Chapter 12
Reasons for
government
intervention in
markets
LEARNING INTENTIONS
In this chapter you will learn how to:
• explain why there is the non-provision of public goods
• explain why there is overconsumption of demerit goods and
the underconsumption of merit goods
• explain why governments control prices in markets.
ECONOMICS IN CONTEXT
Education in Sub-Saharan Africa
There are powerful arguments for government intervention in
education. As a merit good, it is underprovided if left solely to the
private sector. The case for government intervention is much
wider, given that education is a fundamental human right. In most
low and lower middle-income countries government intervention
involves the direct provision of education or providing subsidies
where fees are charged. There is often legislation making
education compulsory up to a certain age, usually 11.
Figure 12.1: Learners in Kenya
According to UNESCO, Sub-Saharan Africa has the highest rates
of children not in education (education exclusion). One-fifth of
children between the ages of six and 11 are not in school, one-third
between 12 and 14 years, and 60% between 15 and 17 years. Far
fewer girls attend school than boys in each of these age ranges.
There are many reasons why children may not be in education,
including corruption and conflict. The main reason though is
poverty.
There are exceptions. In Kenya, government education is free from
primary school through to high school. Boarding fees have to be
paid, although government subsidies are available for low-income
families. Ghana and Sierra Leone have recently introduced free
high school education.
Discuss in a pair or a group:
• What are the benefits of a good education for yourselves and
for the economy?
• Is additional funding the only way in which education in Sub-
Saharan Africa can be improved?
12.1 What is market failure?
When markets work efficiently, they produce the best allocation of
resources. This is an ideal situation. In reality, as economies grow and
become more complex, markets do not always operate in the way that is
set down by economic theory. When this happens, there is market
failure. Market failure is an inefficient allocation of goods and services
in the market. In this case, the free market mechanism does not make
the best use of scarce resources.
Market failure occurs when the price mechanism fails to take into
account all of the costs and benefits that are necessary to produce or
consume a product. Markets are not perfect due to inefficient production
and consumers not having perfect information to be able to make
informed choices.
Microeconomics has many situations where market failure occurs, and
requires government intervention. These situations include:
• lack of public goods (see Section 6.3)
• underproduction of merit goods (see Section 6.4)
• overconsumption of demerit goods (see Section 6.4)
• information failure (see Section 6.4).
ACTIVITY 12.1
In a group of four, look at the market failure situations identified
above. Each learner should research two examples. You could look
at local or national newspapers and news websites.
For each example, say why you think the free market has failed to
produce the best allocation of resources. As a group, discuss the
findings to decide whether the market has failed in each case.
Prepare a leaflet summarising each case.
KEY CONCEPT LINK
The role of government and the issues of equality and equity:
A consequence of market failure is that government intervention
can take various forms in order to produce greater social equality
and equity.
TIP
Before reading the next section, you may find it helpful to recap
public goods, the overconsumption of demerit goods and
underconsumption of merit goods (see Sections 6.3 and 6.4).
12.2 How governments intervene in markets
Addressing the non-provision of public goods
Public goods include the police force, national defence, fire protection,
street lights, non-toll roads and flood control systems. The nature of
public goods is that they are consumed collectively (by everyone) and
their use by one person does not make the public good less available to
others. The free rider problem means that people can enjoy the use of a
public good without contributing towards its cost.
TIP
A lighthouse clearly matches the two characteristics of public goods.
It is a good example to include in an answer for this reason.
It is therefore difficult, if not impossible, to make a direct charge for
consuming a public good. It is obvious that the private sector would not
be interested in providing public goods as there is no opportunity to
make a profit from their investment. When left to the free market, public
goods would not be provided despite the benefits they give to those who
consume. It is for this reason that public goods have to be funded by the
government out of tax revenue and provided free of charge for the
public. Opportunity cost is an issue since the funding for public goods is
competing with other types of government spending, often in countries
with a modest tax base.
Addressing the overconsumption of demerit goods
Demerit goods are ones that are considered undesirable for consumers
and that tend to be over provided, therefore over consumed in the free
market. The main reason for this is that consumers invariably lack full
and proper information on demerit goods such as cigarettes and
tobacco. This is why governments have increasingly intervened in this
particular market.
Over the past ten years or so, in many countries, regulations banning
smoking in public places have been introduced. Manufacturers may be
required to put written warnings and graphic photographs on packaging
explaining the dangers of smoking. Governments reason that measures
such as this will help protect the health and well-being of the
population; other reasons are to promote a more productive workforce
and to make savings in the healthcare budget through treating fewer
patients with smoking-related complaints. These reasons have tended to
be more relevant than the loss of tax revenue through reduced sales of
tobacco products.
ACTIVITY 12.2
For your economy or an economy of your choice, compare how
the government has sought to restrict the excessive consumption of
unhealthy foods such as fried chicken, chocolate and sugar-heavy
drinks. Discuss your findings with another learner.
Addressing the under consumption of merit goods
Merit goods are more beneficial to consumers than they may realise.
This is the result of information failure on the part of consumers. For
example, healthcare and secondary education are both considered by
governments as desirable and able to act as an incentive for economic
growth and development.
The problem for merit goods is that when provided by the private
sector, the quantity supplied is less than what is required. Access is
restricted to those who can afford to pay. This is therefore a case of
market failure, as shown in Figure 12.2. Assume this is the market for
healthcare. The government believes that OY should be produced to
meet the needs of the population. This is represented by the vertical
supply line. The private sector only provides OX and this is at an
average price of p to those in need of healthcare. This leaves under
production of OY − OX.
To correct the market failure, the government could decide to fully take
over the provision of healthcare. Resources would be allocated to meet
OY, with no private sector involvement. A less expensive option would
be to allow the private sector to still provide healthcare with the
government providing the difference OY − OX. The government’s
provision would be for those unable to afford to pay for private sector
fees.
Figure 12.2: Underproduction of a merit good
12.3 Controlling prices in markets
Governments also set maximum prices. This means that sellers of the
good cannot sell it legally at any price above the price ceiling. In some
former socialist economies and elsewhere, basic food items such as
bread were allocated a maximum price. The reason behind this policy
was to protect those on low incomes by providing heavily subsidised
items that were used daily. To be effective the maximum price must be
below the equilibrium price.
Another example is the case of rent controls, the purpose of which is to
provide affordable housing for families on low incomes. Rent controls
are also used to attract key workers such as nurses and teachers to areas
where there are shortages due to the high cost of housing. Most
governments are keen to protect their agricultural sectors to safeguard
food supplies. Prices and farmers’ incomes are unpredictable due to
uncertain supply conditions (see Section 9.3). Governments support
farmers’ incomes by setting a minimum price or price floor for key
agricultural products like wheat and rice. The effect of a minimum price
is to raise the price of a crop above the equilibrium market price. In this
way, the income of farmers is protected and the government can be
more certain about the security of future supplies, as there is likely to be
less need to buy crops on the international market. The downside is that
consumers are likely to be worse off, since the price is now above the
equilibrium and a smaller quantity is being traded. It can also be argued
that this represents an inefficient use of resources (see Section 13.4).
REFLECTION
Market failure is an important concept in microeconomics. Now
that you have studied market failure, how has your confidence
grown in being able to explain things you may have taken for
granted?
THINK LIKE AN ECONOMIST
Reforms to Pakistan’s healthcare system
There never seems to be enough money to fund healthcare. Given
the limited tax base, the problem is particularly acute in low-
income economies like Pakistan. Prime Minister Imran Khan has
promised to reform Pakistan’s healthcare system. His objective is
to provide quality care for all of Pakistan’s residents, something
that had previously been just for the few who could afford to pay
private providers. And even then, there was no guarantee of a
quality experience.
Figure 12.3: A modern healthcare facility in Pakistan
The most important issue is that of funding, especially for public
sector hospitals. Other priorities include the need to develop
preventative healthcare services. Pakistan still struggles to contain
polio and other preventable diseases due to the lack of an effective
immunisation programme. A third priority is to establish effective
regulatory bodies, both for the private and state-owned sectors.
Providing a better healthcare system for the entire population will
take time. The priority is to increase the healthcare budget and to
widen the scope of government provision. Extra funding has to
come from provincial and federal governments to build new
hospitals, especially in rural areas, and to upgrade existing
facilities with modern equipment. Investing at a local level should
take pressure off overcrowded hospitals in major cities.
1 How might the government in Pakistan obtain additional
funding for healthcare?
2 What are the benefits and costs of a better healthcare system
for Pakistan’s economy?
EXAM-STYLE QUESTIONS: MULTIPLE CHOICE
1 Why do governments provide public goods?
A Public goods are needed by the public.
B Public goods are mostly consumed by lower-income
families.
C The private sector does not find it profitable to provide
public goods.
D The government allocates a fixed sum of its budget for
public goods.
2 Healthcare is often provided by the government because:
A no private firm is prepared to do so.
B healthcare is a merit good and people deserve it.
C information failure means most people do not appreciate
the benefits of staying healthy.
D it is appropriate to fund healthcare from tax revenue.
3 A government fixes a maximum price for bread. What is the
most likely reason for this?
A Too much bread is being consumed.
B Production of bread is less than consumption.
C It is a way of supporting low-income families.
D It is a way of reducing non-market transactions.
4 Governments provide minimum prices for agricultural
products in order to:
A reduce demand from consumers.
B allow farmers to compete with imported agricultural
products.
C get farmers to produce as much as they can.
D stabilise farmers’ incomes.
5 Governments restrict the consumption of demerit goods
because:
A resources used in their production can be put to better
use.
B consumers of demerit goods are irresponsible in their
consumption.
C consumers lack proper information on the effects of
consumption.
D the value of imported demerit goods has an adverse
effect on the balance of trade.
SELF-EVALUATION CHECKLIST
After studying this chapter, complete a table like this:
You should be able to: Needs Almost Ready
more there to move
work on
Understand the concept of market
failure
Explain why governments may
intervene in markets to address
non-provision of public goods,
overconsumption of demerit goods
and underconsumption of merit
goods
Analyse why governments may set
maximum prices or minimum
prices in the market
