Public Finance: Causes of Market Failure / Reasons of Government's Intervention in Market Economy:

The market economic system operates under Price Mechanism.  Consumers show their will or desire to buy a commodity at a given price in order to maximise their utility.  On the other hand, the producers are aimed at maximising their profit for what they produce.  In market economy, there is no justification for state intervention but there are some reasons that necessitate the government's intervention in the economy as discussed below:

(a) To avoid Monopoly: Monopoly is a situation in which one seller rules over the whole industry.  The buyers are compelled to purchase commodity at the price fixed by the monopolist.  Therefore, the government interferes for the benefits of the consumers.  The government interferes in pricing of the commodity, and/or encourages new firms to enter into the market/industry.

(b) To maintain Price Mechanism: There may be possibilities of prevailing an unjustified price mechanism even in the presence of perfect competition in the market.  The government can monitor the prices fixed by the market and protect the consumers from the burden of unjustified prices.

(c) To meet Externalities: Externalities represents those activities that affect others for better or worse, without those others paying or being compensated for the activity.  Externalities exist when private costs or benefits do not equal social costs or benefits.  There are two major species, i.e., external economy and external diseconomy.  In such situation, government intervene the market with its different policies.

(d) Increasing Social Welfare and Benefits: Another strong reason of government's intervention in the market economy is the social welfare and benefit.  It is one of the duties of an elected government to work for the common welfare of the nation; to provide social goods and services, like hospitals, education facilities, parks, museums, water and sewerage, electricity, old age benefits, scholarships, etc; and the protect the people from the evils of a laissez faire economy.

(e) To meet Modern Macro-Economic Issues: It is the duty of the government to ensure that the country is in a right direction of economic development.  Government must ensure controlled inflation, greater employment opportunities, rapid technological advancement, adequate capital formation, and higher economic growth rate.

Governmental Activities / Actions taken by the Government:

Intervention of government in the economy takes a number of forms.  The government may undertake the conduct of production, or may influence private economic activity by subsidies or taxes, or they may exercise direct control over behaviour on the private sector.  Finally, governments may transfer purchasing power from some persons to others.  The government activities can be broadly classified into four groups:

(a) Allocative Activities: These activities alter the overall mix of gross national product.  The allocative activities arise out of the failure of the market mechanism to adjust the outputs of various goods in accordance with the preferences of society.  The ultimate goal of the government is to maximise per capita income.

(b) Efficiency in Resource Utilisation: Maximum efficiency in the use of resources requires the attainment of three conditions:

            (i) Attainment of least cost combinations

            (ii) Operation of the firms at the lowest long-run average cost

(iii) Provision of maximum incentive for developing and introducing new techniques.

While the private sector is presumed to be less deficient, on the whole, in attaining optimal efficiency than in attaining optimal allocation of resources, nevertheless in several situations governments may be more effective.

(c) Stabilisation and Growth Activities: are those activities reducing economic instability and unemployment and increasing the potential and actual rates of economic growth.

(d) Distributional Activities: are those activities altering the pattern of distribution of real income.

Approaches of Government Actions:

Following are the approaches or tools of government action plan against the malfunctions of market economy:

(a) Governmental Conduct of Production: The public goods such as defence, law enforcement, etc are supplied by the government, since their inherent character they cannot be produced and sold on a profit-making basis by private enterprise.

Government may also undertake education.  In order to adapt the nature and quality of education to meet community goals, governments produce the services directly, although allowing private enterprise to provide them as well for persons who prefer the private product.

Government conduct of production may also be undertaken for efficiency reasons - to avoid collection costs, to obtain advantages of longer-term investments, or to attain economies of scale.

(b) The Subsidy Approach: An alternative to governmental production is subsidisation of private producers to induce them to increase output or to undertake investments that they would not otherwise make.  Thus private schools could be subsidised to provide additional education at prices less than those equal to marginal cost. Subsidies might also be used to increase investment to lessen unemployment or to lower output when carried beyond the optimal figure.

(c) The Control Approach: For some purposes, direct control of private sector activity, with no governmental production except the limited amount involved in administration of the regulatory rules, is a satisfactory solution. Activity that gives rise to significant external costs, such as pollution, may be subjected to controls, such as requirements for adequate waste disposal.  Monopoly may be broken up by antitrust laws or monopoly firms may be subjected to detailed regulation of rates and services.  This form of regulation creates a continuous clash of interest between government and the firms.

(d) Aggregate Spending: Prevention of unemployment and attainment of the potential rate of economic growth or prevention of inflation may require fiscal and monetary policies that influence aggregate demand in the economy. To eliminate unemployment the government may raise the level of public spending and the scope of its activities beyond the levels as warranted, or may reduce taxes below the optimal levels.

(e) Transfer Payments: Transfer payments are made by the government for bringing down the inequality in income distribution more closely in line with the desired one.  Transfer payments may be 'specific' or 'non-specific', for example, scholarships in universities are specific, and provision of education and parks free of charge is non-specific.  Non-specific transfer payments or general transfer payments are made on the basis of the income status of the recipients in conjunction with various criteria of needs.  For example, old age benefits, aid for dependent children, direct relief, or negative income tax.