Government failure occurs when government intervention leads to a net welfare loss.
Here are four types of government failure, with examples in different markets.
Contents
Distortion of price signals
Government intervention may distort price signals. This may lead to the price mechanism not being able to function. As a result, surpluses and shortages may emerge.
A minimum price may lead to surpluses, also known as excess supply.
- This is because the price cannot fall to eliminate the excess supply, assuming the minimum price lies above the free market price.
Meanwhile, a maximum price may lead to shortages or excess demand of the good.
An example is a maximum price for food.
- A maximum price p1 is set below the free market price p in the diagram below.
- This results in demand at q1 and supply at q2. In other words, there is excess demand of q1-q2, as labelled on the diagram.
- “Excess demand” could mean queues forming for food in this case.
- Without a maximum price, the price mechanism would lead to a higher price and reduce the extent of excess demand.
- However the maximum price prevents the price mechanism from functioning to clear the shortage.
Similar arguments could occur for rent controls. A maximum price on housing rent may lead to excess demand and queues for housing.
This could also apply to state provision.
- For instance, healthcare may be provided free at the point of use, such as the NHS (though this is funded by tax revenue).
- Healthcare being free at the point of use could lead to demand outstripping supply.
- In the case of healthcare, this could mean queues and waiting lists for treatment.
Unintended consequences
Government intervention may lead to unintended consequences.
Unintended consequences for taxes, minimum prices and bans
Consider a minimum price for a good such as alcohol.
- A minimum price could lead to the formation of illegal, underground markets. These markets could sell the good for a price below the minimum price.
- Such underground markets could lead to smuggling (bring goods illegally into the country from abroad) for prices below the minimum price.
Smuggling can also occur following a tax rise. An example of this is cigarette smuggling from Europe into the UK.
Smuggling and illegal supply of the good can also occur following a ban on producing the product. An example of this include alcohol in the US in the 1930s.
Other unintended consequences of raising the price of demerit goods, such as through indirect taxes and minimum prices, include:
- Consumers may substitute to consuming other goods which may be dangerous in themselves.
- For example, a tax on cigarettes may lead consumers to switch away from cigarettes and towards e-cigarettes. E-cigarettes themselves may have their own health consequences.
- Raising the price on a demerit good could drive people into poverty. This is more likely to occur when demand is price-inelastic, as total expenditure on the good will increase if the price rises.
Unintended consequences for maximum prices and subsidies
Conversely, a maximum price on rental housing could have unintended consequences.
- Those supplying rented accommodation have less of an incentive to take care of a property. This reduces investment in maintaining the property.
- Landlords renting out property may look for ways to claim more funds. This includes extra fees for receiving keys to the property or preferring those who can pay rent months or years in advance.
- In the case of housing, if people cannot find rental properties due to excess demand, this could increase the “geographical immobility” of labour.
- For example, even if someone receives a job offer in another city, they may not be able to accept the job offer if they cannot find a place to stay.
Meanwhile, consider subsidies, such as electric vehicle subsidies:
- Subsidies may lead to firms becoming dependent on the subsidy funds.
- Specifically, subsidised firms may invest less and focus less on cost reduction.
- This may inflate costs over time to the extent that, if the subsidy is removed, the firm may shut down.
Excessive administrative costs
Some government interventions come with costs to governments or regulators. These include:
- Costs of setting up the scheme. The scheme may require government legislation needing lawyers and may require civil servants running the scheme.
- Costs of measuring and recording data necessary for the intervention. For example for a per-unit subsidy, the government collects data on the quantity sold by each firm.
- Finally costs to enforce the scheme, for instance regulations and investigating those who do not comply.
If the administrative costs exceed the expected welfare gain in the market itself, then the government intervention may cost more than it delivers in benefits.
Take the example of a tradable pollution permit scheme.
- The government will need to organise an auction or collect data on past emissions to decide who gets permits.
- It may need to do this on a frequent basis if it resets the permit scheme (giving out new permits) every few years.
- Also the government will need to measure or collect data on pollution levels. This is to make sure firms are buying the correct number of permits.
- Then for firms buying too few permits, the government may have to arrange an investigation, creating a further cost.
Information gaps
To set the correct level of government intervention, the government or regulator needs information about the extent of the market failure present.
Suppose the government lacks information about the extent of the market failure.
For instance, the government may not have data available about the size of a negative externality.
- In the case of a negative externality, the free market quantity is higher than the socially optimal quantity.
- So the government may intervene by using a tax.
- If the government sets the tax rate too low, then taxation may not eliminate the market failure. The new equilibrium quantity may still exceed the socially optimal quantity.
- If the government sets the tax rate too high, then taxation may lead to the new equilibrium quantity being below the socially optimal quantity. This creates a welfare loss in the opposite direction, owing to quantity being too low.
This could also happen with tradable pollution permits, regulation or minimum prices. For example:
- Suppose the government sets the number of tradable pollution permits too high.
- Then there may still be a market failure for goods with negative externalities. The new equilibrium quantity still exceeds the socially optimal outcome.
- This also applies when the government sets regulations that are too lenient or a minimum price that is too low.
- Alternatively suppose the government sets the number of tradable pollution permits too low. Or sets regulations that are too strict.
Another example is the government may not have enough data about the size of a positive externality:
- With a positive externality, the free market quantity is lower than the socially optimal quantity.
- So the government may intervene by using a subsidy.
- Suppose the government sets the subsidy level too low. Then the subsidy may not eliminate the market failure.
- Alternatively, suppose the government sets the subsidy level too high. Then the subsidy may lead to too much of the good being provided relative to the socially optimal outcome.
This could affect other policies such as setting the right level of information provision, such as advertising campaigns to increase consumption of healthy food.
Real world examples of government failure
Here are some real world examples of possible government failure:
- Maximum prices on rent in Stockholm, Sweden:
- Waiting lists for publicly controlled housing rents have reached nine years.
- One in five firms in Sweden face difficulties in finding workers because of housing shortages, which may prevent workers from moving to the area.
- Minimum unit pricing on alcohol in Scotland:
- There is evidence that minimum unit pricing on alcohol has been successful in reducing alcohol related deaths. It is linked with150 fewer deaths per year on average, a 13% fall in alcohol deaths, according to the British Medical Journal.
- However minimum unit pricing may have had little effect on alcohol consumption for those with alcohol dependence.
- There is some evidence that financial pressures on households have been worsened due to higher alcohol prices. This may have led to some households reducing spending on necessities or borrowing more.
- Other parties raised concerns about whether alcohol consumers will switch to other substances with health risks, such as drugs or illicit alcohol.
- Education subsidies for UK university education and the tuition fee cap – too low or too high?
- The UK Government subsidises tuition fees for home students attending UK universities. The average payment is £1,150 per student per year.
- Similarly home tuition fees are capped at £9,250 per year per student as of 2024.
- Some argue the subsidy level and the tuition fee cap are too low. Combined with a cap on fees university can charge students, universities may suffer from a lack of funding. This may lead to universities aiming to increase the number of international students as the only way to increase income. Universities may have reduced funding to invest in teaching staff and resources.
- Others suggest the subsidy level may be supporting some university courses that may not offer a significant improvement in career prospects. As a result, the UK’s Conservative Party has suggested reducing government funding for some universities.
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