Market Failures and Intervention by State 1

Governments across the globe have often justified their intervention in the operation of free
market forces on the grounds of market failure. Given the Indian experience of the eighties, two
questions may be asked. The first relates to whether the argument of market failure as
justification for government intervention holds, and if so, under what circumstances. The second
relates to whether government intervention on the grounds of market failure, even if justifiable,
necessarily implies the emergence of socialism. And a third question relates to whether I can
actually keep up this insufferable tone and language for the rest of this note purely on the
strength of pretensions to economic wisdom.

The answer to the third, thankfully, is a “no”. But that does not mean I am not going to try. The
answer to the second too, lies in the negative, but that too does not mean governments do not
try.

However, the thrust of this note is an attempt to answer the first question. To that end, I begin
by defining market failure, identify four specific cases, and then go on to discuss what role
government intervention can play in those cases.

1. Market Failure
Quite simply, a market failure is a phenomenon wherein a market is said to have failed to
perform its function. And if you think that was funny, try this: this definition was presented,
successfully, in an IIM-A interview. I suspect the professors admitted him out of vindictiveness.

A market failure may be defined as an outcome deriving from the self-interested behaviour of
individuals in the context of free trade, in which economic efficiency does not result. That is,
market failure is said to have occurred when the equilibrium resulting from the play of free
market forces is in conflict with economic efficiency.

Perhaps the best way to understand market failure is to first understand market success. For our
purposes, we shall define a market as a mechanism that brings together potential buyers,
potential sellers, and a means of exchange. A particular market is said to have performed, and
achieved an efficient outcome, if it results in the classical perfect competition outcome – supply
equals demand at an equilibrium price that equals the marginal cost to society (or social
marginal cost) of one additional unit of the product.

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Teaching note prepared by Rohithari Rajan, Indian Institute of Management Ahmedabad. December
2000
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Market failure, by definition, occurs when this does not happen. This could imply a case where
price is not equal to social marginal cost, or one where the market itself is unable to exist
despite a need for it – that is, despite the existence of potential buyers and sellers.

Having said that, the reason this note continues for ten more pages is that while all efficient
equilibria are alike in their economic efficiency, market failures occur in various ways. 2

To make life simpler, some kind-hearted economist (yeah well, there are a few of those) has
identified two sources of market failure, and has argued that all instances of market failure seen
in the real world can be attributed to one of these reasons.

The first relates to market failure happening because transactions that need to occur for the sake
of economic efficiency do not. This “Missing Trade“ phenomenon could be caused by a number
of factors, such as high transaction costs, information deficiency, information asymmetry, menu
costs, deliberate strategic behaviour, and the absence of property rights.

The second refers to a situation where the rational actions of individuals driven by self-interest
fail to serve the collective interest, or even harm it.

For our purposes, however, we can safely restrict ourselves to four specific kinds of market
failure, arising in the following cases.
1. Externalities
2. Public Goods
3. Information Asymmetry
4. Monopolies, specifically natural monopolies

2. Externalities: Absence of Property Rights and the Coase Theorem

This is a particularly common type of market failure, caused by an absence of property rights in
a situation where behaviour that maximises individual interests does not optimise collective
interests.

Imagine sharing a room with a smoker when you do not smoke. The fumes that emanate from
your smokestack pal make your room practically uninhabitable. Friendship is all very well, but
you do not see why you should inhale carcinogens and cough your way through a rapidly
shortening life simply because your roommate wants to be the Marlboro Man.

In true WAC style, you list out the options open to you:

2
Tolstoy had a similar idea [cf. Anna Karenina ]
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 You could become a smoker yourself. If you’re a passive sort of a guy, you wouldn’t even
have to spend money on the cigarettes.
 If you’re built like the Marlboro M and he is not, you could threaten bodily harm and declare
your room a smoke-free zone.
 If he’s built like the M Man and you’re not, you could try changing your room
 If all else fails, you could at least spend more time in the library studying economics.

While that may not improve your grades any (you can’t possibly still believe that grades depend
on efforts put in!), if you study the right kind of economics, you might at least be able to use
some hi-fi words to describe your predicament.

For what you are going through is a case of market failure. Your roommate decides upon how
much to smoke by trying to attain the highest indifference curve available to him subject to his
constraints. What he does not take into account is that the quantum of smoking he chooses has
a direct and unpleasant effect on your well-being. In other words, his smoking creates a negative
externality for you.

Now imagine that you were given ownership of the room and the air space within it. Then, you
could charge your roommate for every cigarette that he smoked. By doing so, you would on one
hand make smoking more expensive for your friend, and therefore less attractive. On the other
hand, you would also be compensating yourself for the discomfort (and higher chances of
cancer) that you have to suffer due to his smoking.

What you would get now is an efficient market equilibrium. The smoker would still try to attain
the highest indifference curve available to him given his constraints, but through the market
mechanism, social welfare shall be optimised. The money you would receive would compensate
you adequately for the smoke you would have to bear.

This highlights something called the Coase Theorem. The essence of the theorem is that as long
as property rights are clearly defined, an efficient outcome is possible through free trade.

To continue with our example, if there were no property rights, your roommate and you would
be in a stalemate. You would object to his smoking, but he may not heed you. If you had
property rights over the room, you could charge him for smoking, and through trade, an efficient
outcome would result. If your roommate had the property rights, he could charge you for the
right to clean air, which means you would have to pay him to limit his smoking. Here too, free
trade would lead to an efficient outcome. Of course, you would be far happier if you were the

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one with property rights, while your friend would be much better off if he were the one with the
property rights.

To conclude, the solution to a market failure of this nature lies in intervention by the state, in the
form of clearly assigned property rights. The Coase theorem proves that property rights can lead
to an efficient outcome where externalities have caused a market failure. It does not make
subjective decisions regarding who should be given the property rights.

3. Public Goods and the Free Rider

This sort of a market failure results when rational actions of individuals driven by self-interest fail
to serve collective interest, or even harm it.

Take a look at your marketing group. Chances are I do not need to explain the free rider
phenomenon any further, but I’m not going to give up an opportunity to spout jargon, so here
goes.

A public good is a good characterised by non-rivalry and non-excludability. Non-rivalry means

that your consumption is unaffected by the consumption of the same good by any other person.
For instance, the number of people who are watching the same show does not affect the joy you
derive from watching Friends on your TV set. TV programming is in that sense non-rival in
consumption. A hamburger is not. The joy you derive from your consumption of a hamburger
would be affected if you had to share it with three other people.

Excludability implies that it is possible and feasible to limit the number of people who derive
benefit from a particular good or service. For instance, you can limit the number of people who
share your hamburger. But you cannot limit the number of Indians who benefit from India’s
foreign policies. The benefits of a hamburger are excludable – those of national diplomacy are
not.

Goods that are rival in consumption and excludable are private goods, and a market for them
exists in the conventional sense of the word.

Goods that are rival in consumption but non-excludable can lead to the type of situation I
discussed under externalities. The state can intervene and, by assigning property rights,
generate excludability.

Goods that are non-rival but excludable are those for which, while exclusion is feasible, it is not
socially desirable. Pay channels are a case in point. A market for them exists, and their

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excludability is used. But their benefits are non-rival, so the benefits I derive from watching a
pay channel will not in any way diminish if a million others are also watching that channel. Thus,
excluding anyone from watching the channel would be socially undesirable and inefficient. Yet, it
is precisely this excludability that prevents market failure. For if pay channels were made free-
for-all, ol’ Rupert would become a pauper.

And this brings me to goods that are non-rival and non-excludable. Before the development of
technology that would make television channel services excludable, there were no pay channels.
At least theoretically, any subscriber to a pay channel believes that the services he receives are
worth the price he pays. If the services were non-excludable, they would still be worth the same
amount to our TV junkie, but he would not pay for them now, secure in the knowledge that he
would get to enjoy the late night movie whether or not he paid. The free rider in the marketing
group exists only because he is sure that the submission deadline shall be met even if he slacks
off.

Market failure arises in the case of public goods because consumers have an incentive to
understate how much they value the benefits to them of a good. And here a numerical example
might help.

Purely out of an earnest desire to make life simpler for their juniors, students of a Well-known
Institute of Management in Western India (WIMWI) decide to institutionalise black books 3. A
smart CA estimates that the costs of collecting all old question papers and compiling a nice,
elegant leather bound black book in each subject and for each dorm (with the dorm number
monogrammed in gold on the cover, of course) would amount to Rs.20000.

There are two hundred students. Each values the feel-good benefits of performing this noble
gesture for his4 juniors at Rs.200. Clearly, the optimal solution is for each student to contribute
Rs.100. Each student would receive benefits worth twice the costs incurred, and welfare would
be maximised.

Except that this will not happen, because when the batch meeting is called, each student has an
incentive to RG5 the others by understating what bequeathing a well-organised black-book
system to his juniors is worth to him. If I say I will not derive any benefits at all, I will not have
to pay anything. But since the others value the benefits at Rs.200 per head, each would be
willing to pay Rs.100.51 and the black-book project will still work out. Except that this being

3
A collection of old quiz/exam papers: if you didn’t know that, I hate to think of your grades…
4
The sex ratio at WIMWI in that era was such that I am not being chauvinistic when I use the masculine
pronoun.
5
RG (n, adj, verb ): Colloquial term indicating self-centred, ruthlessly competitive behaviour
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WIMWI, everyone will be smart enough to figure this out. No student would be silly enough to
reveal how much he really values the project. Thus, there would be a market failure and black-
books would not be organised.

The solution, quite simply, is intervention. If the PGP1 representative had some idea of how
much each student values the black-book project, he could set a price and force each student to
pay it. Now extend the example, and here’s how state intervention can solve market failure.

4. Information Asymmetry
One aspect of the informational role of markets concerns the inability of a market to exist
although there is a need for it. The example that follows was first given by Scitovsky.

A steel industry must decide whether or not to begin operations today. If operated now, it will be
profitable only if a railroad industry starts operations five years from now. In turn, the railroad
industry will be profitable only if a steel industry is in operation when the trains start. Clearly,
each industry needs the other – it is efficient for each to operate, and it makes sense for the
steel industry to begin today. However, if the steel industry does not have information that the
railways will materialise five years later, it might not begin operations, in which case the railroad
industry will not materialise. If there are only spot markets for steel, the railroad industry cannot
inform the steel industry of its interests through the marketplace. This inability to communicate
desirable interactions and to coordinate timing is an example of market failure and has been
used as a justification for public involvement in development efforts. That is, an omniscient
government can set up SAIL five years before it sets up Indian Railways, because it knows.

Alternatively, the government could try to create a futures market for steel. It’s a question of
what the government prefers – public sector steel and railways units, or an opportunity for I-
bankers to be employed in India rather than Wall Street.

This sort of market failure is one where the lack of complete information prevents the very
existence of a market under free market forces, and state intervention is required to resolve the
problem.

A second aspect of the informational role of markets concerns the asymmetric distribution of
relevant information. The classic example is one of the securities market, where insiders often
know what outsiders do not. Again, regulation through state intervention is advocated as a
solution.

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5. Monopoly and Market Failure
We defined an efficient market equilibrium as one where supply equals demand at a price that is
the social marginal cost of producing one additional unit of the product.

The profit maximising monopolist’s objective is to equate marginal revenue MR with marginal
cost6 MC. For this to conform to the efficiency condition, MR would also have to equal price. This
means that the efficient outcome is compatible with profit maximisation only at points of
intersection of the demand curve, the MR curve, and the MC curve.

In the case of a linear demand schedule, the slope of the MR curve will be twice that of the
demand curve7. Hence, a market characterised by a profit maximising monopoly would normally
not be expected to fulfil the P = MC condition.

This means that a monopoly should by definition be considered a failure of the free market.
Historically, monopolies have managed to acquire an image akin to tyrannical dictators, rather
like the Nazis, or certain profs. However, all monopolies and all profs are not necessarily cruel
tricks of fate. Before we rush in with our condemnation of monopolies, it is important to
understand how that monopoly came into being. I focus on three cases:
 Natural monopoly
 State-imposed monopoly
 Monopoly as Cost of Innovation

5.1 Natural Monopoly: An industry is said to be a natural monopoly if the total costs of
production are lower when a single firm produces the entire industry output than when any
collection of two of more firms divide the total among themselves. Thus, a natural monopoly is
an industry in which, given the level of demand, technical factors preclude the efficient existence
of more than one firm.

The easiest example of natural monopolies is a public utility, for a number of reasons:
 Duplication
 Large fixed costs, especially of installation
 Increasing returns to scale
 Decreasing cost industry
 Ensuring that price is closer to marginal cost

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Profit () = TR – TC. The first order maximising condition requires that MR – MC =0.
7
Let the demand curve be P = a + bX. Then TR is given by PX = aX + bX 2 and MR is given by the
derivative of this. MR = a + 2bX, which is twice the slope of the demand curve.
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Natural monopolies have actually been covered in EA, which gives me an excuse to avoid
explaining these points in detail.

Take a public utility such as water. You cannot possibly have free entry into the industry – unless
of course out of some sado-masochistic motivation you actually want to see your city dug up
every time a new firm decides to enter the industry and needs to lay its own system of pipes and
stuff. Thankfully, governments have not really been thrilled with this idea – maybe because
they’ve figured out better ways to keep the city dug open most of the time anyway. At any rate,
that’s the duplication argument for natural monopoly.

Next, the fixed costs, including the installation costs, involved in this industry (or, say, the
railways) are extremely high. This has two implications. First, in the context of developing
countries it is possible that there be no firm or even consortium of firms large enough to afford
the investment. Second, high fixed costs imply high break-even volumes, so that if the market
were to be shared by two firms both would end up making losses. Increasing returns to scale
and decreasing costs industry are two more ways of saying essentially the same thing – which is
that high volumes are a necessary prerequisite for any firm to provide the good or service. And
finally, in the absence of the required volumes, or simply because of the existence of monopoly
power, price might exceed marginal cost, which by our definition would constitute market failure.

Thus, a market failure could exist in the sense that the service would not be provided at all
under the operation of the forces of free market, or if provided, might be priced higher than
marginal cost. The solution, predictably, is intervention by the state. The state could set up a
price regulation mechanism or its own producing unit, or it could offer guarantees and other
incentives to private sector firms in order to induce them to set up the industry. Thus, state
intervention might produce an efficient, competitive outcome under a monopolistic market
structure.

5.2 State Imposed Monopoly: The case of natural monopolies is one where a government
might choose to impose a monopoly because of market failure. Governments might also impose
monopolies for other reasons. For instance, they might choose to keep the defence products
industry monopolistic for strategic reasons. Or, they might impose a monopoly simply because
they do not want an efficient market equilibrium as defined by us. For instance, the price we pay
for petrol is far in excess of marginal cost, because petrol is used to cross-subsidise diesel.
Another reason for imposing monopolistic industries was the argument that in the face of severe
foreign exchange constraints, the government wanted to ensure that resources were not mis-
utilised. Thus, under the license regime, monopolies could exist.

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In these situations, the existence of a monopoly is not sufficient to prove the failure of the free
market. In fact, quite the reverse might be true. A monopoly could exist because the State, in its
own wisdom, prevents the existence of a free market. And this brings us to the crucial, rarely
acknowledged distinction between intervention by state in case of market failure; state
intervention on the assumption that the market would fail if allowed to exist; and state
intervention on the assumption that the economically efficient market outcome is not socially or
politically desirable.

In the first case, state intervention is called for, as discussed in the various examples above. This
means that wise and able policymakers have intervened in the interests of economic efficiency.

In the second case, state intervention might actually result in an inefficient outcome, which could
have been avoided if only the state had not been so meddlesome. That is, policymakers who
have absolutely no idea of economics or efficiency have chosen to play God, and made a mess of
things.

In the third case, policymakers go a step further. Sure, they are still playing God. But now, when
some conscientious economist points out to them the inefficiency of their ways, they argue that
they know the relevant economics, and that they intervene only because the economically
efficient outcome is not good for a third world country like ours, and all that sort of thing.

Thus, before condemning a monopoly a failure of the market, it is important to check whether
the market is characterised by Contestability 8. That is, if a firm wished to enter the market, and
had the requisite resources to do so, could it?

5.3 Monopoly as Cost of Innovation 9: This section began by raising a question: is monopoly
per se an instance of market failure? This subsection presents an interesting approach to a long-
standing debate.

Many economists have argued that by pressurising each firm to continually try to beat the
others, competition imposes innovation, while the monopolist has no incentive to innovate since
he has no competition. Not only this, a monopolist has fewer incentives to reduce costs than a
firm in perfect competition. Thus, while it might equate price to marginal cost, the marginal cost
itself might be higher than that prevalent in a competitive market, and might reflect inefficiencies
that would never have survived in a competitive scenario. This means that even when price
equals marginal costs, a monopolistic market equilibrium might actually reflect market failure.

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Contestability: Firms have the freedom to enter the industry, and to exit it costlessly.
9
This part draws upon Schumpeter’s arguments. Sceptics might wish to go through Chapters 4 and 5
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Again, the answer to these arguments is quite simplistic as long as the cause of monopoly is
understood. If a government imposes a monopoly because it wishes to protect domestic industry
(import restrictions to eliminate foreign competition) and conserve foreign exchange (license
regimes to eliminate domestic competition), then there might indeed be an inefficient outcome
due to the existence of monopoly. But this cannot be called a market failure simply because the
government has not allowed market forces to operate.

On the other hand, what if a monopoly exists without government imposition? What if a firm
derives monopoly power from, say, a patent? In this case, monopoly power can be viewed as a
reward for innovation. Would I have the incentive to spend millions in R&D if I knew that any
new innovation I came up with would be immediately copied by rivals and sold at prices lower
than I could charge, since the rivals would not have to recover the R&D investments I made? In
perfect competition, firms may not have the incentive to innovate, unless they expected at least
temporary monopoly power as a reward for their innovation.

Next, a monopoly might be better able to afford intensive R&D. Also, it has been argued that the
cost structures of monopolistic firms are usually lower than those of firms in competition. In fact,
Schumpeter has asserted that even when price exceeds marginal cost to the monopolistic
producer, it might be lower than the marginal cost of producing the same product in perfect
competition.

And finally, Schumpeter argues that a monopoly still has incentive to innovate and reduce costs,
due to the threat of potential competition (contestability again), and of product substitutes. This
would hold unless the firm was guaranteed its monopoly power, which is why understanding the
cause of monopoly is so important.

5.4 A recap: In essence, this section has made three important points (spread over more than
four pages). The first of these is that a monopoly is not a case of market failure if it is the result
of state imposition rather than of the operation of free market forces. As mentioned, this could
be a case of state intervention on the assumption that the market, if allowed to exist, would fail
to achieve an efficient outcome, or a case of intervention on the grounds that the efficient
outcome is not desirable. The second point made in this section is the natural monopolies are a
special case of monopolies that can be viewed as an instance of market failure, calling for state
intervention. And finally, the third point made here is that a monopoly that exists under a free
market or on the strength of, say, a patent, may charge a price higher than marginal cost. By
our definition, this would make it a case of market failure. However, the supernormal profits that

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the monopolist would temporarily (no patent, after all, is eternal) enjoy can be viewed as its
reward for innovation.

Finally, this section also asserts that monopoly does not constitute market failure as long as
there is contestability.

6. Conclusion
With that, we’ve covered each of the four specific instances of market failure identified in the
beginning of this note. Before I’m finally done with this note, however, I’d like to make a
distinction between market intervention by state, and market protection. We’ve discussed
already that government intervention in the operation of free market forces may or may not be
justified. But however free a market, there is still a role for the state – that of regulating market
processes, and protecting the institutions of free enterprise. In fact, free market does not mean
a market free of the state. It only means that the state restricts itself to ensuring that the free
market forces are permitted and able to operate – that government restricts itself to governing
rather than interfering. In fact, a well-defined and well-enforced system of rules and regulations
is imperative to, rather than inconsistent with, the working of free enterprise.

Finally, here’s a summary of the points made in the last five sections.
 Market failure occurs when the equilibrium that results from the operation of free market
forces does not ensure that supply matches demand at a price equal to the social marginal
cost of producing one more unit of the product
 Market failure also arises if a market fails to come into existence despite need for it.
 Market failure can in general be attributed to either or both of two basic underlying factors.
The first is the “Missing Trade” phenomenon, wherein transactions that need to occur for the
sake of economic efficiency, do not. The second is a conflict between rational actions of
individuals driven by self-interest, and the collective interest.
 We have studied four specific instances of market failure – externalities, public goods, lack of
information and information asymmetry, and natural monopolies.
 In each case, we see how state intervention can resolve market failure and yield an efficient
equilibrium.
 A crucial distinction exists, however, between intervention by state in order to resolve
market failure, state intervention on the assumption that market failure would otherwise
result, and state intervention on the grounds that the efficient equilibrium is socially or
politically undesirable.

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Bibliography, [See? I have done some research on this note after all!]
1. Schumpeter, Joseph Alois. Capitalism, Socialism, and Democracy . London: Unwin University
Books, 1943.
2. Gould John P; Lazear, Edward P. Ferguson & Gould’s Microeconomic Theory , 6th ed. Delhi:
All India Traveller Book Sellers.
3. Bannock, Graham; Baxter, R; Davis, Evan. Dictionary of Economics , 6th ed. London: Penguin
Books, 1998.
4. Eatwell, John; Murray, Milgate; Newman, Peter; eds. The New Palgrave: A Dictionary of
Economics. London: The Macmillan Press Limited. 1987.
5. Basant, Rakesh; Nandi, Nabanita Market Failures and Government Intervention . Teaching
note, IIM Ahmedabad, 1999.
6. Bator, Francis. The Anatomy of Market Failure ; Quarterly Journal of Economics, 351-79;
1958.
7. Coase, Ronald. The Problem of Social Cost. Journal of Law and Economics 3, 1-44.

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