Market Failures and Externalities

Before talking about the government’s interventions in the economy, it’s important to point out why it’s necessary in the first place. After all, if an economy served everyone’s best interests, there would be no need for regulations. However, when people’s incentives, or the motivations to do something, clash with each other, then what happens is called a market failure, where the market isn’t allocating resources properly, and thus is not producing the optimal amount of something because people aren’t behaving in the way that would allow for it to do so. Here’s a video explaining just how that works:

When people called free riders are able to exploit resources without having to pay, the tragedy of the commons occurs in which a finite resource may be overexploited because people have unrestricted access, which might make it lose all of its value.

An externality is a benefit or a harm that is caused by either demanding or supplying a product that is overall external to the market. An example of a positive consumption externality is when people consume (take) more vaccines, other people are less likely to get sick. An example of a negative production externality is when the Sriracha factories produced sauce, the fumes from the production plants made the air almost entirely unbreathable. Here’s a great video about externalities:

Monetary and Fiscal Policy

When the economy isn’t doing what it should be doing, or when the economy is producing too much or too little, intervention into the markets is necessary. When too little is produced and we need more production, expansionary policy is needed. When too much is produced, and we need less production, contractionary policy is needed.

Now economic policies that aim to correct the economy can come in two forms: monetary and fiscal policy. Monetary policy is when the Federal Reserve sets interest rates to change economic production. Fiscal policy is when the government either taxes or spends in the economy to correct it. Here’s a video on both policy types:

Let’s look at each one specifically. First with monetary policy, when the Fed increases interest rates, it is a contractionary policy because people will no longer want to borrow as much in order to purchase things because it is more expensive, thus dropping GDP. Also, businesses won’t be willing to borrow in order to invest in capital that can increase the output they can produce. However, when interest rates drop, borrowing becomes more affordable and thus more appealing.

With fiscal policy, when the government taxes people, less money is able to be spent in the economy, so it is a contractionary policy. When taxes are cut, meaning they decrease, then it is an expansionary policy as more money is available to be used. Government spending of course is an expansionary policy, as it purchases products in the economy that would have otherwise not been purchased. Cutting government spending therefore is a contractionary policy.

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