Government Failure

Definition of Government Failure

Government failure: when government intervention to correct a market failure results in a larger net welfare loss or a less efficient allocation of resources than before the intervention.

In other words, the cost of the intervention outweighs the benefit.

Causes of Government Failure

Distortion of Price Signals

Government price controls, such as minimum or maximum prices, can disrupt the market's signalling and incentive functions.

Example: A minimum price for demerit goods such as alcohol may reduce consumption, but it can also create a surplus if the price is set above the market equilibrium, leading to wasted resources and potential black markets.

Unintended Consequences

Economic agents seek to maximise their own welfare, so they may respond to policies in ways that undermine the original aim.

Example: Banning the sale of cigarettes to minors may reduce smoking among young people, but it can also lead to an increase in the demand for other demerit goods such as disposable vapes, which may have similar or worse health effects, and cause a littering problem.

Excessive Administrative Costs

The cost of implementing, monitoring, and enforcing a policy can be greater than the social welfare gain it creates.

If the government spends more on administration than the benefit of the policy, then the intervention is inefficient and leads to government failure.

Information Gaps

Governments also suffer from imperfect information and bounded rationality, just like consumers and firms.

This can lead to poorly designed policies that fail to achieve their aims or worsen the market failure.

Example: The government may not have accurate information about the true costs and benefits of cigarettes, and as a result they may implement an indirect tax that is too high. This could actually result in underconsumption of cigarettes and a larger welfare loss. Underconsumption is possible even with demerit goods since they do provide some value to society, including creating employment opportunities, and generating tax revenue which can be spent on third parties.