A) Understanding government failure

Governments normally intervene because they want to reduce market failure and move a market closer to the socially optimum level.

However, intervention can sometimes create an outcome which is worse than before. If resources are allocated less efficiently and the welfare loss to society increases, government failure has occurred.

Government intervention can also be expensive. For a policy to improve welfare, the benefits gained from the intervention need to outweigh the costs involved.

B) Causes of government failure

Distortion of price signals

Government intervention can prevent the price mechanism from operating freely.

For example, subsidies may allow inefficient firms to remain in a market even though they would otherwise be unable to compete. The subsidy increases their revenue and reduces the pressure on them to cut costs or become more efficient.

Unintended consequences

A policy may produce effects which the government did not intend. For example, regulation designed to reduce a negative externality may increase firms’ costs by more than expected.

If regulation is set too strictly, some firms may be forced out of the market and output could fall by more than the government intended.

Excessive administrative costs

Some forms of intervention can be expensive to administer and enforce.

For example, a tradable pollution permit scheme requires the government to monitor firms’ pollution levels and ensure that the rules are being followed. If these costs are very high, they can reduce the overall benefit gained from the policy.

Information gaps

Governments do not have perfect information about every market. This makes it difficult to know the exact level of intervention which is needed.

For example, regulation may be set too high and impose excessive costs on firms, or it may be set too low and have very little effect on the original market failure.

C) Why government failure matters

The success of government intervention depends on whether the policy produces greater benefits than costs.

A policy may have a sensible objective but still fail because consumers or firms respond differently from what the government expected, because implementation is too expensive or because the government does not have enough information.

What the full guide adds

For this topic, the full AS guide also covers:

• A fuller explanation of how subsidies can distort price signals and allow inefficient firms to remain in the market.
• More developed examples of unintended consequences, including regulation which is set too strictly and subsidies which fail to improve market conditions.
• The administrative and monitoring costs involved in tradable pollution permit schemes.
• More detailed analysis of government information gaps and why it is difficult to identify the socially optimum level of intervention.
• A real-world example involving driving restrictions in Mexico City, where consumers changed their behaviour in ways which reduced the effectiveness of the policy.
• A second application involving rent controls in New York and the effect of price controls on housing supply and shortages.