Uneven distribution of income and wealth is another problem that the government has to try to influence to keep from market failure. Income is the flow of money received in a year through wages, rent, interest etc. Wealth is the stock of goods and physical assets owned by the population like, houses and land. The fact that those with more buying power have the most influence on what is produced (a.k.a. consumer sovereignty) causes an unequal distribution of income and wealth. This is why the government uses polices to redistribute income. They do this through taxation where a percentage of the cost of goods and income is paid to the government. In general, people with a higher income pay a bigger portion of their income in taxes than people with a low income, this is known as progressive taxation. Transfer payments also help to redistribute money by benefiting those with more children, people with no jobs and providing pensions to the retired. This way money transfers from the rich to the poor. To keep these poorer people from having to pay for their children’s schools, hospitals and public transport, these merit goods are provided or subsidized by the government.
Governments have to set up polices for merit goods, public goods and demerit goods. Without government intervention merit goods and public good would be underprovided or not provided at all. This would be yet again, another cost for the poor people. Demerit goods would be over provided without government intervention because no laws or restrictions would be put against them therefore, their supply would not be controlled.
When there is no free market mechanism, for instance when one company monopolises a certain supply or manufacturer of goods, prices can spin upwards out of control. The lack of competition allows these companies to set their prices at virtually any level without losing demand for their products. In an ogliopolistic market the main producers can come together to form a cartel, where the all decide to raise their prices together and control supply. Governments have to set up policies to reduce and eliminate restrictive practices that can put an unfair lead to one company or individual. Antitrust laws make it difficult for these cartels and monopolies to exist, so by enforcing them the government improves competition and avoids price fixing. To prevent one company from having a majority stake in the market the government has put in place the monopoly and merger commission. This commission researches the relative competitive position of companies, which want to merge to avoid a too strong monopolistic position in a certain segment of the market. This commission can effectively block companies from merging together. Governments can also start nationalization to diminish the domination of monopolies.
Externalities are another problem that can lead to market failure. These are side effects of economic activity that can bring benefits or hidden cost to a transaction part of the full opportunity cost of an economic decision. People who are no part of the principal economic activity might either benefit through positive externalities or suffer a cost because of negative externalities. An example of a positive externality is the increase in sales of stores around a sports arena during a sporting match. These stores are experiencing sales benefits from the match. While a negative externality is the cost of double pane windows for a house next to the highway. The owner suffers a cost from the highway near his home. Private or internal costs and benefits are those that are only concerning those individuals participating in the market. While externalities are the costs and benefits to those who are not directly involved. Social costs and benefits are both external and internal together. When social costs do no equal private costs negative or positive externalities must occur.
For all externalities, companies must go through a cost-benefit analysis to evaluate whether a certain economic decision is worth making. For example a new office building for a company, the costs would be the actual building costs, the wages of the new employees, and the cost of maintenance. The benefits would be, greater office space, a possible increase in market share because of increased productivity of the work force. By knowing both the costs and benefits each company can make a trade off to decide the real profit of the decision.
Governments employ many policies to deal with externalities by promoting positive externalities and penalizing negative externalities. Advertising campaigns are used to encourage positive externalities. For example, the use of contraception. This eliminates the cost of teenage birthrates and the spread of aids.
Subsidies are also provided to encourage a positive externality by aiding the promotion of a product. For example the subsidy of pollution free cars, to eliminate the cost of pollution.
Provision and finance of merit goods encourages positive externalities by increasing productivity and GNP. By providing schools and hospitals the education levels rise as well as the percentage of the population able to work. Goods can also be made compulsory to enforce the use of their positive externalities. For example, the law of helmets being used on scooters and motorbikes.
Governments use some policies to discourage negative externalities. They use taxation to slightly reduce supply and raise prices so that demand falls for the product. This way the negative externality is internalized. For example, the gas-guzzler tax in which the taxes for a polluting car are increased to discourage people from buying them.
Permits are implied so that people have to pay to have a right to a negative externality. The more people who want to use the externality, the more demand for the permit, which leads to an increase in cost, and therefore a drop in demand and again, a reduction in negative externalities. Partial bans can be imposed to reduce the amount of users for example the smoking age of 18 in America. Complete bans for undesirable goods can also be put into place to stop the negative externality completely. Although, this is never 100% successful because of the resulting black-market for, for example, cocaine. Litigation is another form or restriction where the legal system is used to discourage negative externalties.
