Ace Your Economics Exam with Expert Help – Sample Question & Solution

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Question:
Discuss the role of government intervention in correcting market failures, focusing on externalities and public goods. Use relevant economic theories to justify your response.

Solution:
Market failures occur when the free market fails to allocate resources efficiently, leading to outcomes that do not maximize social welfare. Two primary causes of market failure are externalities and public goods, both of which justify government intervention.

1. Externalities and Government Intervention
Externalities arise when the actions of individuals or firms affect third parties without compensation. These can be positive (benefits to others, such as education) or negative (costs imposed on others, such as pollution). Without government intervention, negative externalities lead to overproduction of harmful goods, while positive externalities result in underproduction of beneficial goods.

To address negative externalities, governments use:

Pigovian taxes: Levied on goods that generate harmful externalities, such as carbon taxes on emissions.

Regulations and bans: Laws that set pollution limits or restrict harmful activities.

For positive externalities, governments use:

Subsidies: Financial incentives for goods that yield social benefits, like education and vaccinations.

Public provision: Direct government involvement, such as offering free schooling or healthcare.

2. Public Goods and Government Role
Public goods are characterized by non-excludability (no one can be excluded from using them) and non-rivalry (one person’s use does not reduce availability to others). Classic examples include national defense and public parks.

In a free-market system, public goods suffer from the free-rider problem, where individuals consume benefits without paying, leading to underproduction. To resolve this, governments step in through:

Direct provision: Governments produce and finance essential public goods.

Taxation: Compulsory payments ensure collective funding for these goods.

Conclusion
Government intervention is essential to correct market failures, ensuring a more efficient allocation of resources. Through targeted policies such as taxation, subsidies, and public provision, authorities can address externalities and ensure adequate supply of public goods. Without such measures, market inefficiencies would persist, leading to social and economic imbalances.

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