VIETNAM NATIONAL UNIVERSITY

VIETNAM JAPAN UNIVERSITY

INTRODUCTION TO PUBLIC POLICY

Final report
Essay question:
Analyze the relationship between Market Failures and Public Policies

Student : Le Ha Phuong
ID : 19110026
Program : MPP

Hanoi, 2019
1. Introduction
Social welfare optimization is the ultimate goal of economic activities. In order to gain that goal,
economic resources such as capital, labor, and technology must be distributed effectively.
However, there exist market failures preventing economy from operating efficiently. Market
failure is the economic situation defined by the distortion in the allocation of resources. There are
five common types of market failure which are: public goods, macroeconomic instability,
externalities, asymmetric information, and poverty and income inequality. Market cannot
regulate those failures by itself. Therefore, government’s interventions through policies are
necessary to correct them. In this essay, I would like to analyze the relationship between market
failures and public policies
2. Market failure and public policies
2.1. Public goods
Public goods are commodities or services that have two different characteristics: perfectly non-
excludable and perfectly non-rival. Non-excludable means that it is costly or impossible for one
user to exclude others from using a good or enjoying its benefits once this good is available on
the market. Non-rival means that benefits of users do not compete or conflict to each other.
When one person uses a good, its consumption by other people is not be decreased.
Goods such as fireworks are pure public goods because citizens do not be affected if there are
more people watching fireworks and people can enjoy fireworks together while houses, foods,
and vehicle are pure private goods which are excludable and rival. Impure public goods satisfy
those aspects of public goods to some extent, but not perfectly. Figure 1 illustrates different
kinds of goods in terms of their two key characteristics.

Figure 1: The classification of goods by characteristics

(Source: Learning material)
Public goods are a kind of market failure because they might not be supplied effectively through
private market. Non-excludable goods lead to “free rider” problems. Free riders enjoy the
benefits of using such goods without paying for them or helping to maintain them. Once many
people do not want to pay for any kind of goods, which means private sector cannot gain profit
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from it, they will not provide it despite its importance. If the government allows business to
supply a certain type of public goods and collect fees (such as highway), it will lead to
deadweight loss because some potential customers cannot use such good. Furthermore, there are
still some public goods that can be excluded. Transaction cost is required in order to smooth the
exclusion process. Transaction costs is costs incurred that don’t accrue to any participant of the
transaction. It is a sunk cost resulting from economic trade in a market. Transaction cost
decreases social welfare. In addition, some private suppliers are interested in maximizing their
profit more than social benefits. Based on those problems, governments use two methods to
involve in providing public goods.
Firstly, public sector directly manufacture and supply public goods by using government revenue
(from taxes, loans, and so on). Strict laws and policies help to remove “free rider” problem and
the government can easily monitor and manage the quality of commodities and services.
However, this measurement can lead to monopoly, which increases production cost because
there is not motivation for public enterprises to improve. Moreover, there are too many types of
publics goods and the limit capacity of the government does not allow public sector to provide
all of them. Therefore, governments need to forecast public goods’ demand and set up necessary
provision schedules, use fiscal policies effectively. Budget deficit and public debt will increase if
the public sector make a wrong decision on provision public goods.
Secondly, public sector cooperates with private sector in order to supply public goods such as
roads and hospitals, which is called public private partnership – PPP. For this method, private
business are the manufacturers and suppliers of goods while the government intervenes in market
by building policies and laws, monitoring the production process, and sometimes distributing
commodities and services. Public sector can also construct infrastructures and private companies
are responsible for suppling services. PPP is enable private business to reduce production cost
and price thanks to specialization and company competitiveness. It also helps to decrease burden
on government budget. However, due to asymmetric information, public sector has to suffer
costs to manage, ensure quality of goods and behavior of private firms.
It is crucial for governments to decide type of methods to supply public goods in order to
optimize social welfare. Theirs decision will be based on kinds of public commodities and
services, scale and ability of public and private enterprises.
2.2. Macroeconomics instability
GDP of an economy tends to increase while its growth rate shifts up and down. For example, it
can be seen from figure 4 that although Vietnam total GDP shows an upward trend, GDP growth
appears volatile from 1998 to 2018. Business cycle is fluctuation of GDP around its long-term
growth trend. A business cycle includes 6 stages: expansion, peak, recession, depression, trough,
and recovery. Economic cycle gives rise to macroeconomic instability, prevents social welfare
from being optimized. Macroeconomics instability leads to some market failures that are
unemployment, inflation, and deflation.

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 Figure 4: Vietnam GDP and GDP growth from 1998 to 2008
300000000000 8
7
250000000000
6
200000000000
5
150000000000 4
3
100000000000
2
50000000000
1
0 0
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20

GDP (USD) GDP growth (%)

(Data source: World Development Indicators)

Regarding unemployment, this is a situation when a person who is in working age cannot find a
job although he or she is actively seeking employment. Even a healthy economy has natural
unemployment. However, when the economy depresses, the unemployment rate significantly
increases, which causes deadweight loss. Firstly, a high unemployment rate means that total
economic outputs will be declined and consumption during their period of unemployment will
also be reduced. Secondly, governments have to provide unemployment benefits to help
unemployed workers to cover their basic needs until they find a new job. This compensation
burdens the government budget and may lead to budget deficit. Furthermore, unemployed people
may commit illegal actions in order to earn a living, which harms to social.
As for inflation, it happens when the general price of goods and services in an economy during a
period of time increase. The dramatic rise in inflation rate when overheating an economy
decreases the value of money. As a result, people prefer holding financial assets (such as stocks,
bonds) to cash. However, the fewer cash people keep, the more transaction cost they have to pay
to withdraw money, this is called shoe-leather cost. Furthermore, high inflation causes menu
costs. Firms must spend a lot of money to constantly change their prices to keep up with
economic changes. Moreover, high inflation means citizens will receive fewer savings after
paying tax, which discourages investment and savings. The private sector also reduces its
investment since it is difficult for them to make a long term plan when the future purchasing
power of money is uncertain.
By contrast to inflation, deflation is a decrease in the general price level of goods and services.
Deflation is generally regarded negatively since it usually happens when economy in depression
phase. First, deflation may lead to unemployment as firms do not gain enough profits to pay for
employees’ salaries. The falling prices make customers expect to purchase more reasonable price
goods in the future. This worsens unemployment problem because firms must reduce production.
In addition, lower prices make the real value of debt rise, which means borrowers must pay more
than the money they borrowed. In order to stabilize macroeconomic, governments use fiscal
policy and monetary policy to reduce unemployment rate, control inflation and boost economic
growth.

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Fiscal policy is a means by which a government adjusts budget and taxation to monitor and
influence a nation's economy. There are two forms of fiscal policy which are expansionary fiscal
policy and contractionary fiscal policy. Expansionary fiscal policy is used in order to boost
economic by decreasing tax or/and increasing government budget.
- Corporate tax Reduce → Investment Increase → Economic Expand
- Expenditure Increase → Effective Demand Increase → Economic Expand
The functions of contractionary fiscal policy in terms of economic growth are reversed,
increasing tax or/and decreasing government budget to contract economic.
Monetary policy is a means by which monetary authorities (normally central banks) use interest
rate and supply of money to control the quantity of money. There are also two forms of monetary
policy which are expansionary monetary policy and tighten monetary policy. Central banks use
expansionary monetary policy to spurs economic growth through lower interest rate or/and
increasing in money supply.
 Interest Rate Decrease → Investment Increase → Economic Expand
 Money Supply Increase → Interest Rate Decrease → Investment Increase → Economic
Expand
The functions of tighten monetary policy in terms of economic growth are reversed, central
banks increase interest rate or/and reduce the amount of money supply to contract economic.
Moreover, governments can implement some supply side policies such as subsidies, income tax
reduction, deregulation, and privatization. For example, governments use tax system to control
output factor. A reduction in income tax rates will encourage employees to work harder, leading
to an increase in labor supply and more outcomes. By contrast, tax increase will help to avoid
overheating economy.
2.3. Externalities
Externalities are the impact of a decision on a third party which is not directly related to the
transaction that is not taken into account by the decision-maker. There are two types of
externalities: positive or negative ones.

(Source: Learning material)

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Negative externalities cause an external cost to a third party (see figure 2a). In this case, in order
to increase their profits, the private sector produces at quantity Q pvt instead of the more efficient
quantity of social Qsoc. As a result, free market is inefficient since at the quantity Q pvt that is
greater than Qsoc, MSB is less than MSC. It is better if society would not get more quantity of
goods from Qsoc to Qpvt. An example of negative externalities is that using plastic products. The
environment has to suffer from consequences of those goods instead of producers and
consumers.
By contrast, positive externalities occur when producing a good brings a benefit to other (see
figure 2b). In this case, the private sector produces at quantity Q pvt instead of the more efficient
quantity of social Qsoc. As a result, free market is inefficient and tends to shrink their production
since at the quantity Qpvt, their MPB are smaller than MSB. Take a beekeeper as an example of
positive externalities. He or she provides an external benefit to the plant grower because his/her
bees help to fertilize those plants. Both negative and positive externalities cause deadweight loss
of welfare which is the blue part in figure 2. Therefore, governments have to intervene to make
decision-makers take into account these external costs and benefits.
In order to reduce impacts of negative externalities such as environmental pollution,
governments can impose a tax on the goods causing the externalities. Tax increases cost to
manufacture goods at quantity Qpvt, therefore free market will reduce outcomes to efficient
quantity of social Qsoc to gain more profits. Regulation is also one of the most popular solutions
to correct negative externalities. For instance, governments implement protecting environment
laws and regulations to limit environmental harm. Therefore, firms must spend a lot of money to
upgrade green technology instead of providing more goods. Another method to overcome this
market failure is well defining property rights since property owners must compensate for a third
party. However, this method is only used if negotiation cost is insignificant or few parties
involving in negotiation.
Governments intervene to positive externalities to encourage market to increase quantity from
Qpvt to efficient quantity of social Qsoc. Policies using is subsidy and tax reduction to reduce price
and motivate consumption. These tools help to rise demand for goods, therefore, market will
produce more commodities and services.
2.4. Asymmetric information
When starting any transaction, it is crucial for both sellers and buyers to gain sufficient basic
information about goods such as their quality, their characteristics, and their prices in order to
make a right decision. However, there exist differences in information between two parties,
calling asymmetric information. Asymmetric information is a condition that one party possesses
more and better knowledge than the other. This problem causes two consequences: adverse
selection – one party has less accurate information and moral hazard – a party provides
misleading information or increases their exposure to risk. Asymmetric information is market
failure due to 2 reason:
First, it gives rise to inefficient outcomes. When asymmetric information occurs, it is difficult for
either sellers or buyers to analyze cost and benefit relating a transaction. Therefore, the demand
curve D1 will be different from the demand curve representing the quality of goods D 0. If buyers
consider that the quality of a good is better than the real quality, market will produce more this
kind of good than necessary (D1 is greater than D0, see figure 3a). Social welfare loss equals to the
acreage of E0E1E2. By contrast, if customers underrate the quality of a good, fewer kind of such

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good will be manufactured (D1 is smaller than D0, see figure 3b). The acreage of E 0E1E2 is social
welfare loss. Furthermore, asymmetric information can even lead to no market transaction.

Figure 3. Ineffectiveness due to asymmetric information (Source: Public economics textbook)

Second, since market failure cannot be amended by itself, self-correcting this failure methods
including signaling mechanism, screening mechanism and high salary method raises several
consequences. More information party use signaling mechanism to signal and transfer
information to other to solve asymmetric information. However, expense for signaling increases
prices and decreases consumption. By contrast, underinformed party can encourage the other to
reveal more details of a good via screening mechanism. But if sellers reject to disclose more
information, a transaction may not be happened. Regarding the last method, better wage reduces
adverse action of workers by increasing chance to be fired. Therefore, workforce productivity
will be improved. The disadvantage of this method is that it can lead to unemployment when job
demand increases.
Governments apply some methods to to regulate transactions in free market. The first method is
increasing information provision via mass media along with raising awareness for citizens in
order to smooth transactions and prevent asymmetric information. Governments also need issue
regulations regarding information transparency. Without such regulations private sector will not
spend their money to fulfil their role of supplying details of goods. Since purchasers are usually
the shortage of information party, it is necessary to establish consumer protection associations to
protect consumers’ rights and reduce their damage causing from this market failure. In addition,
governments encourage to use economic tools such as provisions on warranty in order to correct
asymmetric information.
2.5. Poverty and income inequality
Poverty is a global issue. Although it can be defined by some different approaches, all definitions
agree that the poor lack at least one factor such as income, basic human needs or condition to
advance their ability comparing to the non-poor. The boundary between poor and not poor is
poverty line. Poverty line includes absolute poverty – when a person or household lives below
adequate living standard and relative poverty – when a citizen’s living standard is less than
others in a country during a period of time. There are many index to describe poverty of a nation
such as headcount index, poverty gap, human poverty index, and multidimensional poverty
index.
Poverty causes welfare loss. Since citizen lacks basic human needs, they do not have enough
health and knowledge to fulfill their work. Therefore, poverty prevents society from achieving
full employment. In addition, governments must subsidize the poor to ensure their basic life.
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This burdens governments’ expenditure, leading to budget deficit. Besides, poverty is one of the
main reasons that give rise to criminal activities, violent behavior, and unrest. Government has to
spend a huge amount of resources to stabilize social order. Moreover, poverty reduces
proficiency of employees, which weakens national competitiveness and declines capacity to
attract foreign investment. As a result, vicious circle of poverty is worse and social welfare
cannot be improved.
Income inequality reflects disparity of income distribution among citizens of a nation. There are
several causes leading to income inequality such as inheritance, consumption behavior, and
abilities of individual workers. Lorenz curve and GINI index are used to measure income
inequality. Lorenz curve is a graph showing the cumulative portion of the population (x) on the
horizontal axis and the cumulative portion of the total income (y) on the vertical axis. When x =
y, everyone has the same income. The line represents this situation is the “line of perfect
equality”. The further Lorentz curve from the "line of perfect equality” and the greater GINI
index, the higher level of income inequality.
Extreme income inequality not only expands the gap between the rich and the poor but puts
pressure on social welfare as well. It also causes social instabilities that are costly to solve.
Therefore, income redistribution will help to maximize social welfare by decreasing law of
diminishing marginal utility and achieving full employment.
Spring from above analysis, governments intervene to correct these market failures, targeting to
achieve poverty reduction and reduce income inequality.
As for poverty, firstly, governments need to provide more opportunities for workers to utilize
labor power by ensuring they approach basic human needs, medical service, and useful
knowledge and technology. Then the poor should be facilitated to receive good jobs with paying
corresponding to their abilities. Secondly, it is crucial to perfect the institutional system, improve
the capacity of bureaucracy in order to protect poor people’s rights, allow them to participate in
making decisions that are related to them. Last but not least, as the poor have low income and
hardly have savings, they are vulnerable to affect from economic, nature and society shocks.
Hence, governments need to enhance social security to help the poor to increase their ability to
deal with and reduce risks from such shocks.
There are many methods to reduce income inequality such as progressive tax and subsidization.
Progressive tax contributes to distributing partial property from the rich to the poor since people
receiving higher income must pay more tax. However, with an unreasonable tax rate, higher-
income people may lose their motivation for self-improvement and creation. Tax collecting will
be used to subsidize.
3. Conclusion
These market failures including public goods, macroeconomic instability, externalities,
asymmetric information, and poverty and income inequality prevent social welfare from reaching
its maximization. They have a correlation with public policies. These failures affect the
policymaking process and a good decision from governments can help to correct these failures.
Each type of failure requires a different policy and levels of intervention. The government should
not excessively intervene in market so as to avoid an inefficient allocation of resources that
sometimes are called government failure.
4. Reference

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Dung, B. D. and Nam, N. M. (2013) Kinh te cong cong [Public Economics], Hanoi, Vietnam
National University Publishing House.