It is a situation where a free market fails in allocating resources or distributing goods and services efficiently.
It is government’s interference in country’s economic activities due to free market failures. Its main purpose is to increase social welfare and to check if the private benefit is not taken at the cost of social benefit.
So basically government intervenes to correct free market failures for instance:
1. Pure public goods – These goods or services are provided with little or no profit to the society and due to this, it becomes the major reason for market failures as private companies cannot offer these services with low or no profit. These goods and services have two main characteristics that are both non-excludable and non-rivalry. Non-excludable means no member of the society is excluded from using these goods and services and non-rivalry means consumption of one good or services by one person doesn’t affect its amount available to others.
2. Pure Monopoly – It exists when a single company is the sole producer of a particular product in the market. This situation could lead to high prices, quality reduction, output restrictions, high barriers or no entry to competitors, etc. This would hit hard on consumers and therefore the government has to intervene and pose certain regulations to maintain a balance.
3. Externalities – It is a benefit or a drawback experienced by an unassociated third party or society due to economic activity done by any individual, company or industry without being reflected in the final outcome of that activity. There are two types of externalities.
- Negative externality – It is a negative result of economic activity or a drawback experienced by unassociated third party or society without being directly or indirectly involved in that activity, for example, the release of waste chemicals by chemical industries into the nearby river, lake or pond can badly affect the people residing in that area. The government can impose high taxes on such goods and services which create negative externalities, higher production cost will ultimately discourage the production of such harmful chemicals.
- Positive externality – It is a positive result of economic activity or a benefit experienced by unassociated third party or society without being directly or indirectly involved in that activity, for example, organic farming is a farming method which discourages usage of chemical fertilizers and pesticides and instead promotes using of organic fertilizers or manures and techniques like crop rotation or mixed cropping. This type of farming is beneficial for the environment as it reduces soil degradation and pollution. It also promotes biological productivity. The government can provide subsidies and grants to promote and encourage such positive externalities.