Why should governments intervene in a market economy? Adam Smith, the father of economics, argued in his 1776 classic, The Wealth of Nations, that people pursuing their own interests are led as if by “an invisible hand” to promote the interests of society. If there is an invisible hand, if markets allocate resources efficiently so that consumers’ wants are satisfied at minimum cost, why should governments intervene in the economy at all? The general argument for government intervention is market failure. Sometimes markets do not allocate resources efficiently, and government intervention may improve economic performance. Economic theory identifies six broad types of market failure, which we describe below. 1. Public Goods Most of the goods supplied by businesses and demanded by consumers are private goods. A private good is a good that, if consumed by one person, cannot be consumed by another. Ice cream is a private good. When you eat your ice cream cone, your friend doesn’t get to consume it. Your clothes are also private goods. When you wear them, everyone else is precluded from wearing them at the same time. But there are goods we can all consume simultaneously, without anyone’s consumption reducing anyone else’s. These are called public goods. A public good is a good that, even if it is consumed by one person, is still available for consumption by others. Clean air is a public good. So is national defence, or public safety. If the armed forces are protecting the country from danger, your being safe in no way prevents anyone else from being safe. It is no coincidence that most public goods are not provided in private markets. Because of the free-rider problem, private markets have trouble ensuring that the right amount of a public good will be produced. A free rider is someone who gets to consume a good that is costly to produce without paying for it. The free-rider problem applies particularly to public goods because, if anyone were to buy the good, it would then be available for everyone else to consume. To get around the free-rider problem, the country has to find some way of deciding together how much to spend on defence. Governments are set up to make such collective decisions. Many of the goods provided by the government are in fact public goods. National defence and police services are certainly public goods. National parks are a mixed case, since the views in the parks are a public good, at least until congestion sets in, but use of the eating facilities is not. It may seem from this discussion that the government should produce public goods and should not produce any other goods. Neither conclusion is correct. The government does not have to produce public goods; it only has to specify how much of each should be produced. It may rely on private contractors to do the actual production, as it does, say, with regard to defence equipment. Indeed, it used to be common for countries to have private contractors provide armies on a commercial basis. It is increasingly common for municipalities to hire private contractors to remove the rubbish. On the other hand, there is no general economic reason why governments should not produce private goods. There are government- owned firms or nationalized industries in most countries. Some government enterprises appear to be commercially successful and efficient. None the less, experience suggests that in many circumstances the government is less likely to produce efficiently than is the private sector. 2. Externalities Markets work well when the price of a good equals society’s cost of producing that good and when the value of the good to the buyer is equal to the benefit of the good to society. However, the costs and benefits of production are sometimes not fully reflected in market prices. Consider the problem of pollution. A firm produces chemicals and discharges the waste into a lake. The discharge pollutes the local water supply, kills fish and birds, and creates an offensive smell. These adverse side-effects represent costs to society of producing the chemical, and they should accordingly be reflected in its market price — but they may not be. Unless the chemical company is charged for the damages caused by its pollution; the market price of its output will understate the true cost of production to society. In this case chemical. An externality exists when the production or consumption of a good directly affects businesses or consumers not involved in buying and selling it and when those spillover effects are not fully reflected in market prices. Externalities are not all negative. The homeowner who repaints her house provides spillover benefits for the neighbours; they no longer have to look at a peeling or dilapidated house. In all externalities, there exists something that affects firms’ costs or consumers’ welfare (such as pollution or views of newly painted houses) but is not traded in a market. Economists often speak of externalities as caused by “missing markets”. When externalities are present, market prices do not reflect all the social costs and benefits of the production of a good. Government intervention may improve the functioning of the economy, for example, by requiring firms to treat their waste products in certain ways before dumping them. Since externalities involve missing markets, they can also be handled in principle by market-type solutions. The government might charge firms (an estimate of) the damages their pollution causes or might permit a certain amount of total pollution and allow firms to buy and sell rights to pollute. The presence of externalities can provide the justification for a number of government activities besides pollution control. Examples range from control of broadcasting (interference is an externality) to various restrictions on land use. David Begg. Economics. — 3rd ed. — McGraw-Hill Book Company, 1991. — P. 50. 1. Read text and do the tasks/answer the questions below. 1. What is the distinction between a private good and a public good? Give the examples of the goods of these types. 2. Explain the essence of the free-rider problem. 3. Should the government produce only public goods? Why? 4. What are the two types of externalities? Give some examples. 5. Do firms and consumers make fully informed decisions in the free market economy? 2. Decide whether the following statements are True or False according to text. 1. Thanks to “an invisible hand”, markets always allocate resources efficiently. ___ 2. There are no public goods in modern market economies. ___ 3. A free-rider is someone who consumes a good after paying for it. ___ 4. There are two types of externalities: positive and negative. ___ 5. Since modern economies are so complex, firms are fully informed about the consequences of their decisions. ___ Fill in the gaps using the prepositions/particles from the box below if necessary. on • for • at • in • of • up 1. Knowing the problems and the opportunities that your tools offer, you design maximum effect ___ minimum effort. 2. The effects ___ the comprehensive policies of the 1960s, reforms of the 1970s and practices of the 1970s and 1980s are available ___ serious discussion only ___ the 1990s. 3. For what reasons has the price ___ fish from Southwest England risen sharply? 4. The decline ___ the price of oil ___ nominal as well as real terms made this clearly less of a problem. 5. The British government has set ___ an inter-departmental committee to review the future of forestry in the country. 6. But ___ the next three to four years at least managers will have to rely more ___ their judgment than ___ hard data in deciding what to charge ___ their services. 7. There was clearly a rising consumption ___ gin which was equally clearly a capitalist product. 8. American politicians were turning to the academic community to provide the intellectual justification ___ confronting Soviet power. 9. Population growth and restrictions ___ settling forest land were other causes ___ this fragmentation.