Public Sector Role in the Economy: Functions & Market Failures

Role of the Public Sector in the Economy

The public sector refers to the government and therefore includes the range of institutional units whose main functions are: to produce goods and services not intended for sale but offered free to society, and to carry out the redistribution of income or wealth.

Why Public Sector Intervention Is Necessary

Free market mechanisms present a series of failures or imperfections that can make market functioning unsatisfactory; in many cases only the public sector can address these problems. These failures are classified into three types: market failures, failures of equity, and stability failures.

Market Failures

Market failures are situations in which the market does not achieve an efficient allocation of resources in the Pareto sense. Resource allocation is Pareto efficient if it is not possible to reassign or allocate resources so as to improve the situation of any market participant without making at least one other participant worse off.

Major market failures are often linked to:

• Public goods: These goods have two key characteristics: they are non-rival in use and non-excludable by the price mechanism. Many assets are non-rival in their use, and many of those non-rival goods are also difficult to exclude people from consuming via price mechanisms. In such cases we call them public goods. Depending on the degree of rivalry and excludability, we distinguish pure public goods and impure public goods.

For example, national defense, radio broadcasts, and certain ideas or technologies are examples of pure public goods: they are non-rival and non-excludable by price. Impure public goods, by contrast, may exhibit some rivalry in use or can be partially excluded through pricing mechanisms.

The problem with public goods is that their production, like any production, incurs costs; but when goods are non-rival and non-excludable, consumers who have not paid cannot be prevented from using them. Even though these goods are highly valued by society, market provision will not supply the revenue required to cover production costs. If left entirely to private production, the market supply of public goods will be insufficient from the viewpoint of economic efficiency.

The absence of an effective market for these goods, or the existence of a market that delivers much less than what is socially desirable, justifies public sector intervention in the economy. The public sector is often the only agent capable of ensuring provision and financing of such goods by mobilizing resources across the economy, for example through taxation.