MARKET FAILURE

Why Do Many Economists Believe That Taxes And Subsidies Should Be Used To Correct Market Failure?

Why Do Many Economists Believe That Taxes And Subsidies Should Be Used To Correct Market Failure?

Introduction

In economics, market failure is a case where the market fails in the optimal allocation of economic resources and goods and services. This is an eminently economic policy concept and therefore controversial, insofar as it serves to justify policy interventions aimed at correcting, if not eliminating, the markets, through peaceful cooperation amongst economic agents (Sullivan & Sheffrin 2007 p. 36). The traditional classification of market failure include monopoly (and monopsony), and the lack of information asymmetries and external effects (externalities). Two most commonly applied tools used by governments to correct market failures are taxes and subsidies (Morris 2007, p. 329). In this essay, I will explore the arguments by many economists who contend that taxes and subsidies are useful in correcting market failure. The essay reviews the mechanisms in which taxes and subsidies operate within an economic system and then traces the theoretical basis of government's intervention in using these tools to correct market failure.

Discussion

Economic theory acknowledges that there are times when markets do not lead spontaneously to allocative efficiency. BATOR shows that market failure occurs when the conditions for the first welfare theorem are not fulfilled, as is the case where there are indivisibilities in consumption, increasing returns to scale in production, and externalities. For him these are all reasons for state intervention (Krugman 2009 p. 95).

Subsidies are a means of rewarding actors for activities they may not have undertaken otherwise. Subsidies may be particularly useful when the actor is not legally obligated to undertake an activity or where restrictions on activities are not feasible for economic, political, or social reasons. For example, enforcement of nonpoint pollution restrictions in agriculture is costly and imperfect and farmers may be incapable, financially or politically, of controls. Pollution reduction may be achieved by subsidizing best management practices or the use of environmentally friendly fuels may be encouraged through subsidies to production or demand. Subsidies may be direct payments, such as price supports for crops used in ethanol production, or favored tax treatment, such as reductions in ethanol fuel taxes (Morris 2007, p. 341).

Direct subsidies are used to fund basic scientific research and development projects (grants), the introduction of new techniques and retraining. On the one hand, subsidies may encourage the development of promising industries, on the other to support unprofitable businesses, but strategically important enterprises (with all the consequences of state intervention in the market economy). Agricultural production is one such business that is subsidized through compensation payments. Indirect subsidies are given by means of fiscal and monetary policies. The State applies preferential taxation of profits of corporations, practicing the return of direct taxes and customs duties, government guarantees and insurance of deposits, export credits, private associations to provide soft loans (Sullivan & Sheffrin 2007 p. 51).

On the other hand, taxes are mandatory payments for individuals and companies to ...