Information failures

    

    The fourth type of market failure arises because real-world consumers and producers are not perfectly informed about all goods and prices. Where lack of such

knowledge is significant, information failure leads to an inefficient outcome in a

market system. A good example is the health effect of tobacco consumption. In a

free market, no firm has an incentive to circulate information about the hazards

of smoking. The demand curve for cigarettes has shifted outwards above what the

level would be if information was symmetric. It is obvious that tobacco companies

have no incentive to rectify the asymmetry. Nor will any individual have an

incentive to provide such enlightenment. Hence the need for government to step

in. Information failures also provide a rationale for public sector involvement

in activities as diverse as drugs testing, health inspection of restaurants, banking

regulation, insurance and the provision of job search centres for the unemployed.

    These four sources of market failure point to the need for government

intervention. The form of such intervention is the subject of the next section.

Government intervention

    The public sector constitutes the major alternative to free private markets. Hence,

a call for government intervention is generally regarded as the logical consequence

of the diagnosed market failures. As we have seen, public sector activity accounts for sizeable proportions of all countries’ national output. Even in a country as market-oriented as the US, government expenditure accounts for a third of GDP.

    Governments can influence economic activity in three major ways: taxation

and subsidisation, regulation and public provision. Together, they constitute the

main elements in the government’s microeconomic policy.

    In evaluating the different modes of intervention, attention is focused on their

efficiency effects rather than the income distribution effects. Of course, in many

instances the modality of intervention may be determined by equity or, indeed,

purely political considerations. For example, it may be ‘easier’ in political terms

to boost farm incomes by raising food prices than by providing highly transparent

subsidies of an equivalent amount. For that reason, arguments about the

inefficiency of one mode of transfer over another may often fall on deaf ears. Yet

research on more effective ways of intervening, and on the costs and benefits of

different forms of intervention, clearly helps rational decision making.

Taxes and subsidies

    Taxes and subsidies are used extensively to distribute income.

 Subsidies require taxes to finance them, and this raises questions concerning the

optimal structure of taxes. We have already referred to the rules which should

govern indirect taxes: impose high tax rates on activities with low price elasticity

of demand and low broadly-based rates on all other activities, assuming

that the motivation for imposing taxes is simply to obtain revenue for the

government.

   

    While most taxes are imposed for this reason, there is another motivation

which merits discussion. Taxes can sometimes be imposed not primarily in order

to collect revenue, but to direct resources in a particular direction – e.g. a pollution

tax. In other instances, the two motives overlap.By the same token,

while the bulk of subsidies are transfer payments to lower-income groups, many

are provided in order to encourage particular activities and regions

    Returning to the example of the polluting chemicals factory, it is easily shown that, if the government taxes the plant by the amount EF for every unit produced, the firm’s private marginal cost is increased and equals the social marginal cost, leading the firm to produce the socially optimum output level of OQ_2. By taxing the polluter by the value of the damage caused, the government is said to have ‘internalised’ the externality. In general, an optimal government policy taxes firms or individuals for the value of the external cost they cause and subsidises them to the value of the external benefit they create. This is the rationale underlying, for instance, taxes on fuel, and subsidies for education and industrial training.