Should Governments Only Intervene in Markets Where Resources Are Under-Allocated?

Question

Given that resources are scarce, governments must make important decisions on when to intervene in the free market. In some cases, resources can be under-allocated if there is factor immobility in the market.

(b) Assess whether governments should only intervene in markets where resources are under-allocated. [15]

Answer

Thesis. A government intervenes in the free market to correct market failure and pursue its microeconomic objectives of efficiency and equity. Under-allocation — too few resources channelled to a good — is one symptom of market failure, but it is not the only one: over-allocation is equally a failure, and equity concerns can warrant intervention independent of either. I argue that governments should not confine intervention to under-allocated markets; they should intervene wherever there is allocative inefficiency or inequity, subject to the severity and urgency of the failure given a limited budget.

Governments should intervene where resources are under-allocated. Market failure can leave a good under-produced or under-consumed relative to the social optimum. Factor immobility is one cause: labour and capital that are unable or unwilling to move between uses cannot be allocated efficiently. Occupational immobility, for instance, arises when workers willing and able to work cannot fill vacancies because their skills do not match what employers need — many firms seeking software engineers while too few workers hold the relevant skills. Labour is then under-allocated to the industries that demand it, firms cannot produce the allocatively efficient quantity, and welfare falls. In such cases the government should intervene — for example through retraining and skills-upgrading schemes — to improve allocative efficiency.

Evaluation. Yet even where resources are under-allocated, intervention is not automatically warranted. Because resources are scarce and the government’s budget is limited, it must weigh the severity and urgency of the under-allocation before acting. A mild or non-pressing under-allocation may not justify the opportunity cost of the funds intervention would consume.

Governments should equally intervene where resources are over-allocated. Over-allocation is a symmetric market failure that an “under-allocation only” rule would wrongly ignore. Consider imperfect information in the market for cigarettes: through ignorance, consumers under-estimate the true private cost of smoking — the elevated risk of lung cancer and heart disease — so their perceived marginal private cost falls short of the actual marginal private cost. Assuming no externalities, consumers settle at $Q_m$ where $MPC_{\text{perceived}} = MPB$, above the socially optimal $Q_s$ where $MPC_{\text{actual}} = MPB$. The gap $Q_m - Q_s$ is the over-consumption and hence over-allocation of resources to cigarettes. (This is examined in prose; the 9570 syllabus carries no imperfect-information diagram.) Here too the government should intervene — through regulation, taxation or correcting the externality where one is present — to restore allocative efficiency. That the failure manifests as over-allocation rather than under-allocation is no reason to withhold intervention.

Equity provides a further, independent ground. Beyond efficiency, the government also pursues equity — a fair distribution of welfare so that essential goods reach those who need them. A market may allocate resources efficiently yet still leave a distribution the government judges unfair, warranting intervention (through subsidies or transfers) on grounds that have nothing to do with whether resources are under- or over-allocated.

Conclusion. Governments should not restrict intervention to under-allocated markets. The case for intervention rests on the presence of allocative inefficiency or inequity, and inefficiency arises just as readily from over-allocation as from under-allocation. The binding qualification is not the direction of the misallocation but its severity and urgency against a limited budget: more severe failures, such as the negative externalities of drugs (over-allocation), and more urgent ones, such as information failure during a pandemic (under-allocation), are prioritised. A rational government therefore intervenes across all markets where efficiency or equity is compromised, allocating its scarce budget to the failures where the welfare gain is greatest — not according to whether resources happen to be under-allocated.