During the history governments have had various impacts over the economy. For example monarchs had unlimited power upon the economy during the middle ages, but on the 18th century a famous Scotsman A. Smith issued his book "An Inquiry into the Nature and Causes of the Wealth of Nations", where he suggested that the government ought to leave the economy alone, then it will reach to optimum allocation of resources. His idea of the "invisible hand" became a fundamental part of the governments economic policies until Keynes ideas were accepted in 1940ies. A. Smith's principle was, that as the exchange of goods and services is voluntary, it will only take place when it is profitable to both sides. So if the economy is left alone the optimum allocation of resources through these exchanges (using money as a medium) will occur.
It seems from above that there is no need for government. It is not quite so. The exactly efficient allocation of resources (or Pareto efficiency) will occur only in markets with perfect competition, the markets with imperfect competition (monopoly, oligopoly, monopolistic competition) will have numerous inefficiencies and the welfare is lost, some of which could be "brought back" by government regulation.
If we consider the monopoly, the monopolist bases its decisions to produce in the basis of marginal revenue (they will produce where MC=MR, so at output q). This can be shown on the diagram:
As the socially efficient production will occur when AR=AC (at q1, where no abnormal profits are made), where the quantity produced is bigger and the wants of all consumers are satisfied. The quantity when MR=MC is less, so not all the wants are satisfied, so there is a loss of welfare. Also if there is no competition the efficiency tends to be low and welfare is lost again.
The income might be unevenly distributed towards producers, too, which is undesirable. The monopoly might also use price discrimination, but this will usually have equating effect as firm is charging more for people that are prepared to pay (usually richer people), and less for people who are not. So it might make the distribution of income more even.
Other modifying factors are the economies of scales made in monopoly because of the larger scale production. The intervention to create condition AC=AR would be very difficult as the firm will have MR<0 in the last units produced.
Governments can act on that by regulating the monopoly (the Monopolies and Restrictive Practices Act of 1948). It can also impose a minimum price (the same idea is used by imposing minimum wages) or nationalise the industry. The latter is often done at the case of natural monopolies where the service is provided much more effectively by one firm than by several firms. The disadvantages of such government intervention are the high administration costs and lack of motivation and drive in state industries which will lead to even greater loss of welfare.
Another case of possible government intervention arises from production of externalities. They are said to be existing when the actions of producers or consumers affect not only themselves, but also third parties other than through the working of the price mechanism, or in other words, when costs (or benefits) are not received by those taking the decisions. Smith, and later on the other "classical economists", divided the costs of producing (and consuming) into two categories: private and social costs. Same categories apply to benefits. The individuals make their decisions to purchase and firms make their decisions to produce usually only relating to their private costs. So according to the theory, for example, the firm producing fertilisers will make its decisions of which production method to use only based on its private costs, and will not account the pollution, which might arise. There are cases showing that it is not so for every firm, but it is the usual pattern. Some firms care about the environment, but if only one firm would account the social costs and others do not, then this firm will have larger costs and can end up in liquidation. The cheapest technology will usually pollute most and as this is chosen the environment we left to future generations will be in awful state. This was an example of externalty (pollution) arising from the production and this is a case when government should intervene and correct the failure.
The other cases of externalities arising, besides those arising from production, are those arising from consumption. The best example in here is the congestion of the roads when too many people are using them. Motorists base their decisions to drive from one place to another only on the bases of their private costs (e.g., the cost of petrol), but not taking into account the amount of time wasted by other drivers because of them. If they would be aware of them, they might not use the roads so often.
Besides the external costs to the society, external benefits also exist. For example, if I buy a telephone other people will also benefit from that, because they can now make a contact with me much quicker and the utility of their telephones increases. Other external benefits include the decrease in pollution when people use public transport etc.
These three examples where externalities arising from production on production (pollution), consumption on consumption (motorists), consumption on production (firms using the clean water) and production on consumption (phones) respectively. The effects upon the market price are showed in the diagram below, where the supply of the good or service is represented by private and social costs it has(SMC and PMC) and demand is represented by its social or personal benefit(SMB/PMB). We can use PMC and PMB in the case of perfect competition, where the supply is represented by the sum of the individual firm's marginal costs.
Negative externalities Positive externalities
Q0= socially efficient level of usage
Q1= free market equilibrium
ABC-loss of welfare due to overproduction
Q0= socially efficient level of usage
Q1= free market equilibrium
ABC-loss of welfare due to underproduction
It is quite obvious that government would try to decrease the production at the first case and increase at the second case. It can do that by means of subsidies and taxes. The tax will shift the PMC curve upward by the amount of tax (in my example right tax from the Q0 unit would be AB). The subsidies will shift the PMC curve downwards by the amount of subsidy (in my example the right subsidy would be AB to eliminate the lost of welfare). For example the trains going to London every morning are expensive to run and would be unprofitable. Anyway the jam that would result if all the people would go to London by car would have enormous external costs, so the state subsidies the train transport.
In theory the other users as well could compensate the loss of somebody's benefit by the decrease of their cost caused by the first user not using the service. In first example, if the equilibrium quantity would be between Q0 and Q1 then the persons who lost before because SMC was higher could now give that money to people who did not use the service for compensation and still gain in welfare. This kind of solution is called a bargaining solution as producers usually bargain about the sum of the compensation. This kind of behaviour is described by the Coase theorem, put into practice by S. Cheung with its works on bees and orchards and how bee-keepers paid orchard owners for the privilege of grazing their bees on those fruit trees providing better nectar and vice-versa.
The problem with this kind of compensating arises from the difficulty of calculating it, because benefits differ from consumer to consumer. Also the cost of calculating these compensations might be bigger than the benefit itself.
On the other hand the action can be taken against the production of goods having external costs. Their production can be limited or totally banned or the pollution might be totally banned. These options are not very favourable, as the ban of some products too quickly good lead to some other crises. The best method seems to be to price the external cost and tax the firms accordingly as then some of the firms (who find it beneficial to do so) will change to other methods, and if the cost of changing to different methods of production is too high they will pay the tax. This kind of taxation carries also ethical disadvantages, e.g., how can one price the lives lost by cancer because of a pollution?
Intervention might also be applicable in the case of public goods. Public goods are defined as products where, for any given output, consumption by additional consumers does not reduce the quantity consumed by existing consumers. Public goods are law, parks, street-lighting etc. As there is no marginal cost in producing the public goods, it is generally argued that they must be provided free of charge, because otherwise the people who benefit less than the cost of using the public good, will not use it. That will lead to a loss of welfare. Also the goods are mostly non-excludable, that means that if once provided everybody can use them, which when charged will lead to "free-riding". So the solution is, that state must provide these goods and finance them from taxes collected from everybody.
The final case of possible government intervention is when the merit goods are involved. These are products generally not distributed by means of the price system, but on the basis of merit or need, because people although having perfect knowledge would purchase the wrong amount of them. These goods can be supplied by free market, but not on the right quantity. Merit goods are, for example, education and to some extent the health-care. They are provided by state on the basis of "good for you". Health care carries also external benefits. For example if one is vaccinated it benefits the others as it decreases the risk of epidemic diseases.
These were possible interventions suggested by classical economist to correct the market failure. Keynes and socialists suggested much more government intervention, for example the over-supply of spending by government to create new jobs and the increasing tax rate to redistribute the income more equally, but these are not so strictly defined as the failures of market forces and thus are not strictly relevant to this essay.