Markets, Market Failure and the Role of Government

This chapter introduces Pareto efficiency as the key normative concept of welfare economics and describes the conditions under which we expect efficiency or market failure. We pay particular attention to the existence of externalities and show how these can, but do not always, cause markets to fail. Whenever there is market failure it is conceptually possible for government to intervene in order to improve outcomes. Government failure also occurs, however, and so such intervention is not always practical. When considering imperfect alternatives, we must engage in comparative institutional analysis.

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Notes

In the standard analysis, the tax is levied on the production of the good itself. As Plott (1966) points out, the tax should instead be levied on the output of the externality (i.e. the pollution) or on the resource which causes the pollution. This provides the right incentives for firms to change their production process to remove externalities rather than simply reducing production. Since it does not alter the central points we wish to make in this chapter, we will use the simpler case of taxes imposed on the output of a good.

Inframarginal externalities can in some cases be inefficient in the sense that net benefits would be increased by moving from equilibrium to a much smaller or greater level of output, even though marginal changes would cause inefficiency (Buchanan and Stubblebine 1962: 374).

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Author information

Authors and Affiliations

1. School of Politics and International Relations, Australian National University, Canberra, ACT, Australia Keith Dowding
2. School of Commerce, University of Southern Queensland, Springfield, QLD, Australia Brad R. Taylor

1. Keith Dowding