Role of Government When The Market Fails

The market may work to drive down prices of consumer goods and produce iPhones and laptops, but those same principles don’t work when it comes to things like a fire department or education–this is called a market failure, and is when the government needs to step in to levy taxes and use tax revenue to provide the service. One of the roles of the government in the market economy is to step in and fill the gaps for these market failures.

What you need to learn

How and when the government steps in to fill the gaps and limitations of the market.

Market Failures

free rider & taxes

tragedy of the commons & incentives

collective wellbeing & public goods

non-exclusion & non-rivalry


positive externality

negative externality

role of government in externalities

regulatory policies

monetary policies

market based policies

Market Failures

In economics, a market failure refers to a situation where the free market, operating on its own, fails to allocate resources efficiently, leading to a net social welfare loss. This means that the market does not produce the most beneficial outcomes for society. Market failures can occur due to several reasons, each leading to an inefficient distribution of goods and services.

Key causes and types of market failure include:

  1. Externalities: These are costs or benefits that affect a party who did not choose to incur that cost or benefit. For example, pollution is a negative externality because it harms those not involved in the production or consumption of the polluting product.
  2. Public Goods: These are goods that are non-excludable (people cannot be easily excluded from using them) and non-rivalrous (one person’s use does not reduce availability for others). Due to these characteristics, private markets may underproduce public goods, as seen in the free rider problem.
  3. Tragedy of the Commons: This happens when a shared resource is overused and depleted because of self-interested incentives. We see this happening today in areas of non-renewable resources and overfishing in our lakes & oceans.
  4. Monopoly Power: When a single firm (or a group of firms) controls a significant portion of the market, they can manipulate prices and output, leading to inefficiencies. This lack of competition can result in higher prices and lower quantities than what would be observed in a competitive market.
  5. Merit and Demerit Goods: Markets may fail to produce and allocate the optimal quantity of goods that are beneficial for society (merit goods) or overproduce goods that are harmful (demerit goods).

When market failures occur, it often justifies government intervention. Governments can implement policies like taxes, subsidies, regulations, or provision of public goods to correct these failures and improve social welfare. However, such interventions must be carefully designed to avoid government failures, where the intervention causes more harm than the original market failure.

Tragedy of the Commons

In economics, the concept of “tragedy of the commons” refers to a situation where a shared resource is overused and depleted because individuals act according to their own self-interest and neglect the well-being of the whole group. This term stems from a scenario where multiple individuals, who have open and free access to a common resource (like a pasture or a fishing ground), end up exploiting it unsustainably.

Here’s a breakdown of how this works:

  1. Shared Resource: The resource is commonly shared and not owned by any single individual. This could be a natural resource like a forest, a fishing area, the atmosphere, or even a man-made one like a public park or a shared facility.
  2. Self-Interest: Each individual acts in their own self-interest. They use the resource to maximize their personal benefit, often without considering the long-term impact of their actions on the resource or others.
  3. Overuse and Depletion: When everyone acts this way, it leads to the overuse and eventual depletion of the resource. For example, if fishermen overfish a lake, the fish population may decrease to a point where it can’t replenish itself.
  4. Negative Outcome for All: The tragedy is that, in the end, the resource becomes depleted or destroyed, leaving everyone worse off, including those who initially benefited from overusing it.

The tragedy of the commons is significant in economics because it demonstrates a key limitation of free markets: they can fail to manage common resources sustainably. It highlights the need for effective management strategies, such as regulation, privatization, or community-based resource management, to prevent the overuse and depletion of shared resources.

Tragedy of the Commons: A Community Garden Scenario

Let’s say your school starts a community garden. Everyone is excited to plant and agrees that anyone can take some produce home. Initially, it’s a paradise of fresh tomatoes and lettuce. But soon, you notice something: the more people take, the less there is for others. Some students start taking more than their share, thinking, “If I don’t take these now, someone else will.” The garden soon becomes barren.

This is the tragedy of the commons in action. It’s not just about fishing or grazing fields; it’s about how individual actions, even seemingly rational ones, can lead to the depletion of a shared resource. When everyone acts for personal gain without considering the collective impact, the resource gets exhausted, and everyone loses out.

The Free Rider Problem

The free rider problem occurs when individuals benefit from resources, goods, or services without paying for them or contributing to their provision. This situation typically arises with public goods, which are non-excludable and non-rivalrous.

Here’s a more detailed look at the concept:

  1. Public Goods: The free rider problem is often associated with public goods. These are goods or services that are available to all members of a society, regardless of whether they contribute to their creation or maintenance. Public goods are non-excludable (you can’t prevent people from using them) and non-rivalrous (one person’s use doesn’t reduce availability for others). Examples include public parks, street lighting, and national defense.
  2. Lack of Incentive to Pay: Since individuals can use these goods without directly paying for them, they have little incentive to voluntarily contribute to their cost. If a person can benefit from a well-lit street or national defense without contributing to the cost, they might choose not to pay if given the option.
  3. Under-provision of the Good: The crux of the free rider problem is that it can lead to the under-provision or even the non-provision of the good. If too many people choose not to contribute financially, there might not be enough resources to provide the good or service at an adequate level, or at all.
  4. Government Intervention: Often, governments step in to solve the free rider problem. They do this by funding public goods through taxation. Since taxes are obligatory, everyone contributes, which ensures the provision of these goods. This solution, however, can be contentious as it involves compulsory payments and government decisions on resource allocation.

The free rider problem highlights a fundamental challenge in economic systems: providing and maintaining public goods in a way that is both efficient and fair. It underscores the need for collective action and often justifies government intervention to ensure that essential public goods are available to all members of society.

Free Rider Problem: The School Project Dilemma
A Familiar School Experience

Think about a group project where everyone is supposed to contribute equally. But there’s always that one person who doesn’t do their part, hoping to ride on the group’s efforts. Despite their lack of contribution, they still get the same grade as everyone else.

Understanding the Dynamics

This is the essence of the free rider problem. It shows up in school, in public services, and in community initiatives. It’s when some benefit from a resource or service without contributing their fair share, placing a heavier burden on those who do contribute. This can lead to underfunded or poorly maintained public services, as those who can avoid paying, will.


Externalities are a type of market failure where the actions of an individual or firm result in costs or benefits that are not reflected in the market price and are borne by a third party. These external effects can be either positive or negative and occur outside of a market transaction, meaning they are not compensated through the market.

Types of Externalities
  1. Negative Externalities: These occur when the actions of individuals or firms impose costs on others. A classic example is pollution. When a factory emits pollutants into the air, it can harm the health and property of people who are not part of the economic transaction that produced the pollution. These costs are not reflected in the price of the factory’s products, so the factory does not bear the full cost of its production, leading to overproduction and inefficiency from a societal perspective.
  2. Positive Externalities: These arise when the actions of individuals or firms create benefits for others who are not part of the transaction. An example is vaccination. When a person gets vaccinated, they reduce the risk of spreading the disease to others, creating a societal benefit. However, the market price of the vaccine may not fully reflect this additional benefit, potentially leading to underconsumption of the vaccine compared to the socially optimal level.
Impact and Solutions

Externalities can lead to inefficiencies because the market does not allocate resources in a way that reflects the true social costs or benefits. This results in overproduction in the case of negative externalities and underproduction in the case of positive externalities.

To address externalities, governments often intervene through policies such as:

  • Taxes and Subsidies: Imposing taxes on goods with negative externalities (like carbon taxes on emissions) can help internalize the external costs. Conversely, providing subsidies for goods with positive externalities (like subsidies for education or renewable energy) can encourage consumption or production to the socially optimal level.
  • Regulations: Governments can also directly regulate activities that cause negative externalities, such as setting emission standards for factories or mandating vaccinations.
  • Creation of Property Rights: In some cases, creating or clarifying property rights can help address externalities, as seen in the case of pollution rights trading schemes.

The Tech Company’s Innovation (Positive Externality):

A tech company develops a new software that significantly improves data security. While the company profits from its product, the broader economy benefits too. Other businesses, including small startups, use this software to protect their data, leading to a decrease in cybercrime and boosting overall digital confidence in the economy. This scenario demonstrates how one company’s innovation can create widespread benefits beyond its immediate customers, enhancing the overall digital security landscape.

The Factory’s Pollution (Negative Externality):

An industrial factory produces goods at low cost, contributing to economic growth and job creation. However, it also emits pollutants into the air and local water bodies, affecting public health and the environment. The costs of these health impacts and environmental damage are not borne by the factory but by the wider community and government, which may need to spend more on healthcare and environmental clean-up. This illustrates a negative externality where the economic activity of one entity imposes costs on society at large.

The Car Manufacturer’s Research (Positive Externality):

A car manufacturer invests heavily in research and development to create more fuel-efficient engines. While this initially benefits the company through increased sales, the broader economy benefits from reduced fuel consumption and lower greenhouse gas emissions. This results in improved air quality and lower health-related expenses, showcasing how private sector innovation can have public benefits that are not captured in the market price of the goods.

The Real Estate Boom and Traffic Congestion (Negative Externality):

A city experiences a real estate boom, leading to rapid construction of new housing and commercial spaces. While this boom stimulates the local economy and increases property values, it also leads to increased traffic congestion. Residents and businesses outside the real estate sector bear the cost of this congestion through longer commute times and increased transportation costs, representing a negative externality of the economic growth in real estate.

The University’s Research Breakthrough (Positive Externality):

A university conducts groundbreaking research in agricultural techniques, leading to a significant increase in crop yields. While the university gains in terms of academic prestige and potential patent income, the wider economy benefits from increased food production, lower food prices, and improved food security. This scenario highlights how academic research can generate positive externalities that extend far beyond the direct benefits to the institution.

By recognizing and addressing externalities, economies can work towards more efficient resource allocation that better reflects the true social costs and benefits, leading to improved societal welfare.