Government failure


Government failure, in the context of public economics, is an economic inefficiency caused by a government intervention, if the inefficiency would not exist in a true free market. It can be viewed in contrast to a market failure, which is an economic inefficiency that results from the free market itself, and can potentially be corrected through government regulation. The idea of government failure is associated with the policy argument that, even if particular markets may not meet the standard conditions of perfect competition required to ensure social optimality, government intervention may make matters worse rather than better.
As with a market failure, a government failure is not a failure to bring a particular or favored solution into existence but is rather a problem which prevents an efficient outcome. The problem to be solved need not be a market failure; governments may act to create inefficiencies even when an efficient market solution is possible.
Government failure does not occur when government action creates winners and losers, making some people better off and others worse off than they would be without governmental regulation. It occurs only when governmental action creates an inefficient outcome, where efficiency would otherwise exist. A defining feature of government failure is where it would be possible for everyone to be better off under a different regulatory environment.
Examples of government failure include regulatory capture and regulatory arbitrage. Government failure may arise because of unanticipated consequences of a government intervention, or because an inefficient outcome is more politically feasible than a Pareto improvement to it. Government failure can be on both the demand side and the supply side. Demand-side failures include preference-revelation problems and the illogics of voting and collective behaviour. Supply-side failures largely result from principal–agent problem.

History

The phrase "government failure" emerged as a term of art in the early 1960s with the rise of intellectual and political criticism of government regulations. Building on the premise that the only legitimate rationale for government regulation was market failure, economists advanced new theories arguing that government interventions in markets were costly and tend to fail.
An early use of "government failure" was by Ronald Coase in comparing an actual and ideal system of industrial regulation:
Roland McKean used the term in 1965 to suggest limitations on an invisible-hand notion of government behavior. More formal and general analysis followed in such areas as development economics, ecological economics, political science, political economy, public choice theory, and transaction-cost economics.

Causes of government failure

Sometimes, when the government intervenes it can turn out to be ineffective, misplaced and inequitable.

Imperfect information

Imperfect information may be a source of not only the market failure, but also of the government one. Even the state cannot be provided with all the information, which is nesessary to reach the equilibrium and stability within the market.

Human factor

People working inside the governments are also ordinary humans. It is usual for humans to strive to reach personal interests and maximize welfare. Thus if a person places own interests above common interests, decisions taken by such person can degrade public welfare.

Influence of interest or pressure groups

Not uncommon is also the impact of people or even groups of people, who are able to manipulate politicians inside a government in order to reach their common goals. These groups usually have a powerful influence. It is difficult for the society to confront them because these groups act in a coherant way due to restricted number of members and shared objective in contrast to the rest of the society.

Political self-interest

When politicians and civil servants seek to pursuit self-interest, it can lead to incorrect allocation of resources. The pressures of the upcoming elections or the influence of interest groups can support an environment in which inappropriate spending and tax decisions can be made. - e.g. increasing social expenditure before the elections or presenting the main capital expenditure items for infrastructure projects without the projects being subjected to a full and proper cost-benefit analysis to determine the likely social costs and benefits.

Policy myopia

Another cause of the government failure, as many critics of government intervention claim, is that politicians tend to look for short term fixes with instant and visible results that do not have to last, to difficult economic problems rather than making thorough analysis for solving long term solutions.

Government intervention and evasion

It is believed that when a government tries to levy higher taxes on goods such as alcohol, also called de-merit goods, it can lead to increase attempts of illegal activities as tax avoidance, tax evasion or development of grey markets, people could try to sell goods with no taxes. Also legalizing and taxing some drugs may arise in a quick expansion of the supply of drugs, which can lead to overconsumption, which can mean a decrease in welfare.

Costs of administration and enforcement

When the government intervenes and tries to solve some kind of problem, the costs to do so may turn out to be higher than expected.

Examples

Economic crowding out

is the displacement of private sector investment by way of higher interest rates, when the government expands its borrowing to finance increased expenditure or tax cuts in excess of revenue. Government spending is also said to crowd out private spending by individuals.

Regulatory

is a regulated institution's taking advantage of the difference between its real risk and the regulatory position.
Regulatory capture is the co-opting of regulatory agencies by members of or the entire regulated industry. Rent seeking and rational ignorance are two of the mechanisms which allow this to happen.
Regulatory risk is the risk faced by private-sector firms that regulatory changes will hurt their business.
Alexander Hamilton of the World Bank Institute argued in 2013 that rent extraction positively correlates with government size even in stable democracies with high income, robust rule of law mechanisms, transparency, and media freedom.
Many Austrian economists, such as Murray Rothbard, argue that regulation is the source of market failure in the form of monopoly, adding that the term "natural monopoly" is a misnomer. From this perspective, all governmental interference in free markets creates inefficiencies and are therefore less preferable to private market self-correction.

Distortion of markets

Taxation can lead to market distortion. They can artificially change prices thus distorting markets and disturb the way markets allocate scarce resources. Also, taxes can give people incentive to evade them, which is illegal. Minimum price can also result in markets’ distortion. Consumer would spend more on harmful good, therefore less of his/her income will be spent on beneficial goods. Subsidies can also lead to misuse of scarce resources as they can help inefficient enterprises by protecting them from free market forces.

Administration costs

Enforcement of laws through legal system and tax collection demand considerable costs. Excessive bureaucracy can lead to inefficiency and public sector might face principal-agent problem.

Unintended consequences

Government intervention may result in unpredicted outcomes. Average speed on a particular road with traffic calming measures might increase as drivers may speed up between warning signs and speed bumps.

Overcoming Government Failure

When a country gets into this kind of complicated situation it is not possible to reverse it right away. However, there are some arrangements that the government could do, to try to overcome it step by step. For example: