Appendix 1- Problem Identification
Markets and Market Failure
In general, decision making is considered best left to private individuals, who have the best information on their needs. Further, the operation of markets is considered the most effective means, on the whole, of ensuring least cost production, and that resources go to their highest value use, thereby maximising their contribution to the economy and public welfare. However, in some circumstances markets may fail to do this (see Box 1).
Box 1: Common Market Failures
| Externalities | Externalities are negative (or positive) effects arising from a transaction, which fall on third parties. As a result, they may not be taken into account in production decisions, and too much (or too little) may be produced. An example of an externality is pollution, emitted as part of a manufacturing process, the cost of which does not fall on the manufacturer.
Governments may choose to use economic instruments to ensure that prices include the cost of the externality, or technical standards so that less of a negative externality is produced. |
| Imperfect competition | Where barriers to entry into a market exist, producers may be able to set prices higher than competitive levels, and/or restrict output. Governments may wish to intervene to prevent this (for example, through implementing anti-trust laws).
Competition problems may also arise in the case of natural monopolies. A natural monopoly exists when one firm can provide the entire market demand at a lower cost than two or more firms. For example, electricity and gas transmission networks tend to be natural monopolies for any given geographical location. It should be noted, however, that either breaking-up or over-regulating a natural monopoly might lead to higher costs to consumers. |
| Information problems | Where producers or consumers do not have full information on which to base their decisions, this can lead to poor outcomes. For example, if consumers do not recognise high quality goods or services this may lead to lower prices, thereby causing high quality suppliers to exit the market. Alternatively, it may allow for producers of poor quality goods or services to "free ride" on the good producers, to the detriment of the market. |
| Public goods | Public goods are non-rivalrous and non-exclusive. This means that consumption of the good by one person does not reduce the ability of others to consume the good, and it is difficult or even impossible to exclude people from consuming the good. As a result it can be very difficult to obtain payment for the good directly from users. In these circumstances the market is unlikely, if left to itself, to supply enough of a public good. Typical examples of public goods include defence and light-houses. Changes to technology may mean that it will be possible to charge directly for some public goods in the future, that is, by making it possible to directly measure and charge individuals for use and benefit.
NB: Just because a good or service is produced by the government sector for the public does not mean that it is a "public good", for example, passports. |
Nearly all markets exhibit some form of market failure. As such, it is important to consider the magnitude of the failure, as there are costs associated with all interventions which will need to be weighed against the expected benefits (refer below).
Government Failure
In some cases, today's problems may be a result of yesterday's intervention. In developing options for government intervention, it is also important to consider the likelihood and nature of government failure, i.e. the reasons government policy initiatives may fail to meet their objectives, or result in unintended costs:
- actions may distort market incentives. Government interventions, rather than assisting the operation of markets, may impede their normal functioning. For example, subsidies going to the agricultural sector during the 1970s and 1980s encouraged farmers to greater levels of sheep production, in spite of huge over-supply in world markets. With prices distorted in this way, there was little reason for farmers to move into areas of growing world demand such as goats, pine trees, and deer.
- complex regulations. If the regulations are too complex, people will have difficulty in interpreting what is required. This creates uncertainty, high transaction costs, and may leave the courts to interpret the intent of the legislation.
- as owner/purchaser, the government has weak incentives to monitor resource use. Without the threat of take-over, or going bankrupt, there is less incentive for government enterprises to operate efficiently, or to be responsive to consumer demand. Also, a mix of political and commercial objectives can make it difficult to hold managers to account for their performance.
- bounded rationality. Just as the private sector may not have the time, resources or capability to secure and process all the information necessary for the market to function properly, the government too, for the same reasons, may not be able to adequately identify all the likely consequences of a government intervention.
- interest group capture. Interest groups are sometimes able to unduly influence government decision making, that is, to their own advantage but not necessarily to that of the country. Interest group capture can be of officials, or Ministers.
- over tax/regulate. A common problem for governments is the temptation to over tax, that is, beyond the point where the cost of increasing tax receipts exceeds the benefit from the extra government spending. There is perhaps an even stronger incentive for governments to over-regulate. Regulation may be used in preference to taxation because there are fewer barriers to a regulatory proposals as compared to a spending proposal, for example, the budget process.
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