Market Failure and the Role of the Government

Mixed Economy

A system combining command (public sector, government) and free market (private sector, Laissez-Faire) principles.

Free Market Economy

An economy that is self-regulating, guided by the Invisible Hand where households (demand) and firms (supply) reach equilibrium based on self-interest.

Invisible Hand

A force that guides buyers and sellers in a free market to reach equilibrium, often without direct government intervention.

Perfect Competition

A theoretical market structure where competition is at its highest level, producing efficient resource allocation at the production-possibility frontier.

Features of Perfect Competition

1. Many buyers and sellers

2. Freedom of entry and exit

3. Homogenous products

4. Firms are price takers

5. Buyers have perfect information

Market Failure

A situation where the free market fails to efficiently allocate resources, leading to a net loss in social welfare.

Types of Market Failure

1. Imperfect Competition

2. Externalities

3. Public Goods

Imperfect Competition

Occurs when a buyer or seller can influence prices.

Features of Imperfect Competition

• Sell different products/services

• Set individual prices

• Compete for market share

• Protected by natural/artificial barriers (e.g., patents, franchises)

Externalities

Spill-over effects of production/consumption not reflected in the product’s price. Can be positive or negative.

Positive Externality

When benefits are gained by others outside the transaction. Example: Sharing notes helps classmates perform better.

Negative Externality

When costs are imposed on others outside the transaction. Example: Loud music at night disturbs neighbors.

Public Goods

Commodities enjoyed by everyone, from which no one can be excluded.

Characteristics of Public Goods

1. Non-Exclusion – People cannot be easily prevented from using the good.

2. Shared Consumption – Use by one person does not reduce availability for others.

Free Rider Problem

When individuals benefit from public goods without paying for them, leading to lack of profit incentives.

Government Role in Market Failures

Governments intervene to correct inefficiency through taxes, regulations, and provision of collective goods and services.

Three Economic Functions of Government

1. Increase Efficiency

2. Promote Equity

3. Foster Stability and Growth

Increase Efficiency (Government Function)

Promotes competition, reduces externalities like pollution, and provides public goods.

Promote Equity (Government Function)

Redistributes income via taxes, subsidies, and expenditure programs to reduce inequality.

Examples of Promoting Equity

• Progressive taxation

• Transfer payments (4Ps, SAP, AKAP, TUPAD)

• Subsidies (food stamps, medical care, housing)

Foster Stability and Growth (Government Function)

Governments reduce unemployment and inflation while encouraging growth using fiscal and monetary policy.

Fiscal Policy

Government adjusts spending and tax rates to influence the economy.

Monetary Policy

Management of money supply and interest rates to stabilize the economy.

True or False: In a free market economy, the government regulates prices and production

False

Which of the following is NOT a feature of perfect competition?

c) Firms are price makers

A monopoly is an example of what type of market failure?

b) Imperfect Competition

True or False: Negative externalities always benefit people outside the transaction.

False

Scenario: A student shares their organized notes, helping a classmate score higher without additional effort from the classmate. What is this an example of?

c) Positive Externality

Which of the following is a characteristic of public goods?

b) Shared consumption

True or False: The free rider problem occurs because some people use public goods without paying for them.

True

What are the three main economic functions of government?

b) Increase Efficiency, Promote Equity, Foster Stability and Growth

Fiscal Policy involves:

b) Adjusting government spending and taxation

True or False: Monetary policy is managed by changing government spending levels.

False