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Part H: The relationship between...
Chapter 20: Reasons for government intervention in the market

Chapter summary

  • Government intervention in the market sets out to attain two goals: social efficiency and equity. Social efficiency is achieved at the point where the marginal benefits to society for either production or consumption are equal to the marginal costs of either production or consumption. Issues of equity are difficult to judge due to the subjective assessment of what is, and what is not, a fair distribution of resources.
  • Externalities are spillover costs or benefits. Whenever there are external costs, the market will (other things being equal) lead to a level of production and consumption above the socially efficient level. Whenever there are external benefits, the market will (other things being equal) lead to a level of production and consumption below the socially efficient level.
  • Public goods will be underprovided by the market. The problem is that they have large external benefits relative to private benefits, and without government intervention it would not be possible to prevent people having a ‘free ride’ and thereby escaping contributing to their cost of production.
  • Monopoly power will (other things being equal) lead to a level of output below the socially efficient level. It will lead to a deadweight welfare loss: a loss of consumer plus producer surplus.
  • Ignorance and uncertainty may prevent people from consuming or producing at the levels they would otherwise choose. Information may sometimes be provided (at a price) by the market, but it may be imperfect; in some cases it may not be available at all.
  • Markets may respond sluggishly to changes in demand and supply. The time lags in adjustment can lead to a permanent state of disequilibrium and to problems of instability.
  • In a free market there may be inadequate provision for dependants and an inadequate output of merit goods.
  • Taxes and subsidies are one means of correcting market distortions. Externalities can be corrected by imposing tax rates equal to the size of the marginal external cost, and granting rates of subsidy equal to marginal external benefits.
  • Taxes and subsidies can also be used to affect monopoly price, output and profit. Subsidies can be used to persuade a monopolist to increase output to the competitive level. Lump-sum taxes can be used to reduce monopoly profits without affecting price or output.
  • Taxes and subsidies have the advantages of ‘internalising’ externalities and of providing incentives to reduce external costs. On the other hand, they may be impractical to use when different rates are required for each case, or when it is impossible to know the full effects of the activities that the taxes or subsidies are being used to correct.
  • An extension of property rights may allow individuals to prevent others from imposing costs on them. This is not practical, however, when many people are affected to a small degree, or where several people are affected but differ in their attitudes towards what they want doing about the ‘problem’.
  • Laws can be used to regulate activities that impose external costs, to regulate monopolies and oligopolies, and to provide consumer protection. Legal controls are often simpler and easier to operate than taxes, and are safer when the danger is potentially great. However, they tend to be rather a blunt weapon.
  • Regulatory bodies can be set up to monitor and control activities that are against the public interest (e.g. anti-competitive behaviour of oligopolists). They can conduct investigations of specific cases, but these may be expensive and time consuming, and may not be acted on by the authorities.
  • The government may provide information in cases where the private sector fails to provide an adequate level. It may also provide goods and services directly. These could be either public goods or other goods where the government feels that provision by the market is inadequate. The government could also influence production in publicly owned industries.
  • Government intervention in the market may lead to shortages or surpluses; it may be based on poor information; it may be costly in terms of administration; it may stifle incentives; it may be disruptive if government policies change too frequently; it may not represent the majority of voters’ interests if the government is elected by a minority, or if voters did not fully understand the issues at election time, or if the policies were not in the government’s manifesto; it may remove certain liberties.
  • By contrast, a free market leads to automatic adjustments to changes in economic conditions; the prospect of monopoly/oligopoly profits may stimulate risk taking and hence research and development and innovation, and this advantage may outweigh any problems of resource misallocation; there may still be a high degree of actual or potential competition under monopoly and oligopoly.
  • There are two views of social responsibility. The first states that it should be of no concern to business, which would do best for society by serving the interests of its shareholders. Social policy should be left to politicians. The alternative view is that business needs to consider the impact of its actions upon society, and to take changing social and political considerations into account when making decisions. This is good business.
  • The virtue matrix is a means of illustrating the drivers of corporate social responsibility. Firms will take socially responsible actions if they are required to by law or if social norms dictate. These pressures on firms represent the ‘civil foundation’. Some firms will take corporate social responsibility further and thus move into the ‘frontier’. Here they may do things that are socially beneficial and may only possibly lead to higher profits, or may even clearly reduce profits. As firms become more socially responsible over time and as social pressures on business increase, so the civil foundation is likely to grow.
  • Evidence suggests that economic performance is likely to be enhanced as the corporate responsibility of firms grows.



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