Author: Geoff Riley Last updated: Sunday 23 September, 2012
A failure of the free market and the price mechanism to deliver an allocatively efficient allocation of scarce resources is normally regarded as justification for government intervention.
This intervention is designed to correct for instances of market failure and achieve an improvement in economic and social welfare.
But what if intervention leads to further inefficiencies? What if government policies prove to be costly to implement but ineffective in achieving their desired outcomes? What happens if intervention distorts markets still further leading to a further loss of efficiency?
What is Government Failure?
Even with good intentions governments seldom get their policy application correct. They can tax, control and regulate but the outcome may be a deepening of the market failure or even worse a new failure may arise
Government failure may range from the trivial, when intervention is merely ineffective, but where harm is restricted to the cost of resources used up and wasted by the intervention, to cases where intervention produces new and more serious problems that did not exist before. The consequences of this can take many years to reverse.
Government failure in a non-market economy
The collapse of the Soviet Union in the late 1980s marked the failure of command economies as a means of allocating resources among competing uses. The essence of a command economy was that the state planning mechanism would decide what to produce and how to produce it and for whom to produce. Government failure occurred when the central planners produced products that were not wanted by consumers – a loss of allocative efficiency, since there was no price mechanism to signal changes in consumer preferences and demand.
Another fundamental failing of the pure command economy was that there was little incentive for workers to raise productivity; poor quality control; and little innovation by firms as no profit motive existed. Command economies also suffered massive environmental de-gradation because they did not posses structures for valuing the environment and giving consumers and producers the right incentives to protect their environmental heritage.
Example of Government Failure – Fisheries Policy in the European Union
Few policies have attracted as much criticism and contempt as the Common Fisheries Policy of the European Union. To many it is a prime example of government failure; a policy with good intentions that has failed to achieve its objectives and caused much deeper problems for the European fishing industry.
At the heart of the problem is overfishing – the ‘tragedy of the commons’ - 30% of EU fish stocks are beyond safe limits.
The EU quota system does not work well in restoring fish stocks and the EU fishing sector suffers from overfishing, fleet overcapacity, heavy subsidies and decline in the volume of fish caught. Many European governments seek to protect the interests of their own fishing businesses rather than agree on a policy that will benefit the EU sea fishing industry as a whole.
Over-fishing is a cause of market failure arising from a failure to enforce agreed fishing quotas and the absence of enforceable property rights for what is perceived to be a common ownership of a natural and renewable resource.
One key demand for reform is to end dumping of discarded fish. Currently, up to half the catch of some species has to be discarded because vessels have exceeded their quota, or because the fish are undersized.
Causes of Government Failure
Government intervention can prove to be ineffective, inequitable and misplaced.
(a) Political self-interest
The pursuit of self-interest amongst politicians and civil servants can often lead to a misallocation of resources.
For example decisions about where to build new roads, by-passes, schools and hospitals may be decided with at least one eye to the political consequences.
The pressures of a looming election or the influence exerted by special interest groups can foster an environment in which inappropriate spending and tax decisions are made. - e.g. boosting welfare spending in the run up to an election, or bringing forward major items of capital spending on infrastructural projects without the projects being subjected to a full and proper cost-benefit analysis to determine the likely social costs and benefits. Critics of current government policy towards tobacco taxation and advertising, and the controversial issue of genetically modified foods argue that government departments are too sensitive to political lobbying from the major corporations.
(b) Policy myopia
Critics of government intervention in the economy argue that politicians have a tendency to look for short term solutions or “quick fixes” to difficult economic problems rather than making considered analysis of long term considerations.
For example, a decision to build more roads and by-passes might simply add to the problems of traffic congestion in the long run encouraging an increase in the total number of cars on the roads.
The risk is that myopic decision-making will only provide short term relief to particular problems but does little to address structural economic problems.
Critics of government subsidies to particular industries also claim that they distort the proper functioning of markets and lead to inefficiencies in the economy. For example short term financial support to coal producers to keep open loss-making coal pits might prove to be a waste of scarce resources if the industry concerned has little realistic prospect of achieving a viable rate of return in the long run given the strength of global competition.
(c) Regulatory capture
This is when the industries under the control of a regulatory body (i.e. a government agency) appear to operate in favour of the vested interest of producers rather can consumers
Some economists argue that regulators can prevent the ability of the market to operate freely. We might find examples of this in agriculture, telecommunications, the main household utilities and in transport regulation.
For example, to what extent has the system of agricultural support known as the Common Agricultural Policy operated too much in the interests of farmers and the farming industry in general? And as a result, has the CAP worked against the long-term interest of consumers, the environment and developing countries who claim that they are being unfairly treated in world markets by the effects of import tariffs on food and export subsidies to loss-making European farmers?
(d) Government intervention and disincentive effects
Free market economists who fear government failure at every turn argue that attempts to reduce income and wealth inequalities can worsen incentives and productivity. They would argue against the National Minimum Wage because they believe that it artificially raises wages above their true free-market level and can lead to real-wage unemployment. They would argue against raising the higher rates of income tax because it is deemed to have a negative effect on the incentives of wealth-creators in the economy and generally acts as a disincentive to work longer hours or take a better paid job.
(e) Government intervention and evasion
A decision by the government to raise taxes on de-merit goods such as cigarettes might lead to an increase in attempted tax avoidance, tax evasion, smuggling and the development of grey markets where trade takes place between consumers and suppliers without paying tax
Case Study: The Unintended Economic Effects of a Tariff
In 2005 the US government slapped anti-dumping tariffs on the imports of Chinese furniture. At the time, imports accounted for 58% of the market for beds and similar items.
What happened next was probably not in the plans of US lawmakers and the local furniture manufacturers who supported the tariffs. Although imports from China did fall sharply, a number of Chinese manufacturers moved their plants to different countries, Vietnam being the main choice. The result was that as of 2010, imports now account for 70% of the total market!
A decision to legalize and then tax some drugs might lead to a rapid expansion of the supply of drugs and a substantial loss of social welfare arising from over consumption.
(f) Policy decisions based on imperfect information
How does the government establish what citizens want it to do in their name? Can the government ever really know the true revealed preferences of so many people?
Often a government will choose to go ahead with a project or policy without having the full amount of information required for a proper cost-benefit analysis. The result can be misguided policies and damaging long-term consequences.
How does the government know how many extra houses need to be built in the UK over the next twenty years? Is building thousands of extra homes in an already congested South-east the right option? Are there better solutions? There have been plenty of instances of government housing policy having failed in previous decades!
(g) The Law of Unintended Consequences
The law of unintended consequences is that actions of consumer and producers — and especially of government—always have effects that are unanticipated or "unintended." Particularly when people do not always act in the way that the economics textbooks would predict
The law of unintended consequences is often used to criticise the effects of government legislation, taxation and regulation. People find ways to circumvent laws; shadow markets develop to undermine an official policy; people act in unexpected ways because or ignorance and / or error. Unintended consequences can add hugely to the financial costs of some government programmes so that they make them extremely expensive when set against their original goals and objectives.
(h) Costs of administration and enforcement
Government intervention can prove costly to administer and enforce. The estimated social benefits of a particular policy might be largely swamped by the administrative costs of introducing it.