Government intervention in the marketplace is justified by market failure, that is, suboptimal market outcomes.
The micro failures of the market originate in public goods, externalities, market power, and inequity. These flaws deter the market from achieving the optimal mix of output or distribution of income.
Public goods are those that cannot be consumed exclusively; they are jointly consumed regardless of who pays. Because everyone seeks a free ride, no one demands public goods in the marketplace. Hence the market underproduces public goods.
Externalities are costs (or benefits) of a market transaction borne by a third party. Externalities create a divergence between social and private costs (or benefits), causing suboptimal market outcomes. The market overproduces goods with external costs and underproduces goods with external benefits.
Market power enables a producer to thwart market signals and maintain a suboptimal mix of output. Antitrust policy seeks to prevent or restrict market power.
The market-generated distribution of income may be regarded as unfair. This equity concern may prompt the government to intervene with taxes and transfer payments that redistribute incomes.
The macro failures of the marketplace are reflected in unemployment and inflation. Government intervention at the macro level is intended to achieve full employment and price stability.
Government failure occurs when intervention fails to improve, or even worsens, economic outcomes.
