Lesson preview · Fixing market failure, and when fixes fail
Choosing and judging an intervention
~8 min · Free to read
In November 1989, Mexico City tried to clean up its air. The city banned most cars from its roads on one weekday a week, picked by the last digit of each car’s number plate.
A 2008 study by the economist Lucas Davis, using the city’s air monitors, found no evidence that the ban had cleaned the air. Later studies suggest the air improved for a few months before the gain faded.
A market failure is a market making the wrong amount when left alone. It gives a reason to consider an intervention: a government action that changes how a market works. But an intervention can fail too.
Key Term
Five tools for a market failure
- Corrective tax: a tax on each unit of something that harms others, such as a charge per tonne of factory smoke.
- Subsidy: a government payment for each unit made or bought, such as money off flu jabs, which help others.
- Regulation: rules, such as a limit on a factory’s smoke, or a ban.
- Direct provision: the government supplies the good and pays from taxes, as with street lights.
- Information: telling people facts they lack, such as an energy label on a fridge.
Some governments also issue tradeable permits: a fixed number of licences to pollute, which firms can buy and sell.
Start by asking what went wrong. Left alone, the market makes too much of a good that harms people outside the deal, so tax it or limit it. It makes too little of a good that helps them, so subsidise it. If nobody can be made to pay, as with a flood barrier, no firm will supply it, so the government provides it. If buyers lack the facts, give them the facts.
Each unit a factory makes sends out smoke that does 25 dollars of harm to its neighbours. What one more unit costs the factory itself is its marginal private cost. Add the 25 dollars of harm and you get the marginal social cost (MSC), the cost to everyone.
A corrective tax of 25 dollars a unit makes the factory count the harm as a cost. It is also called a Pigouvian tax, after the economist Arthur Pigou.
The socially best quantity is the best amount for everyone once the harm is counted. The rule: set the tax equal to the harm one more unit does at that quantity.
The red triangle is the deadweight loss: value lost because the wrong amount is traded. It vanished at a tax of about 25 dollars, the harm each unit does. Once the firm counts its smoke as a cost, the market stops at the socially best quantity by itself. A smaller tax leaves too much smoke. A bigger one stops trades worth more to buyers than their full cost, smoke included.
If a good affects no one outside the deal, the best tax is zero. Any tax stops trades worth making, and a bigger tax stops more.
Tip
Tax or ban?
A tax cuts output without stopping it. That suits most harms, because some output is worth its full cost. A ban suits a good when almost none of it is worth its full cost.
Lead in petrol is an example. The World Health Organization says no level of lead exposure is known to be safe, and cars can run on unleaded petrol instead. So governments banned it, and in July 2021 the last country selling it for cars, Algeria, stopped.
Key Term
Government failure
Government failure happens when an intervention leaves things worse, or costs more than it gains. Common causes:
- Poor information. Nobody can measure the harm exactly, so the government may set a tax too high or too low.
- Lobbying. Firms press for exemptions (being let off a tax or rule), or for rules that suit them.
- Enforcement costs. Rules need paid inspectors and courts.
- Unintended consequences. People react in ways that work against the plan.
Trap · Common Misconception
"Any intervention makes things better"
A market failure shows that the market gets the amount wrong, not that a given fix gets it right. A tax at the wrong level, or a ban people dodge, can leave things no better, or worse. Compare the market with the fix as it will really work, not with a perfect fix.
Tip
Evaluating an intervention
- Strengths. What does it fix, and how well?
- Limitations. What does it cost, who loses, and how might people react?
- Overall judgement. Weigh the two and say what your answer depends on. Write “a smoke tax works if the harm can be measured”, not “it has good and bad points”.
Check yourself · no marks
Back to Mexico City. A family needs to drive every day, but the ban keeps their car at home one weekday a week. What could they do, and what would that do to the city’s air?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 6
Which option matches the problem to a suitable remedy?
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