Are Governments always better at allocation than markets?

 The market system is one in which attempts to answer the basic economic problem of resource allocation in a world of scarcity by employing the price mechanism. In such a system, market price is used to allocate resources, to signal to producers and consumers what to produce and what is available, and to provide an incentive via profits and consumer surplus to sell or buy.  This means that the market will, via an ‘invisible hand’ be expected to clear the market, by selling all available goods at the prevailing price that people are willing to pay. This is contrasted with government schemes which seek to take advantage of concentrated information to make choices according to a national plan which is then imposed on producers and consumers.

It has been recognised for centuries that the market system can be ‘allocatively efficient’ though it rarely is fully so.  Allocative efficiency is a state in which an economy produces goods so that the marginal cost of the producer is equal to the marginal utility to the consumer. It means that all consumers have the combination of goods and services which they require.

Consumers can become indifferent to the balance between two different goods so long as the combination they choose, in line with their budget, creates the same utility. This means that allocation of resources is an expression of indifference, in that the actual amount produced has to be related to that of another, with a diminishing marginal utility to more and more of any one thing.

Consumers are encouraged in such a system to rationally identify what provides them with utility, to measure it against the alternatives and in combination with other things, and to pay what they can afford. Producers are encouraged to watch where profits are rising, and produce more until they stop rising, or less if profits are falling.  This can happen very quickly, in comparison to governmental decisions which are subject to decision and implementation lags.

 In the perfect market, price is equal to the meeting point of demand and supply for the whole industry, and is given to the firm, which has to produce where its MC=MR and AC=P. Since the goods in such a market are homogenous, and consumers have perfect information and perfect knowledge, the allocation of resources at market price will ensure that marginal cost equals the Average Revenue.

Markets are rarely, however, perfect. Sometimes consumers become fixated on something other than price, and therefore develop a demand curve which changes in its elasticity and allows for producers to make ‘abnormal’ profits by producing where marginal cost equals marginal revenue but selling where average revenue is maximised. This means that producers in such markets will sell less than they could, and charge more than they might, which is inefficient.  As time goes on, consumers might become more inelastic in their demand, and producers might make higher or continuous abnormal profits, because of advertising, marketing, or behavioural and habitual choices on the part of consumers.

Some markets and goods also produce externalities which suggest that too much of a good or service is being produced at too low a price to reflect its cost to society. This describes the deadweight loss to society of a negative externality. If left alone, producers will overproduce, and consumers will underpay, a good which forces society and people not involved in the original transaction to pay the difference. This situation, which arises with demerit goods, is one in which a government could, through taxation, regulation, or provision, reset resource allocation in a better way than the market.

Similarly, merit goods will benefit society by producing a positive externality, but the market will ‘under allocate’ resources to the production of such goods or services, whilst raising their price above the social optimum. In the case of public goods, which everyone could benefit from, but which are non-rival and non-excludable, producers in the market have very little incentive to provide them at all.

Markets absolutely cannot be trusted to allocate optimally for society in the case of natural monopolies. In these, very high barriers to entry and sunk costs mean that the initial provision of a good or service is subject to extremely high average and marginal costs, but these rapidly decline for the first company which invests. Following its investment, costs fall at any reasonable level of output whereas AR (and MR) are highly inelastic, leading to huge levels of abnormal profit, transferred from consumer surplus and other potential activities. At the same time, there is no reason for any other company to invest as the market does not allow for duplication and competition without a premium on costs; this can be seen in the example of physical gas or broadband networks, or water supply systems, for instance. 

Where natural monopolies exist, government, which is not subject to a profit requirement, or non-profit companies controlled by the government, or government intervention in the market via price caps,, will ensure an allocation which is optimal for society and the economy rather than the natural monopolist. This might extend to government simply nationalising the industry (though many natural monopolies started as government companies and were then privatised.)

Some markets start off imperfectly, but rather than turning through competition, contestability and low barriers towards a more perfect allocation, instead strengthen firms and allow them to become oligopolies and monopolies. This means that firms acquire great market power and can distort supplier prices and revenues through monopsony status, distorting the wider economy in turn, as well as controlling price or supply at levels which are not optimal. Via great profits and monopsony, such firms can effectively hold back competition and limit or eliminate consumer choice, and potentially, can corrupt governments and legislators. This leads to gross inefficiency.

Government can therefore in certain circumstances improve or replace market systems and achieve a better allocation of resources for the economy. Government will not always be able to do so, however. Like markets, governments can fail too. This can be seen in public choice theory, where government companies, administrators, and regulators, could make decisions to keep themselves in jobs rather than to make allocation efficient. It could be expressed in terms of regulatory failure, where regulators make decisions for companies rather than consumers, as some allege the UK office of gas and electricity markets does with gas price caps. I

Government failure can be understood also in terms of lag times between the identification of problems, the creation of solutions, and their implementation, which could lead to governments acting after the need to do so is required in a counter-productive way. ‘Incentives’ from governments also tend towards compulsion or control, which has been shown to be less effective and subtle than the incentives of profit and marginal utility or consumer surplus in the market system when dealing with normal goods.

Governments which take over industries also have an incentive, given that their funds come from taxpayers or bondholders, to limit investment, exempt the government from environmental standards or rules, and to keep unproductive businesses which employ key voters in business. Such behaviour is ultimately very bad for economies and leads not only to inefficient allocation of resources but to resource depletion, periodic supply chain problems, a lack of investment, and a lack of development of infrastructure even amounting to famine and energy gaps, as the history of the USSR and PRC, amongst others, show. Often, government decisions to provide goods at below the optimal price which would have prevailed in markets, or free, have led to excess or infinite demand, queues, rationing, shortages, or black markets in such circumstances.

It therefore follows that markets do not always allocate resources efficiently, though the situations in which they fail could give rise to market alternatives, or simply require ‘gentle touch’ regulation; governments can in certain industries where there are barriers to entry or information, natural monopolies, or externalities, do better than the market, but can also fail if they misapply themselves.