Government Failure

28 July 2017 by Tejvan Pettinger

Definition of government failure:

This occurs when government intervention in the economy causes an inefficient allocation of resources
and a decline in economic welfare.

Often government failure arises from an attempt to solve market failure but creates a different set of
problems.

Reasons for government failure

 Lack of incentives: In the public sector, there is limited or no profit motive. Because workers and
managers lack incentives to improve services and cut costs it can lead to inefficiency. For
example, the public sector may be more prone to over-staffing. The government may be
reluctant to make people redundant because of the political costs associated with
unemployment.

 Poor information, politicians may have poor information about the type of service to provide.
Politicians may not be experts in their department but concentrate on their political ideology.

 Political interference Decisions made for short-term political gain – rather than sound
economics, e.g. keep on unproductive workers. e.g. politicians may take the short-term view
rather than considering the long-term effects
  No consistency. Change of government often leads to change of approach and new political
initiatives

 Moral hazard. The government may offer a guarantee to all bank deposits to protect the
financial system, but this could encourage banks to take risks – because they know they can be
bailed out by the government.

 Regulatory capture – When government agencies become too friendly with business/groups
they are trying to regulate

 Unintended consequences. Policies to reduce relative poverty ‘means-tested benefits’ can

create ‘welfare dependency.’ For those on means-tested benefits, moving from benefits to work
could lead to very little extra income because of lost benefits and higher taxes. Benefits can then
solve one problem of relative poverty but create new problems of higher spending and lower
levels of labour market participation.

 Special interest groups. In the US, many types of business have special tax credits for their
industry; this makes it difficult to reform the tax system, and leads to horizontal inequality –
business with same income can be treated differently. In the Europe, farmers receive substantial
financial support from the EU, making it difficult to reform CAP. Once people are used to
receiving subsidies it can be politically difficult for the government to take it away.

Examples of government failure

 White elephant projects. Concorde supersonic airliner was a joint venture between British and
French government. It was seen as a prestigious venture, so even when studies suggested it was
uneconomic, politicians didn’t want to back-track but kept putting in public money. Developing
Concorde cost the British and French governments £1.1 billion (about £11 billion in 2003 prices)
before it even went into service—nearly ten times what was budgeted. (Economist)

 Tax leads to fly-tipping. A tax on rubbish is a policy to overcome market failure. To try and
include the external cost of rubbish in the price. However, a tax on rubbish can lead to illegal
dumping of rubbish on the roads. This creates a different problem of fly-tipping.

 Common Agricultural Policy. The CAP was intended to solve market failure in agriculture and
protect farmers incomes, but the EU didn’t take into account minimum prices would lead to
over-supply; there were also unintended consequences of trade wars and environmental
problems from farmers trying to supply as much as they could. See: CAP.

 Prohibition strengthened the mafia. When the government banned alcohol in the US, it caused
the mafia to supply alcohol, leading to a rise in organised crime.

Overcoming government failure

There are various things the government can try and do to overcome government failure

 Give performance targets/profit incentives

 Competitive tendering – where public sector bodies face competition from the private sector for
the right to run a public service.
  Employing outside private sector consultants to make decisions about how to cut costs.

 Delegating certain decisions to non-political bodies. For example, setting interest rates was
given to the Bank of England as politicians often set interest rates for political reasons.

 See also: How to overcome government failure

Evaluation of government failure

It should be remembered many public services are not subject to the same profit goals. It is difficult to
give a profit motive in health or education because the goal is not profit but the quality of service.

Also, although government failure is a real issue, it is often much less than the problems arising from
market failure. Just because government intervention may be inefficient, doesn’t mean we should try to
tackle problems of pollution e.t.c.

Government Failure

Government Failure

Government failure occurs when the result of government intervention in the economy results in a net
loss of economic welfare, in example the social cost of the intervention is greater than the social benefit.

It can happen for any of the following reasons:

Distortion of Price Signals

Indirect taxes and subsidies may lead to a misallocation of resources, particularly when the reason for
the tax or subsidy is NOT to correct for a market failure. In many countries agriculture and other
industries considered strategically important may be protected from foreign competition by taxing
imports. This will lead to higher levels of domestic production at the expense of producers overseas. This
can create a welfare loss to consumers, as food prices rise. It also results in inefficiency, as high cost
domestic producers displace low cost foreign producers.

A subsidy to domestic producers will also lead to increased domestic output at the expense of foreign
producers, and therefore causes a loss of efficiency, but it won’t cause food prices to rise. It also results
in a redistribution of income from taxpayers, who bear the cost of the subsidy, to domestic producers.
This may not necessarily be considered desirable if the producers are already well off.

In Europe, most governments have imposed minimum wages in particular industries or across the
economy as a whole. In Britain it is unlawful to pay an adult over 21 less than the National Living Wage,
which will rise to £9.00 an hour by 2020. This may benefit workers who keep their jobs, at the expense
of an increase in unemployment as firms lay off some workers or invest in machines to do the work
instead.

Generous benefits for people who are not working may reduce incentives for them to find work. This
may also lead to higher levels of unemployment and a loss of efficiency as the economy is not operating
on its production possibility frontier.
Excessive Administrative Costs

Some forms of intervention by government may be costly to implement and produce little benefit. Some
regulations of businesses, such as health and safety may cost firms a lot of money to put in place and
taxpayers have to pay for the cost of inspection and enforcement. If the regulation does not make much
difference to employees’ health and safety, it may not be worthwhile. The same point may apply to
excessive environmental regulations that are costly to enforce but do little to improve the environment.

Unintended Consequences

Sometimes government intervention can have undesirable consequences that were not foreseen. A
recent example is the Renewable Heat Incentive in Northern Ireland, that paid a subsidy to businesses
who used wood burners rather than fossil fuel boilers. The subsidy turned out to be more than the cost
of the wood, so businesses had a perverse incentive to burn as much wood as possible, just to collect
more in subsidy. Similarly, the Common Agricultural Policy of the EU used to give farmers guaranteed
prices for their produce, with the EU buying up any output farmers could not sell. This gave farmers an
incentive to overproduce and lead to beef and butter ‘mountains’ and milk ‘lakes’ across Europe, at vast
cost to taxpayers.

Information Gaps

Governments spend a lot of money on expensive projects that the private sector might regard as too
risky. This is a legitimate thing for governments to do, but they may underestimate the costs and/or
overestimate the benefits. In the 1960s the government constructed a huge reservoir in the North East
of England called Kielder Water, believing it was necessary to ensure an adequate supply of water for
industrial users in the region. But over the next 20 years there was a big decline in industries such as
heavy engineering, shipbuilding and steel, which were all big users of water. The reservoir cost many
£millions and was not needed.

Government Failure

Government intervention to resolve market failures, and to manage the macroeconomy, can fail to
achieve a socially efficient allocation of resources. Government failure is commonly defined as a
situation where government intervention in the economy creates inefficiency and leads to a
misallocation of scarce resources.

Examples of government failure include:

Distortion of the price mechanism

Intervention through taxation, through subsidisation, or via other interventions can result in a distortion
of markets and a weakening of the operation of the price mechanism. Taxes and subsidies on goods and
services can artificially raise or lower prices and distort how markets work to allocate scarce resources.

Direct taxation can create a disincentive effect for households and firms. We have seen that taxes on
harmful demerit goods, where demand is inelastic, may simply mean that more income is allocated to
expenditure on harmful goods, and hence less income is available for spending on beneficial goods.
The same is possible with the imposition of a minimum price, such as the one on alcohol, where
spending is distorted with the consumer allocating more income to alcohol rather than less.

Subsidies can be criticised as they can encourage the wasteful misuse or over-use of scarce resources.
For example, free healthcare can result in doctors’ waiting rooms becoming become full with the
malingerers and the so-called ‘worried well’. This can result in a waste of public resources and a denial
of access to these services by those in genuine need.

Subsidies may also protect inefficient firms from open competition as well as creating artificial barriers
to entry for new firms – given that prices are kept ‘artificially’ low. Subsidies, and other assistance, can
lead to the wider problem of moral hazard.

Taxation can also distort behaviour by encouraging people to either avoid taxes (which is the attempt to
find legal loopholes in the tax system) or evade taxes (which is illegal) through criminal activity such as
smuggling and the use of black markets.

Governments can also fix prices, such as minimum and maximum prices, but this can create distortions
which can lead to:

 Shortages, which may arise when government fixes price below the market rate. Because public
healthcare is provide free at the point of consumption there will be long waiting lists for
treatment.

 Surpluses, which may arise when government fixes prices above the natural market rate, as
supply will exceed demand. For example, guaranteeing farmers a high price encourages over-
production and wasteful surpluses. Setting a ‘minimum wage’ is likely to create an excess of
supply of labour in markets where the ‘market clearing equilibrium’ is less than the minimum.

Costs of administration

Excessive bureaucracy is also a potential government failure. This is caused by the public sector when it
tries to solve the principal-agent problem. Government must appoint bureaucrats to ensure that its
objectives are pursued by the managers of public sector organisations, such as the NHS.

Intervention through the imposition of taxes, or through legislation incurs various administration costs.
Taxes must be collected through government departments, including Her Majesty’s Customs and
Excise (HMRC) and laws must be enforced through the legal system. Both of these incur considerable
costs.

Imperfect knowledge

Information failure is also an issue for governments, given that government and policy makers do not
necessarily ‘know’ enough to enable them to make effective decisions about the best way to allocate
scarce resources.

Government intervention requires decisions to be made about the degree of intervention and its timing.
In order to prevent or reduce market failures, tax rates need to be set and level of subsidies and
minimum prices must be decided. However, governments and agencies do not have access to all the
knowledge that it required to set the necessary rate or level to achieve the desired outcome. For
example, if the government wishes to get 3 million students to attend university each year it may decide
to subsidise tuition fees, but it is highly unlikely that it could achieve such a target with precision.

Many economists believe in the efficient market hypothesis,  which assumes that the market will always
contain more information than any individual or government. The implication is that market prices and
market movements should be free from interference because markets cannot be improved upon by
individuals or governments.

Critics of intervention and supporters of free markets, such a Hayek, argue that it is impossible for a
group of planners to have as much knowledge as is contained within a free market, and that
government intervention almost inevitably is less efficient as compared with allowed resources to be
allocated through freely interacting market forces.

Law of unintended consequences

Finally, and related to the idea of information gaps, is idea that intervention can result in outcomes
which were entirely unplanned and unpredicted. Traffic calming measures may encourage drivers to
speed up in areas or stretches of roads between speed bumps, cameras or warning signs – with a result
that ‘average’ speeds increase. This resulted in new systems which track average speeds. However, in an
average speed area drivers may drive a below the speed limit so that they can speed up along other
parts of the journey.

When assessing any intervention in the micro or macroeconomy government failures are a common
source of evaluation points.