Government and Market Failure

Table of Content

The role of government in the economic system has always been a controversial question. Economists of different centuries were looking into this question, and discussing advantages and disadvantages of government interference in the economy. While earlier economists mostly argued for the limited role of government (Adam Smith, David Ricardo), at present more and more economists claim that the role of government in the effective functioning of the economy is enormous.

In the time of Adam Smith, there were no such phenomena as inflation for example, and therefore he could give theory-based grounds of the “laissez-faire” policy. According to Adam Smith, the best thing government could do for the economy was leaving it alone. Adam Smith was talking about “the invisible hand” of the market which was going to guide the economy to the right direction.

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This “invisible hand” would be able to provide the answers to the questions: what to produce, how to produce, and who is going to consume the produced goods. According to Adam Smith, the interference of government was very unfavorable on economy because it prevented it from having a balance. According to the economist, only the market was able to bring supply and demand into the balance which the successful economy requires. The market was supposed to regulate the economy, make sure the capital was flowing from less successful fields to more successful ones, guarantee that more goods would be produced if the demand for them became higher.

In Adam Smith’s world, “laissez-faire” policy was the most efficient. However, very soon economists started to discover that this policy had many disadvantages, and started re-considering some of its issues. It soon appeared obvious that without the interference of government, the market system would not be able to function efficiently. For example, the market system is unable to take care of the following issues:

Market doesn’t provide the legislation to regulate trade and commerce. It’s very important for the economy to have legislation regulation issues connected with the functioning of economy. For example, there have to be laws regulating trade between countries, operations inside the country, taxation code, laws protecting competition., laws dealing with operations with securities, and others laws. Without the mentioned laws, the economy cannot function efficiently.

Business isn’t always a fair game because businessmen might try to get profits in illegal ways, therefore the legislation regulating their operations should have no loop-holes. Only in such a case the economy will function in the most efficient way. Government is the only authority which can provide legislation, therefore the importance of its role in the regulation of the economy cannot be doubted.

Market doesn’t have a mechanism created to protect competition. In the market economy, one large company can get the whole market due to offering some unique product, and there will be no force to decrease its influence. The company can put obstacles for smaller companies to enter the market, and raise the prices since it’s a monopolist. Government can adopt laws which protect competition, and don’t let such situations happen. Customers benefit very much from such laws because they don’t have to buy good at very high monopoly prices.

Market cannot provide redistribution of profits. Market doesn’t care about the abilities people have. It distributes profits according to the capital, real estate people own, and doesn’t provide for the poor. In the market economy, there would be no way for old or sick people to receive any money, they would be left without any support. Government makes sure that taxes are paid by businesses and working people so that those who cannot work are able to live well.

Market is unable to stabilize economy in cases of the increase of unemployment rate and inflation. The characteristic feature of market economy, as it was mentioned already, is the policy of “laissez-faire”, no regulation of economy. However, the market is incapable of achieving balance in cases of rapidly increasing rate of unemployment and inflation. In such a case, only government can take measures and protect the economy.

For example, the government can provide monetary policy through its main tools:

  • operations in the open market with government securities;
  • regulation of the rate at which loans for commercial banks are given;
  • regulation of the norm of commercial banks reserves.

The government can also regulate the minimum salary, and take lots of other measures. The fiscal tools are also very helpful in this situation, such as government purchases and taxation policy. In the situation of inflation, the government can raise taxes in order to take the money away from companies and overcome the inflation. There is no way market can do anything in such a situation, therefore it’s very important for the government to provide the efficient regulation of the economy in such cases.

Market doesn’t provide public goods. There are some industries the production in which would be not profitable for commercial companies. For example, companies don’t want to build roads for public usage, they don’t want to install traffic lights, or fight with insects. Companies want to get involved only into production which will bring steady profits to them but they don’t want to produce public goods which people use for free, and there is no way to make them pay for those benefits. Therefore, it’s necessary for the government to provide those public goods.

Market cannot take care of externalities. One of the examples of externalities is the pollution of the atmosphere or water by some plant. There are many companies which work in “dirty” industries, and therefore their production deals with pollution a lot. In the market economy, no measures would be able to be taken in such a case, and the plant or factory would be polluting atmosphere and water. However, government is able to regulate externalities through various tools. One of the tools is legislation.

Government is able to issue specific laws which prohibit the pollution, and in case when it’s inevitable and the case of pollution really occurs, requires the company to destroy all of the results of the pollution. For example, companies can be required to buy special equipment which eliminates pollution, equipment which cleans the water after the company dumped some waste in the water. In such a way, government makes the companies to take care of all the costs which result from externalities. Another tool which government can use in such a case are specific taxes.

The government can adopt a law according to which companies which pollute the atmosphere or water will be required to pay the tax. The amount paid as tax has to be not less than the costs resulting from externalities. Government can use either tool to take care of the problem.

The provided analysis has shown that the role of the government in the economy is very important. There are many disadvantages in market economy which the government is able to take care. However, command economy is which government plays the major role and market tools are neglected is also not beneficial for the country in many ways. Therefore, lots of economists nowadays argue for the mixed economy which is a synthesis of economies with market and government emphasize.

In the mixed economy, the role of market isn’t limited, but the government takes care of the issues described above. It’s the most efficient way of building the economy, and this approach has been applied by many highly-developed countries.


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