Evaluate the View That Government Intervention Can Correct All the Market Failures Caused by the Effects of Economic Activity on the Environment

Evaluate the view that government intervention can correct all the market failures caused by the effects of economic activity on the environment

Market failure occurs when the price mechanism fails to allocate scarce resources efficiently or when market forces lead to a net social welfare loss. Market failure leads to productive and allocative inefficiency. Productive inefficiency occurs when firms aren’t producing output at minimum possible cost. This means that resources are being wasted which could have been used to satisfy wants and needs elsewhere. Allocative inefficiency occurs when resources aren’t used to produce the goods and services that consumers demand. Environmental market failure stems from negative externalities arising from production or consumption. A negative externality is a negative spillover effects to third parties not involved with the consumption or production of the good. It occurs where social costs exceed private costs.

The government can intervene to improve the working of the market through; legislation and regulation, direct state provision of goods and services (privatisation), fiscal policy intervention and improving the quality and availability of information. However, government intervention can sometimes lead to government failure. Government failure occurs when government intervention to correct market failure doesn’t improve the allocation of resources or leads to a worsening of the situation. The main types and causes of government failure include: political self interest, imperfect information, unintended consequences and regulatory capture.

When there are negative environmental externalities it means that the free market equilibrium price is less than the social equilibrium price, whilst the free market equilibrium quantity is normally higher than the social equilibrium. The diagram below illustrate market failure arising from negative environmental externalities. In the diagram you can see that the marginal social cost of production is above the marginal private cost. This means that there are external costs of production in this market, the size of the cost is equal to the distance between the two cost curves. The free market equilibrium quantity demanded and supplied occurs where marginal private cost is equal to marginal benefits, this is as point Q1. Social equilibrium occurs where marginal social benefits are equal to the full costs of production, so this is where MSB meets MSC at Q2. If all costs in society were taken into account the equilibrium quantity produced and consumed would fall to Q2, whilst the price would rise to P2.

Without government intervention (in a free market) there would be allocative inefficiency, this is because the socially optimal quantity isn’t being produced and the price doesn’t include