There are several ways to deal with market failure such as:
- the provision of public and merit goods
- indirect taxation of demerit goods
- tradable pollution permits
- provision of information
The Provision Of Public And Merit Goods
Public goods are not provided in the free market, so the Government provides them for free. Society gain the benefit of public goods whilst the Government gains the tax revenue to cover the cost. Merit goods are underprovided in the free market, so the Government provides them as well as the private sector. However, voters are often unhappy with tax increases to improve public and merit good provision. As well as this it can be expensive for the Government to provide these, incurring the opportunity cost of what they could have spent the money on.
Indirect Taxation of Demerit Goods
VAT and excise duty (tax on production or sale of a good) are added to the selling price of all goods but demerit goods in particular. This increases the prices of harmful goods and prevents their overconsumption. Some example of this are green tax (on non-environmentally friendly products), sugar tax (on soft drinks at 18p or 24p per litre depending on proportion of sugar). This internalises the externality as effectively the perpetrator is paying in advance for the damage they are causing.
Tradable Pollution Permits
This involves the government issuing a restricted number of permits, equal to the desired level of emissions. Each polluter is given a licence with an allowance to release a specific amount of pollutants. Companies can keep these or reduce emissions and make money by selling on permits to larger polluters. This reduces negative externalities as it encourages firm to be more efficient and reduce pollution.
Provision of Information
Direct education in schools and campaigns to raise awareness of issues, this includes services such as comparison websites which offer more information to consumers. By doing so, the Government avoids information failure allowing people to make informed economic decisions.
These have very clear rule and they ban or restrict activity/goods that lead to negative externalities. They have known repercussions which are meant to deter people but may not work. It also leads to the erosion of civil liberty and the Government being looked upon as creating a ‘nanny state’.
This is often used to set environmental standards and then control and monitor activity e.g. a quota or minimum standards from a business. Firms which fail to follow regulations will pay large fines, creating a disincentive to break the rule. However, some firms are willing to do so as they can afford the cost of a fine with relative ease compared to having to change their production process. These regulations are also costly and difficult to enforce.
These are government grants to encourage beneficial products that may otherwise be under-consumed. This makes them cheaper and increases demand for better products that cause less externalities. The disadvantages of subsidies include the opportunity cost to the government and potential higher taxes, the potential for firms to become inefficient if they rely on the subsidy and government failure, if they subsidise less efficient industries.