MN 5227

Business Economics

INDIVIDUAL ASSIGNMENT

Department of Management of Technology

University of Moratuwa
2020
University of Moratuwa
MBA in Management of Technology
Department of Management of Technology
 Cover Sheet for Assignment

Names with Initials & student no:

Number Name

208282F Lavan Sathananthan

Title of the Assignment: Market Failures and Government Interventions to Rescue the
Economy

Subject Code : MN 5227

Subject : Business Economics

Lecturer : Prof. Sarath Dasanayaka

Student’s Statement :
I certify that I have not plagiarized the work of others or participated in unauthorized collusion
when preparing this assignment.

Signature ………………….. Date: 19-Dec-2020

Office use only :

Deadline Met Extension Given Late Submission

Marks Given :
Signature:………………………….
 Table of Contents

1. Introduction
2. The Role of the Government in the Modern Economy
2.1 Capitalist Economy
2.2 Socialist Economy
2.3 Mixed Economy
3. How Market Failures Happen
3.1 Defining Market Failure
3.2 Causes of Market Failure
4. Government Interventions to Rescue the Economy
4.1 Why Governments Intervene in Markets
4.2 How Governments Intervene During Market Failures
5. References
 Market Failures and Government Interventions to Rescue the
Economy

1. Introduction
The shortcomings of the structure of the free market in which there is no government
involvement in a nation's economic growth. The government's interference became
necessary for the development of an economy because of the failure of the free market
process.
Now, in controlling and managing economic activities, the question arises of determining the
extent of government involvement. Among numerous economists, this remains a debatable
problem. This is because government interference is still unable to fully eliminate a nation's
economic problems.
The role of government in an economy has been given different perspectives by different
economists.
According to Colin Clark, “The role of government must be held at a ceiling of 25 per cent of
the national income.”
According to Samuelson, “There are no rules concerning the proper role of government that
can be established by a priori reasoning.”

2. The Role of the Government in the Modern Economy

It can be inferred from the above-mentioned points of view that the exact and accurate
percentage or sum of government interference in an economy is difficult to determine and
calls for a collective social choice dilemma. In different economies, the degree of the
government's position differs. An economic system is a means by which to own and distribute
economic capital.
The economic system can be grouped into three categories based on resource ownership and
distribution which are given below.

Economic
System

Capitalist Socialist Mixed

Economy Economy Economy
2.1 Capitalist Economy
A capitalist economy refers to an economy that works on the principle of the free market
mechanism. It is also termed as laissez faire system.
The position of the government is very restricted in a capitalist economy. The primary
functions of government, as provided by Adam Smith, are to maintain law and order in a
country, reinforce national defense, and regulate the supply of money. However, over a
period, the roles of government in an economy have increased.
Main responsibilities of a government are:

• Developing and sustaining the free market mechanism system

• Elimination of any constraints on the operation of the free competitive market
• Improving the efficacy of the free competitive market system through different
measures
Other responsibilities of a government are:

• By formulating and enforcing various fiscal and monetary policies, regulating and
managing various economic conditions, such as inflation and deflation
• Controlling the capacity of monopolistic and multinational firms to prevent numerous
economic issues, such as unemployment and the inequitable distribution of wealth
• Ownership of public services, such as railway, education, medical care, water and
electricity, which the economy needs
• Prohibiting discrimination among individuals and giving them equal opportunities for
education and employment
• Limiting labor practices that are restrictive and power of trade unions
• Supporting private ventures in an economy
• Establishment of a central planning body that helps to build a larger-scale economy
• Dealing with environmental issues, natural resource extinction and population growth
We may therefore conclude that regulation and promotion of the free market mechanism is
the main role of government in a capitalist economy. In addition, private ventures to
safeguard the future of an economy should be supported by the government.

2.2 Socialist Economy

The role of government in a socialist economy is completely distinct from the function of
government in a capitalist economy. The government functions as a legislative and
complementary body in a capitalist economy. In a socialist economy, on the other hand, the
government plays a comprehensive role in almost all the economic activities of a country,
such as production, distribution, and consumption.
Not only is private property ownership tolerated to a restricted degree in a socialist economy,
but the notion of a free market system is also abolished.
Private ownership of capital is altered by state ownership in a socialist economy. Moreover,
the government plans and controls all economic operations directly at the state level in a
socialist economy. In addition, decisions relating to production, resource allocation,
employment, pricing and consumption depend entirely on the government or its central
planning authority. In a socialist economy, the actions of individuals depend entirely on the
government's limits.
For instance, freedom of choice is granted to individuals, but it is subject to the limitations of
the policy framework of the socialist economy. China, Yugoslavia, Czechoslovakia, and Poland
are countries in which the socialist economy is adopted.
In a socialist economy, the government's objective is the same as in a capitalist economy, such
as prosperity, productivity, and protection of justice. The ways embraced by the socialist
economy to accomplish those objectives, however, differ from the capitalist economy.
In the capitalist economy, for example, private benefit is the main driving force, while social
welfare is the stimulating factor in the social economy. The socialist way of managing the
economy makes it possible to eradicate various evil practices of capitalist economy, such as
labor exploitation, unemployment, and inequality in society. This is just the socialist
economy's classical view.
Over time, however, the scope of the socialist economy has also been limited for different
reasons, such as the prohibition of private sector income, the inefficient use of capital and
the limitation of economic growth, as the Union of Soviet Socialist Republics points out
(USSR).

2.3 Mixed Economy

The mixed economy is an economy with the characteristics of both the socialist economy and
the capitalist economy. This means that the operation of a mixed economy is based on the
concepts of a framework for the free market mechanism and a centrally planned economic
system.
In a mixed economy, under a political and economic policy outline agreed by the government,
the private sector is encouraged to operate based on the free market system. The public
sector, on the other hand, is interested in the growth and development of public utilities in a
mixed economy, which is based on the concept of a socialist economy.
The public sector includes certain industries, businesses, and activities in a mixed economy
that are entirely owned, regulated, and controlled by the government. In addition, in a mixed
economy, the government has enacted some laws to limit private entrepreneurs' entry into
industries reserved for the public sector.
Besides this, by nationalizing different private businesses, the government still aims hard for
the growth of the public sector. For instance, in India, many private banks have been
nationalized by the government, which has led to the expansion of the public sector. In
addition to working for the growth and development of the public sector, the government,
through the implementation of various monetary and fiscal policies, controls the activities of
the private sector in a mixed economy.

3. How Market Failures Happen

3.1 Defining Market Failure

Market failure occurs when the price mechanism fails to account for all the costs and benefits
necessary to provide and consume a good. The market will fail by not supplying the socially
optimal amount of the good.
Where the price represents the marginal gain of consumption, supply and demand on the
market do not generate amounts of products prior to market failure. The imbalance, which is
the over- or under-consumption of the good, induces allocative inefficiency.
Market systems' structure leads to market failure. In the real world, because of inefficient
suppliers, externalities, environmental issues, and a shortage of public goods, it is not possible
for economies to be perfect. An externality is a consequence of the production or use of a
good or service on a third party.

3.2 Causes of Market Failure

Market failure occurs due to inefficiency in the allocation of goods and services.
In delivering or consuming a particular product, a price mechanism does not account for all
the costs and benefits involved. When this occurs, the production of the socially desirable
good will not be produced by the economy, it will be over or under produced.
It is important to consider the reasons why a market will fail to truly understand market
failure. It is unlikely for them to be perfect, due to the structure of the markets. Therefore,
most economies do not thrive and need forms of intervention.
Market failure reasons include:

• Positive and negative externalities: externality implies the effect of the consumption
or production of a good or service on a third party. A positive externality is a positive
spillover that results from a good or service being consumed or produced. Although
public education, for example, can only directly influence students and schools, an
educated community can have a positive impact on society. A negative externality is
a negative spillover effect on third parties. Secondhand smoke, for instance, can
adversely affect people's health, even though they do not indulge in smoking directly.
• Environmental concerns: environmental impacts as essential factors as well as
sustainable development.
 • Lack of public goods: public goods are goods where, along with the number of
consumers, the overall cost of production does not increase. A lighthouse has a fixed
cost of production, as an example of a public good, which is the same, if one ship or
one hundred ships use its light. Public goods can be underproduced; there is little
motivation to have a lighthouse from a private point of view, since one can wait for
someone else to supply it, and then use its light without incurring a charge. This issue
is referred to as the free rider issue, anyone who profits from resources or products
and services without paying for the cost of the gain.
• Underproduction of merit goods: a merit good is a private good that society claims is
under-consumed, often with positive externalities. For example, merit goods are
education, healthcare, and sports centers.
• Overprovision of demerit goods: a demerit good is a private good that society feels is
over consumed, often with adverse externalities. Cigarettes, alcohol, and prostitution,
for example, are known as demerit goods.
The government typically intervenes when a market fails, depending on the cause for the
failure.

4. Government Interventions to Rescue the Economy

4.1 Why Governments Intervene in Markets

Governments intervene in markets to address inefficiency.
Resources are perfectly distributed to those who need them in the quantities they need in an
optimally efficient market. This is not the case in inefficient markets; some may have too
much of a resource, while others do not have enough. Inefficiency can take several forms. By
legislation, taxes, and subsidies, the government seeks to counter these inequities.
Maximizing Social Welfare
Cartels and other types of organizations may exert monopoly control in an unregulated,
inefficient market, increasing entry costs and restricting infrastructure growth. Businesses
can, without control, create negative externalities without consequences. All this leads to
decreased resources, stifled innovation, and minimized trade and its associated advantages.
Government interference by legislation will handle these problems directly.
Public goods include another instance of action to encourage social welfare. Some
depreciable goods, such as public parks, do not belong to a person. This implies that the use
of the good is not given a price and anyone may use it. It is very easy for these assets to be
depleted as a result. In order to ensure that those resources are not depleted, governments
intervene.
Macro-Economic Factors
To mitigate the harm caused by naturally occurring economic activities, governments often
interfere. Inflation and recessions are part of the normal cycle of business but can have a
serious impact on people. In these situations, governments intervene to reduce the harsh
effect of economic forces on their citizens by subsidies and manipulation of the supply of
money.
Socio-Economic Factors
To encourage general economic justice, governments may also interfere in markets.
Government also seeks to reallocate financial resources from the rich to those who are most
in need through taxation and welfare services. For socio-economic purposes, other examples
of market interference include employment legislation to protect certain groups of the
population and restrictions on the production of certain goods to ensure the health and well-
being of consumers.
Other Objectives
To facilitate other purposes, such as national unity and development, governments may often
interfere in markets. Governments should have a military to defend their citizens and this be
a form of interference. Not only does increasing a large and impressive military improve the
stability of a nation, but it may also be a source of pride. For government leaders, intervening
in a way that encourages national unity and pride can be an incredibly valuable aim.

4.2 How Governments Intervene During Market Failures

The government typically reacts to varying degrees during market failures. Potential solutions
from the government during market failures include:

• Legislation – Enacting particular laws. Banning smoking in restaurants, for instance, or

making high school attendance compulsory.
• Direct provision of merit and public goods – The production of goods that have
positive externalities is regulated by governments. For example, by offering huge
amounts of education, parks, or libraries.
• Taxation – Taxing certain goods in order to discourage their use and to internalize
external costs. For instance, imposing a 'sin-tax' on tobacco products and thereby
raising the cost of consumption of tobacco.
• Subsidies – Depending on the public benefit that is obtained, the price of a product is
reduced. Reducing college tuition, for instance, because society profits from more
skilled workers. To promote activity that has positive externalities, subsidies are most
fitting.
• Tradable permits – Permits that allow businesses to generate a certain amount of
something, usually emissions. In order to increase or decrease what they can produce,
companies can exchange permits with other firms. This is the cornerstone behind cap-
and-trade, an effort at emissions control.
• Property rights extension - To develop a market for emissions, it generates
privatization for such non-private goods such as lakes, rivers, and beaches. Then, for
polluting those fields, people get fined.
• Advertising – encourages or discourages consumption.
• International cooperation among governments – Governments cooperate on topics
impacting the environment's future.
References
Boundless Economics: Government Intervention and Disequilibrium. (2020). Retrieved from Lumen
Learning: https://courses.lumenlearning.com/boundless-economics/chapter/government-
intervention-and-
disequilibrium/#:~:text=The%20government%20tries%20to%20combat,understood%20reas
ons%20for%20government%20intervention.

Boundless Economics: Lumen Learning. (2020). Retrieved from Lumen Learning:

https://courses.lumenlearning.com/boundless-economics/chapter/introducing-market-
failure/#:~:text=transaction%20or%20act.-
,Market%20failure%20occurs%20when%20the%20price%20mechanism%20fails%20to%20ac
count,optimal%20amount%20of%20the%20good.&text=The%20imb

Nitisha. (2020). Retrieved from Economics Discussion:

https://www.economicsdiscussion.net/government/role-of-government-in-economic-
systems/4041