Market failure happens when there is an overdemand or undersupply of goods and services in an economy. A tool that helps to revert the consequences of market failure is government policies. For example, in case of excessive fishing, the government can set a quota on the quantity of fish that can be caught per day.
However, in some cases, government policies can backfire. Instead of resolving the issues, they incur more costs for society. The term for this is government failure.
What is government failure? Definition
When the market fails, the government has to step in to alleviate the situation. However, in some cases, government intervention can bring more harm than good.
Government failure occurs when the government intervenes to correct a market failure but ends up causing a net loss of economic welfare. In other words, the costs of the intervention are greater than the benefits provided by it.
Let's look at an example of what a government failure might be like:
To correct market failures caused by escalating rental prices, the government enacts a price ceiling (a maximum price a landlord is allowed to charge the tenant).While the housing prices decrease, this comes with several social costs:
- Landlords earn less from their properties.
- Black markets emerge as landlords choose to ignore the law and deal with 'cash only'. This puts tenants at greater risk while reducing tax revenues for the government.
- As prices of rentals drop, housing companies will have to lay off workers to lower the expenses. As a result, the unemployment levels in the area may increase.
In this case, the price ceiling reflects a government failure.
One economic consequence caused by the intervention of the government is the distortion of prices. For example, to ensure farmers a minimum income, the government can provide subsidies for domestic agricultural products or enact tariffs on imported goods from other countries.
While farmers can earn more from their goods, this can increase food prices for consumers and create an extra burden for them. In addition, the tariffs will make exported goods more expensive and discourage healthy global competition.
Sources and reasons for government failure
There are a number of reasons why government failures occur. Some of these reasons are highlighted in Figure 1 below:
Fig 1. Sources of government failure
Let's take a look at each of these reasons in more detail.
Imperfect information
Imperfection information happens when the government lacks the necessary information to make decisions regarding a market failure. This results in the enactment of a policy that exacerbates the issue instead of resolving it.
The government places a quota on the number of fish to be caught each day to avoid excessive fishing. However, it is not aware of the fact that fishermen who accidentally overfish can dump the excessive fish back into the ocean in order to 'meet' the quota. As a result, the valuable fishery resources are still depleting while new problems such as bio-waste and water pollution arise.
Political interests
Given that government officials are ordinary humans, they can implement policies that degrade public welfare for their own personal gains. In economics, this is called the public choice theory.
One example is a politician who runs for office. They might enact a policy that benefits only their voters while ignoring the rest of the citizens. Thus, while the result of the election is favourable to the politician, there might be a long-term social cost.
Conflicting objectives
The implementation of one policy can come at the expense of another. In this case, the government has to make a trade-off for a policy that it believes will bring more social benefits. That said, it might happen that the policy fails to yield the expected results and causes a government failure.
A government is weighing two options: funding an environmental project to fight climate change and building another factory to create more local jobs. Here, there are conflicting objectives. The implementation of the environment project can improve the well-being of the citizens. However, it will mean that there won't be sufficient funds to build the factory to resolve the unemployment situation.
In contrast, the building of another factory will bring more jobs but lead to more greenhouse gas emissions and decreased public health. Whichever project the government goes for, there will be a social cost. This results in government failure.
High administrative costs
Correcting market failure might require substantial amounts of money. When the costs exceed the intended initial funds, government failure can occur.
The government provides subsidies to make public transport cheaper so that there will be fewer cars on the road and fewer traffic jams. However, this can be extremely costly and can put a dent in the government's tax revenues. Not to mention, people still prefer to travel by car since it's faster and more convenient. Thus, the higher subsidy on public transportation can backfire and end up a government failure.
Government failure vs market failure
Market failure is caused by an inefficient allocation of goods and services in the economy. In this case, an extra cost is incurred but not passed to the consumer.
Typically, when a market failure happens, the government is supposed to intervene and come up with a solution. For example, if firms are releasing a significant amount of waste and pollution into the environment, the government can introduce policies to mitigate their environmental impact.
However, it might happen that a government intervention incurs more social costs than the social benefits that it provides.
Sticking with the previous example, the policy the government introduced to mitigate harmful environmental impacts from firms might actually work and benefit the environment, but it costs both the government and firms a lot of time, money, and effort to implement eco-friendly solutions. The enactment of a wrong policy can result in a significant net loss in economic welfare.
Examples of government failure in history
Now that we've learned what government failure is and what causes it, let's look at several real-life examples of government failures.
White Elephant Project
The White Elephant Project was the name given to the Concorde Supersonic Aircraft project. This was a joint project by the British and French governments. The project was seen as a 'lofty endeavour' since the aircraft was the first computer-controlled engine in the air, a huge achievement at the time.
The project started in 1962. The first commercial flight took place on 21 January 1976. The project was a great success until a tragic crash in Paris in 2000 killed 113 passengers. One year later, roughly £71 million had been raised to improve the safety protocols but to no avail. The aircraft was shut down the following year.1
Fig. 2 - Official handover ceremony of the first commercial Concorde in 1976
The Concorde project was put down due to its heavy oil consumption and the extensive funds to improve safety standards while maintaining high-class onboard service. This is the case of government failure that stems from administrative costs and unpredictable events.
Common agricultural policy (CAP)
The CAP was a policy set up as a result of the Treaties of Rome that united the European market. The policy aimed to improve agricultural production in the region while securing farmers an adequate income. However, contrary to expectations, the policy turned out to be a failure.
During the 1970s and 1980s, the majority of EU funds went to CAP, yet the consumers still pay much higher prices for foods than before the CAP was implemented. The policy also put farmers in countries outside of the EU such as the USA and New Zealand in struggle as their products couldn't compete with the below-world-level prices of the EU agricultural products.
How to avoid government failure
Without timely solutions, government failure can result in a significant loss of economic welfare. Here are some common ways to revert the outcome of government failure:
Fig. 3 - Solutions to government failure
Adopt competitive tendering
To avoid the abusive behaviour of an influential public service company, the government can adopt competitive tendering: bids submitted by different firms to win the right to implement a certain project. Competitive tendering gives the private-sector and public-sector firms the same chance to compete while motivating both parties to innovate and improve product quality to avoid being outperformed by the other.
Reduce unnecessary costs
One of the main causes for government failure when correcting a market failure is running out of funds. To prevent this, the government can hire a professional to analyse and cut unnecessary costs in implementing the policy. With lower costs of execution, the government plan will have a higher chance to succeed or lasts long enough to exceed all the social costs.
Delegate tasks and decisions
One common mistake for executives in both public and private sectors is lack of delegation.
Delegation is the act of giving a certain individual or party the authority to make decisions on a task.
By delegating tasks and decisions, the government can concentrate on more high-value tasks to accomplish the set goals.
Provide incentives for workers
Failure in the government sector can happen due to the low performance of the party involved. One way to remedy this is to introduce profit incentives in the public sector.
Instead of paying a minimum hourly wage for people to complete a job, the government can offer a higher fixed payment for a completed task. Higher wages will encourage people to work harder, which contributes to the development of the public sector.
Government failure - Key takeaways
Sources
1. Concorde: The Real Reason Why the Supersonic Passenger Jet Failed, Interesting Engineering, 2017.
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