

So if we look at pollution as an example, let's take a look at this. So let's say that a company knows that its production process is going to emit some levels of pollution. They have to take a look at deciding how much should we pollute verses, OK, how green should we make our process? Clearly producing cleanly is, generally speaking, more expensive. So when they decide whether to quote unquote "go green" or not, they're going to weigh costs and benefits to make the most efficient decision for their company. It's what any rational firm or rational individual does, is cost benefit analysis.

But unfortunately, this process is going to leave something out that's really important. What they're not going to take into consideration is how they're pollution is going to impact the people living downwind from them. So they're looking at their own costs and their own benefits of this decision, but they're not considering this third party.

These people will in fact face higher health care costs, and they have nothing at all to do with the market, yet they're faced with the cost of the company's pollution. So the company's decision and then therefore how much pollution they decide to emit, neglects to take these third party costs into consideration. And for that reason, an inefficient amount of pollution will be produced.

The positive externalities are the opposite. These are benefits of a good or service to a third party. So one example is, let's say the flu vaccine. If you get the flu vaccine, that actually benefits me, even if I choose not to get it. I now can't get the flu from you. I'm not involved in your decision, yet I benefit from you getting the flu vaccine. Environmental cleanup is the opposite of what we just talked about. If a company does decide to clean up their act and stop polluting as much, many other people are going to enjoy the benefits of that even though they didn't pay for it.

So without government regulation, these positive externalities actually tend to be under produced, and negative externalities, unfortunately, tend to be over produced. Again, because when companies or individuals are going through that cost benefit analysis, they're not correctly identifying the true costs or the true benefits.

OK, so often the government coming in and regulating is suggested as a way to reduce especially negative externalities. So in the case of secondhand smoke, I know where I live, it's actually been made completely illegal to smoke in almost all restaurants and bars. Another way of preventing secondhand smoke from being put out as a third party cost is to tax cigarettes. Taxes are extremely high on cigarettes, and that's meant to curb people's consumption of them.

With pollution, we can put limits on companies polluting, passing laws, we could put taxes on it to make it more expensive and to try to encourage them to go green. So consumers and firms are weighing costs and benefits, like I said, whenever they make decisions. And estimating the cost of negative externalities like pollution and then the benefits of regulation can be really difficult.

So unfortunately, this is going to make quote unquote the "optimal" amount of regulation then difficult to estimate. If we can't accurately figure out the real cost and the real benefits of something, that's where it gets extremely difficult to figure out what is the efficient or optimal amount of it. So, and also to keep in mind, is that any regulation is going to take place through the political process, which we all know is not exactly a perfect process. Politicians have to-- their supposed to keep in mind-- what is in society's best interest, but we know that sometimes their own interests, their own constituents, that can really cloud whatever is in society overall, in society's best interest.

So unfortunately the political process can sometimes lead to what we call government failure. And government failure is a situation involving government intervention that results in increased inefficiency in the allocation of goods and services. So the goal of any government regulation is to try to use the regulation to reduce market failures. But we need to understand that because of that political process being imperfect, it actually might result in being kind of worse than the market failure. We hope that that's not the case, but unfortunately sometimes they can be.

So in this tutorial, we talked about how markets fail whenever there's an inefficient allocation of goods and services. Externalities cause market failure due to either overproduction or underproduction. And we looked at both positive and negative externalities. And then finally I mentioned how government regulation does attempt to address market failure, but unfortunately, sometimes can make the outcome even worse. Thank you so much for listening. Have a great day.

Terms to Know

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

Government Failure

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

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.