A) Understanding of government failure as intervention that results in a net welfare loss:
Government failure occurs when resource allocation in a given market is more inefficient then before the government intervened. As a result of this, the net welfare loss to society increases rather than decreases, which is the opposite of what the government aims to achieve when intervening in markets.
B) Causes of government failure:
Government failure exists due to a range of different factors. However, in all cases, the costs of the government intervening outweigh the benefits. This leads to even worse outcomes in the market and therefore the welfare loss to society increases. Government failure can be extremely costly to the government considering how much money is needed to intervene in the market e.g. through a subsidy. Therefore for it to lead to even worse outcomes then before is extremely wasteful.
Distortion of price signals
This can occur when the government gives out subsidies to firms. Information gaps can often lead to the government giving out subsidies to firms that are inefficient. This causes firms to become reliant on government subsidies rather than trying to cut down waste in order to become more competitive in the market. If it was left to the free market, inefficient firms wouldn’t survive in the market. However, government intervention has distorted these price signals as now subsidised firms have a higher level of revenue than if they weren’t subsided. This means that they achieve profit levels high enough to remain in the market. If the government hadn’t intervened then the firms would not be breaking even and therefore would be forced out of the market. Overall, this leads to an inefficient allocation of resources as a result of the price mechanism not being able to act freely.
Unintended consequences
Another example can often be seen when setting levels of regulation. The aim of this is too reduce the negative externalities that occur through overproduction. However, governments can often set regulation levels too high. This can cause a massive increase in the costs of production for firms. As a result of this, they are unable to make a profit in the market and therefore more inefficient firms will be forced out of the market. This is an unintended consequence of government intervention and will lead to outcomes that are much worse than before. The socially optimum level will actually be lower than before as fewer firms are in the market, causing overall output in the market to fall.
Subsidies can also be used an example of unintended consequences derived from government intervention. The aim of a subsidy is to increase the quantity of goods/services that a firm produces. However, subsidies can often be given to inefficient firms. As a result of this, these firms rely on the subsidy in order to survive in the market which is not the intended outcome when subsidising firms. If it was left up to the free market then inefficient firms wouldn’t be able to stay in the market as they’re not competitive enough. This can lead to the government spending lots of money on subsidies while not improving market conditions. As a result of this, government failure occurs.
Excessive administrative costs
A good example of this is when the government intervenes in a market where there is excessive pollution, implementing a trade pollution permit scheme. The cost of policing the pollution levels of firms involved can be extremely high. Therefore, in order for the intervention to be successful, the benefits have to be even higher than this. However, this is a more difficult outcome to achieve compared to other types of intervention which are less expensive. As a result of this, intervention through schemes such as tradable pollution permits are more likely to end up in government failure as the costs are more likely to outweigh the benefits.
Information gaps
Governments can often intervene in markets without having a perfect level of information about that market. Just like firms and consumers can have information gaps, so can the government. This leads them to making irrational decisions. For example, when implementing regulations to fix a market failure, if the government does not have perfect information then they are more likely to set regulations at a level different from the socially optimal level. Either too much regulation can be set, forcing firms out of the market, or too little regulation can be set, having minimal impact and therefore not solving the market failure. Overall, when taking into account the cost of the government intervening in the market, an outcome that does not fix the market failure will result in government failure.
C) Government failure in various markets
In 2008 Mexico extended a scheme using licence plates that required cars to stay off the road at least once a week to Saturdays also. Analysis indicated that doing so would result in a 16% decrease in nitrogen oxides and large particulates. The policy aimed at reducing pollution levels in Mexico City which are some of the worst in the world.