4.1.8.10 - Government Failure

Government Failure

= When government intervention leads to a misallocation of resources that is worse than the free-market outcome, and a net welfare loss.

- would have been better off if the gov did not intervene

Reasons for Government Failure:

- Inadequate Information

- Conflicting Objectives

- Costs of Intervention (admin costs)

- Market Distortions

- Unintended Consequences

Inadequate Information

- Governments and regulators do not have perfect information / have poor-quality information

- Government is subject to the same information gaps and cognitive biases that consumers face

- This could lead to the government intervening in the wrong way, or by the wrong amount --> resulting in a worsening of the market failure

Conflicting Objectives

- The implementation of government intervention in one market to maximise social welfare causes a loss in social welfare in another market.

or

- Government policy will raise social welfare in the LONG-RUN, but may be unpopular in the SHORT-RUN

- Therefore, governments have to make a trade-off that it believes will maximise social welfare, at the expense of another objective.

Conflicting Objectives Example (sugary drinks)

e.g.

The imposition of tax on sugary drinks decreases the overconsumption of sugary drinks, improving the social welfare in that market.

However, it may shift consumption towards drinks low in sugar but higher in artificial sweeteners. This substitute good are also demerit goods as they also have adverse private effects of consumption, so the gov may have worsened market failure.

Costs of Intervention (Administrative Costs)

- Administrative or enforcement costs of government intervention can be expensive.

- These costs may end up outweighing the benefits of improved social welfare of gov intervention, leading to a worsening of resource allocation.

Market Distortions

- Price intervention may help solve one problem, but can create others by DISTORTING PRICE SIGNALS

- The SIGNALLING FUNCTION of the PRICE MECHANISM is artificially altered

- This causes changes to QUANTITIES traded for goods and services

- This can lead to an inefficient allocation of resources - surpluses and shorages

Unintended Consequences

Government intervention policies can lead to unpredictable, unintended consequences which worsen the allocation of resources and net welfare

Minimum Price Unintended Consequences

Loss of international competitiveness

- Minimum price must be placed above free market equilibrium

- Therefore, market price of factor inputs (labour, energy) rises, meaning firms prefer to produce goods abroad rather than in the UK.

Bans/Tax/Regulation Unintended Consequences

Formation of Informal Black Markets with worse social outcomes

- When products are sold legally, governments are able to regulate them through quantity, packaging, ingredients, production methods, who they are sold to.

- However when banned, people may turn to sell them in informal black markets which are UNREGULATED.

- Suppliers are able to exploit customers, use dangerous ingredients, sell to minors

- Therefore, damaging social welfare

Subsidies Unintended Consequences

Inefficiency among Producers

- Producers may rely on subsidies to survive, rather than cost-cutting and innovation

- They devote less resources to improving their production process to keep costs of production down

- It also protects inefficient firms from competition and create barriers to entry for new firms because prices are kept 'artificially' low.

- Leads to moral hazard