Unit III: Government Interventions to Correct Market Failure | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


2.60 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
 UNIT III: GOVERNMENT 
INTERVENTIONS TO CORRECT 
MARKET FAILURE 
At the end of this unit, you will be able to: 
? Describe the different forms of government intervention for correcting 
market failure 
? Evaluate the outcomes of intervention in case of public goods, merit 
goods and demerit goods 
? Illustrate how intervention combat market power, externalities, 
inequalities and information failure 
? Elucidate the functioning and outcomes of price intervention 
 
 
In the previous unit, we have seen that under a variety of circumstances the 
market and the price system fail to achieve productive and allocative efficiency in 
an economy. As such, it should be construed that the existence of a free market 
does not altogether eliminate the need for government and that government 
Public Finance
Government 
Interventions to Correct 
Market Failure
Minimize 
Market 
Power
Correct 
Externalities
Merit & 
Demerit 
Goods
Correcting 
Information 
Failure
Equitable 
Distribution
UNIT OVERVIEW 
Page 2


2.60 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
 UNIT III: GOVERNMENT 
INTERVENTIONS TO CORRECT 
MARKET FAILURE 
At the end of this unit, you will be able to: 
? Describe the different forms of government intervention for correcting 
market failure 
? Evaluate the outcomes of intervention in case of public goods, merit 
goods and demerit goods 
? Illustrate how intervention combat market power, externalities, 
inequalities and information failure 
? Elucidate the functioning and outcomes of price intervention 
 
 
In the previous unit, we have seen that under a variety of circumstances the 
market and the price system fail to achieve productive and allocative efficiency in 
an economy. As such, it should be construed that the existence of a free market 
does not altogether eliminate the need for government and that government 
Public Finance
Government 
Interventions to Correct 
Market Failure
Minimize 
Market 
Power
Correct 
Externalities
Merit & 
Demerit 
Goods
Correcting 
Information 
Failure
Equitable 
Distribution
UNIT OVERVIEW 
2.61 
 
GOVERNMENT INTERVENTIONS TO CORRECT MARKET 
 
intervention is essential for the efficient functioning of markets. The focus of this 
unit will be the intervention mechanisms which governments adopt to ensure 
greater welfare to the society and the probable outcomes of such market 
interventions. 
Government plays a vital role in creating the necessary physical and institutional 
infrastructure within which fair and open competitive markets can exist. The 
physical infrastructure such as roads, bridges, airports and waterways are often 
provided by governments. The government-provided institutional infrastructure 
namely, the legal and regulatory framework, is essential for a well functioning 
market.  It is indispensable that government establishes the ‘rule of law’, and in 
this process, creates and protects property rights, ensures that contracts are 
upheld and sets up necessary institutions for proper functioning of markets.  For 
achieving this, an appropriately framed competition and consumer law framework 
that regulates the activities of firms and individuals in their market exchanges 
should be in place. 
We have seen in the previous unit that the major reasons for market failure are 
market power, externalities, public goods, and incomplete information. Before we 
go into the details of government intervention, we shall try to have a quick 
glimpse of the forms of government intervention.  
Government
Intervention 
Direct 
As As Supplier Supplier Supplier 
Public Goods/ Public Goods/ 
Information
As buyer / 
Procurement 
Indirect 
Taxes /Subsidies  to 
alter costs 
Regulation/influence 
Page 3


2.60 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
 UNIT III: GOVERNMENT 
INTERVENTIONS TO CORRECT 
MARKET FAILURE 
At the end of this unit, you will be able to: 
? Describe the different forms of government intervention for correcting 
market failure 
? Evaluate the outcomes of intervention in case of public goods, merit 
goods and demerit goods 
? Illustrate how intervention combat market power, externalities, 
inequalities and information failure 
? Elucidate the functioning and outcomes of price intervention 
 
 
In the previous unit, we have seen that under a variety of circumstances the 
market and the price system fail to achieve productive and allocative efficiency in 
an economy. As such, it should be construed that the existence of a free market 
does not altogether eliminate the need for government and that government 
Public Finance
Government 
Interventions to Correct 
Market Failure
Minimize 
Market 
Power
Correct 
Externalities
Merit & 
Demerit 
Goods
Correcting 
Information 
Failure
Equitable 
Distribution
UNIT OVERVIEW 
2.61 
 
GOVERNMENT INTERVENTIONS TO CORRECT MARKET 
 
intervention is essential for the efficient functioning of markets. The focus of this 
unit will be the intervention mechanisms which governments adopt to ensure 
greater welfare to the society and the probable outcomes of such market 
interventions. 
Government plays a vital role in creating the necessary physical and institutional 
infrastructure within which fair and open competitive markets can exist. The 
physical infrastructure such as roads, bridges, airports and waterways are often 
provided by governments. The government-provided institutional infrastructure 
namely, the legal and regulatory framework, is essential for a well functioning 
market.  It is indispensable that government establishes the ‘rule of law’, and in 
this process, creates and protects property rights, ensures that contracts are 
upheld and sets up necessary institutions for proper functioning of markets.  For 
achieving this, an appropriately framed competition and consumer law framework 
that regulates the activities of firms and individuals in their market exchanges 
should be in place. 
We have seen in the previous unit that the major reasons for market failure are 
market power, externalities, public goods, and incomplete information. Before we 
go into the details of government intervention, we shall try to have a quick 
glimpse of the forms of government intervention.  
Government
Intervention 
Direct 
As As Supplier Supplier Supplier 
Public Goods/ Public Goods/ 
Information
As buyer / 
Procurement 
Indirect 
Taxes /Subsidies  to 
alter costs 
Regulation/influence 
2.62 ECONOMICS FOR FINANCE 
 3.1 GOVERNMENT INTERVENTION TO 
MINIMIZE MARKET POWER 
As we are aware, market power—exercised either by sellers or buyers— is an 
important factor that contributes to inefficiency because it results in higher prices 
than competitive prices. In addition, market power also tends to restrict output 
and leads to deadweight loss. Because of the social costs imposed by monopoly, 
governments intervene by establishing rules and regulations designed to 
promote competition and prohibit actions that are likely to restrain competition. 
These legislations differ from country to country. For example, in India, we have   
the Competition Act, 2002(as amended by the Competition (Amendment) Act, 
2007) to promote and sustain competition in markets. The Antitrust laws in the US 
and the Competition Act, 1998 of UK etc are designed to promote competitive 
economy by prohibiting actions that are likely to restrain competition. Such 
legislations generally aim at prohibiting contracts, combinations and collusions 
among producers or traders which are in restraint of trade and other 
anticompetitive actions such as predatory pricing.  
Other measures include:  
• Market liberalisation by introducing competition in previously monopolistic 
sectors such as energy, telecommunication etc 
• Controls on mergers and acquisitions if there is possible market domination  
• Price capping and price regulation based on the firm’s marginal costs, 
average costs, past prices, or possible inflation and productivity growth 
• Profit or rate of return regulation  
• Performance targets and performance standards 
• Patronage to consumer associations  
• Tough investigations into cartelisation and unfair practices such as collusion 
and predatory pricing 
• Restrictions on monopsony power of firms 
• Reduction in import controls and 
• Nationalisation  
It is common that some of the regulatory responses of government to incentive 
failure tend to create and protect monopoly positions of firms that have 
Page 4


2.60 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
 UNIT III: GOVERNMENT 
INTERVENTIONS TO CORRECT 
MARKET FAILURE 
At the end of this unit, you will be able to: 
? Describe the different forms of government intervention for correcting 
market failure 
? Evaluate the outcomes of intervention in case of public goods, merit 
goods and demerit goods 
? Illustrate how intervention combat market power, externalities, 
inequalities and information failure 
? Elucidate the functioning and outcomes of price intervention 
 
 
In the previous unit, we have seen that under a variety of circumstances the 
market and the price system fail to achieve productive and allocative efficiency in 
an economy. As such, it should be construed that the existence of a free market 
does not altogether eliminate the need for government and that government 
Public Finance
Government 
Interventions to Correct 
Market Failure
Minimize 
Market 
Power
Correct 
Externalities
Merit & 
Demerit 
Goods
Correcting 
Information 
Failure
Equitable 
Distribution
UNIT OVERVIEW 
2.61 
 
GOVERNMENT INTERVENTIONS TO CORRECT MARKET 
 
intervention is essential for the efficient functioning of markets. The focus of this 
unit will be the intervention mechanisms which governments adopt to ensure 
greater welfare to the society and the probable outcomes of such market 
interventions. 
Government plays a vital role in creating the necessary physical and institutional 
infrastructure within which fair and open competitive markets can exist. The 
physical infrastructure such as roads, bridges, airports and waterways are often 
provided by governments. The government-provided institutional infrastructure 
namely, the legal and regulatory framework, is essential for a well functioning 
market.  It is indispensable that government establishes the ‘rule of law’, and in 
this process, creates and protects property rights, ensures that contracts are 
upheld and sets up necessary institutions for proper functioning of markets.  For 
achieving this, an appropriately framed competition and consumer law framework 
that regulates the activities of firms and individuals in their market exchanges 
should be in place. 
We have seen in the previous unit that the major reasons for market failure are 
market power, externalities, public goods, and incomplete information. Before we 
go into the details of government intervention, we shall try to have a quick 
glimpse of the forms of government intervention.  
Government
Intervention 
Direct 
As As Supplier Supplier Supplier 
Public Goods/ Public Goods/ 
Information
As buyer / 
Procurement 
Indirect 
Taxes /Subsidies  to 
alter costs 
Regulation/influence 
2.62 ECONOMICS FOR FINANCE 
 3.1 GOVERNMENT INTERVENTION TO 
MINIMIZE MARKET POWER 
As we are aware, market power—exercised either by sellers or buyers— is an 
important factor that contributes to inefficiency because it results in higher prices 
than competitive prices. In addition, market power also tends to restrict output 
and leads to deadweight loss. Because of the social costs imposed by monopoly, 
governments intervene by establishing rules and regulations designed to 
promote competition and prohibit actions that are likely to restrain competition. 
These legislations differ from country to country. For example, in India, we have   
the Competition Act, 2002(as amended by the Competition (Amendment) Act, 
2007) to promote and sustain competition in markets. The Antitrust laws in the US 
and the Competition Act, 1998 of UK etc are designed to promote competitive 
economy by prohibiting actions that are likely to restrain competition. Such 
legislations generally aim at prohibiting contracts, combinations and collusions 
among producers or traders which are in restraint of trade and other 
anticompetitive actions such as predatory pricing.  
Other measures include:  
• Market liberalisation by introducing competition in previously monopolistic 
sectors such as energy, telecommunication etc 
• Controls on mergers and acquisitions if there is possible market domination  
• Price capping and price regulation based on the firm’s marginal costs, 
average costs, past prices, or possible inflation and productivity growth 
• Profit or rate of return regulation  
• Performance targets and performance standards 
• Patronage to consumer associations  
• Tough investigations into cartelisation and unfair practices such as collusion 
and predatory pricing 
• Restrictions on monopsony power of firms 
• Reduction in import controls and 
• Nationalisation  
It is common that some of the regulatory responses of government to incentive 
failure tend to create and protect monopoly positions of firms that have 
2.63 
 
GOVERNMENT INTERVENTIONS TO CORRECT MARKET 
 
developed unique innovations.  For example, patent and copyright laws grant 
exclusive rights of products or processes to provide incentives for invention and 
innovation. Another example is that of permitted natural monopoly. Natural 
monopolies can produce the entire output of the market at a cost that is lower 
than what it would be if there were several firms. If a firm is a natural monopoly, it 
is more efficient to permit it to serve the entire market rather than have several 
firms compete each other. Examples of such natural monopoly are electricity, gas 
and water supplies. The Policy options for limiting market power in case of natural 
monopolies include price regulation in the form of setting maximum prices that 
firms can charge. In some cases, the government‘s regulatory agency determines 
an acceptable price, so as to ensure a competitive or fair rate of return. This 
practice is called rate-of-return regulation. 
 3.2 GOVERNMENT INTERVENTION TO CORRECT 
EXTERNALITIES 
As you may easily recall, freely functioning markets produce externalities because 
producers and consumers need to consider only their private costs and benefits 
and not the costs imposed on or benefits accrued to others. To promote the 
overall welfare of all members of society, social returns should be maximized and 
social costs minimized. This implies that all costs and benefits need to be 
internalized by consumers and producers while making buying and production 
decisions. Otherwise, market outcomes involve underproduction of goods or 
services that entail positive externalities or overproduction in the case of negative 
externalities. 
Governments have numerous methods to reduce the effects of negative 
externalities and to promote positive externalities. We shall first examine how 
government regulation can deal with the inefficiencies that arise from negative 
externalities. Since the most commonly referred negative externality is pollution, 
we shall take it as an exemplar in the following discussion.         
Government initiatives towards negative externalities may be classified as: 
1. Direct controls or regulations that openly regulate the actions of those 
involved in generating negative externalities, and 
2. Market-based policies that would provide economic incentives so that the 
self-interest of the market participants would achieve the socially optimal 
solution.  
 3
Page 5


2.60 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
 UNIT III: GOVERNMENT 
INTERVENTIONS TO CORRECT 
MARKET FAILURE 
At the end of this unit, you will be able to: 
? Describe the different forms of government intervention for correcting 
market failure 
? Evaluate the outcomes of intervention in case of public goods, merit 
goods and demerit goods 
? Illustrate how intervention combat market power, externalities, 
inequalities and information failure 
? Elucidate the functioning and outcomes of price intervention 
 
 
In the previous unit, we have seen that under a variety of circumstances the 
market and the price system fail to achieve productive and allocative efficiency in 
an economy. As such, it should be construed that the existence of a free market 
does not altogether eliminate the need for government and that government 
Public Finance
Government 
Interventions to Correct 
Market Failure
Minimize 
Market 
Power
Correct 
Externalities
Merit & 
Demerit 
Goods
Correcting 
Information 
Failure
Equitable 
Distribution
UNIT OVERVIEW 
2.61 
 
GOVERNMENT INTERVENTIONS TO CORRECT MARKET 
 
intervention is essential for the efficient functioning of markets. The focus of this 
unit will be the intervention mechanisms which governments adopt to ensure 
greater welfare to the society and the probable outcomes of such market 
interventions. 
Government plays a vital role in creating the necessary physical and institutional 
infrastructure within which fair and open competitive markets can exist. The 
physical infrastructure such as roads, bridges, airports and waterways are often 
provided by governments. The government-provided institutional infrastructure 
namely, the legal and regulatory framework, is essential for a well functioning 
market.  It is indispensable that government establishes the ‘rule of law’, and in 
this process, creates and protects property rights, ensures that contracts are 
upheld and sets up necessary institutions for proper functioning of markets.  For 
achieving this, an appropriately framed competition and consumer law framework 
that regulates the activities of firms and individuals in their market exchanges 
should be in place. 
We have seen in the previous unit that the major reasons for market failure are 
market power, externalities, public goods, and incomplete information. Before we 
go into the details of government intervention, we shall try to have a quick 
glimpse of the forms of government intervention.  
Government
Intervention 
Direct 
As As Supplier Supplier Supplier 
Public Goods/ Public Goods/ 
Information
As buyer / 
Procurement 
Indirect 
Taxes /Subsidies  to 
alter costs 
Regulation/influence 
2.62 ECONOMICS FOR FINANCE 
 3.1 GOVERNMENT INTERVENTION TO 
MINIMIZE MARKET POWER 
As we are aware, market power—exercised either by sellers or buyers— is an 
important factor that contributes to inefficiency because it results in higher prices 
than competitive prices. In addition, market power also tends to restrict output 
and leads to deadweight loss. Because of the social costs imposed by monopoly, 
governments intervene by establishing rules and regulations designed to 
promote competition and prohibit actions that are likely to restrain competition. 
These legislations differ from country to country. For example, in India, we have   
the Competition Act, 2002(as amended by the Competition (Amendment) Act, 
2007) to promote and sustain competition in markets. The Antitrust laws in the US 
and the Competition Act, 1998 of UK etc are designed to promote competitive 
economy by prohibiting actions that are likely to restrain competition. Such 
legislations generally aim at prohibiting contracts, combinations and collusions 
among producers or traders which are in restraint of trade and other 
anticompetitive actions such as predatory pricing.  
Other measures include:  
• Market liberalisation by introducing competition in previously monopolistic 
sectors such as energy, telecommunication etc 
• Controls on mergers and acquisitions if there is possible market domination  
• Price capping and price regulation based on the firm’s marginal costs, 
average costs, past prices, or possible inflation and productivity growth 
• Profit or rate of return regulation  
• Performance targets and performance standards 
• Patronage to consumer associations  
• Tough investigations into cartelisation and unfair practices such as collusion 
and predatory pricing 
• Restrictions on monopsony power of firms 
• Reduction in import controls and 
• Nationalisation  
It is common that some of the regulatory responses of government to incentive 
failure tend to create and protect monopoly positions of firms that have 
2.63 
 
GOVERNMENT INTERVENTIONS TO CORRECT MARKET 
 
developed unique innovations.  For example, patent and copyright laws grant 
exclusive rights of products or processes to provide incentives for invention and 
innovation. Another example is that of permitted natural monopoly. Natural 
monopolies can produce the entire output of the market at a cost that is lower 
than what it would be if there were several firms. If a firm is a natural monopoly, it 
is more efficient to permit it to serve the entire market rather than have several 
firms compete each other. Examples of such natural monopoly are electricity, gas 
and water supplies. The Policy options for limiting market power in case of natural 
monopolies include price regulation in the form of setting maximum prices that 
firms can charge. In some cases, the government‘s regulatory agency determines 
an acceptable price, so as to ensure a competitive or fair rate of return. This 
practice is called rate-of-return regulation. 
 3.2 GOVERNMENT INTERVENTION TO CORRECT 
EXTERNALITIES 
As you may easily recall, freely functioning markets produce externalities because 
producers and consumers need to consider only their private costs and benefits 
and not the costs imposed on or benefits accrued to others. To promote the 
overall welfare of all members of society, social returns should be maximized and 
social costs minimized. This implies that all costs and benefits need to be 
internalized by consumers and producers while making buying and production 
decisions. Otherwise, market outcomes involve underproduction of goods or 
services that entail positive externalities or overproduction in the case of negative 
externalities. 
Governments have numerous methods to reduce the effects of negative 
externalities and to promote positive externalities. We shall first examine how 
government regulation can deal with the inefficiencies that arise from negative 
externalities. Since the most commonly referred negative externality is pollution, 
we shall take it as an exemplar in the following discussion.         
Government initiatives towards negative externalities may be classified as: 
1. Direct controls or regulations that openly regulate the actions of those 
involved in generating negative externalities, and 
2. Market-based policies that would provide economic incentives so that the 
self-interest of the market participants would achieve the socially optimal 
solution.  
 3
  
 
2.64 ECONOMICS FOR FINANCE 
Direct controls, also known as command solutions, prohibit specific activities that 
explicitly create negative externalities or require that the negative externality be 
limited to a certain level. For example, government may limit the amounts of 
certain pollutants released into water and air by individual firms or make it 
mandatory to use pollution control devices. Licensing, production quotas and 
mandates regarding acceptable production processes are other examples of 
direct intervention by governments. Production, use and sale of many 
commodities and services are prohibited in our country.  Smoking is completely 
banned in many public places.  Stringent rules are in place in respect of tobacco 
advertising, packaging and labelling etc.  
Governments may pass laws to alleviate the effects of negative externalities. 
Government stipulated environmental standards are rules that protect the 
environment by specifying actions by producers and consumers.  For example, 
India has enacted the Environment (Protection) Act, 1986. The government may, 
through legislation, fix emissions standard which is a legal limit on how much 
pollutant a firm can emit. The set standard ensures that the firm produces 
efficiently. If the firm exceeds the limit, it can invite monetary penalties or/and 
criminal liabilities. The firms have to install pollution-abatement mechanisms to 
ensure adherence to the emission standards. This means additional expenditure 
to the firm leading to rise in the firm’s average cost. New firms will find it 
profitable to enter the industry only if the price of the product is greater than the 
average cost of production plus abatement expenditure.  
Another method is to charge an emissions fee which is levied on each unit of a 
firm’s emissions. The firms can minimize costs and enhance their profitability by 
reducing emissions. Governments may also form special bodies/ boards to 
specifically address the problem: for instance the Ministry of Environment & 
Forest, the Pollution Control Board of India and the State Pollution Control 
Boards. 
The market-based approaches–environmental taxes and cap-and-trade – operate 
through price mechanism to create an incentive for change. In other words, they 
rely on economic incentives to accomplish environmental goals at lesser costs.  
The market based approaches focus on generation of a market price for pollution.  
This is achieved by:  
1. Setting  the price directly through a pollution tax  
2. Setting the price indirectly through the establishment of a cap-and-trade 
system.