Government Failure Versus Market Failure

In theory, government intervention in economic life is justified to stabilize the macroeconomy, correct market failures such as monopoly and externalities, and to pursue social goals such as reducing poverty and ensuring fairness in the labor market.

How does public investment fit into these justifications? Generally, a private firm will provide a good or service if it can earn a normal profit. Market failure occurs when a socially desirable good or service—that is, a good or service whose social benefits exceed its social costs—is not provided because firms would find it unprofitable to do so. For example, when the nation was developing its road system, a private firm or firms may not have been able to raise sufficient capital (let alone repay the accumulated debt) to build a private interstate highway system. Similarly, a private urban rail system may not be able to attract sufficient ridership and charge sufficiently high fares to be profitable. In such cases, the government can increase economic welfare by financing socially desirable services like roads and public transit that would not be supplied by the private sector. Thus public production of these activities is correcting a market failure.

Another area of market failure occurs when firms’ R&D creates positive spillovers to their actual or potential competitors. Innovative effort may therefore be suboptimal because knowledge can be transmitted from its creator to prospective competitors at low cost. The federal government has tried to spur innovation—and correct another potential source of market failure—by establishing the patent system and subsidizing firms through direct funding, tax credits, and competitions.