Government failure
Encyclopedia
Government failure is the public sector analogy to market failure
and occurs when a government intervention causes a more inefficient allocation of goods and resources than would occur without that intervention. Likewise, the government's failure to intervene in a market failure that would result in a socially preferable mix of output is referred to as passive Government failure (Weimer and Vining, 2004). Just as with market failures, there are many different kinds of government failures that describe corresponding distortions
.
The term, coined by Roland McKean
in 1965, became popular with the rise of public choice theory
in the 1970s. 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.
Just as a market failure is not a failure to bring a particular or favored solution into existence at desired prices, but is rather a problem which prevents the market from operating efficiently, a government failure is not a failure of the government to bring about a particular solution, but is rather a systemic problem which prevents an efficient government solution to a problem. The problem to be solved need not be a market failure; sometimes, some voters may prefer a governmental solution even when a market solution is possible.
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 problems.
Market failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...
and occurs when a government intervention causes a more inefficient allocation of goods and resources than would occur without that intervention. Likewise, the government's failure to intervene in a market failure that would result in a socially preferable mix of output is referred to as passive Government failure (Weimer and Vining, 2004). Just as with market failures, there are many different kinds of government failures that describe corresponding distortions
Distortions (economics)
A distortion is a condition that creates economic inefficiency, thus interfering with economic agents maximizing "social welfare" when they maximize their own welfare....
.
The term, coined by Roland McKean
Roland McKean
Roland N. McKean is an American economist. He received his A.B. and Ph.D. degrees in economics from the University of Chicago. From 1951 to 1963, he was a research economist with the RAND Corporation...
in 1965, became popular with the rise of public choice theory
Public choice theory
In economics, public choice theory is the use of modern economic tools to study problems that traditionally are in the province of political science...
in the 1970s. 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.
Just as a market failure is not a failure to bring a particular or favored solution into existence at desired prices, but is rather a problem which prevents the market from operating efficiently, a government failure is not a failure of the government to bring about a particular solution, but is rather a systemic problem which prevents an efficient government solution to a problem. The problem to be solved need not be a market failure; sometimes, some voters may prefer a governmental solution even when a market solution is possible.
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 problems.
Legislative
- Crowding outCrowding out (economics)In economics, crowding out occurs when Expansionary Fiscal Policy causes interest rates to rise, thereby reducing private spending. That means increase in government spending crowds out investment spending....
- Crowding out occurs when the government expands its borrowing more to finance increased expenditure or tax cuts in excess of revenue crowding out private sector investment by way of higher interest rates. Government spending is also said to crowd out private spending (Shaghil Ahmed, “Temporary and Permanent Government Spending in an Open Economy,” Journal of Monetary Economics, Vol. 17, No. 2 (March 1986), pp. 197–224). - Horse tradingHorse tradingIn the original sense, Horse trading is the buying and selling of horses, also called "Horse Dealing". Due to the difficulties in evaluating the merits of a horse offered for sale, the selling of horses offered great opportunities for dishonesty...
/LogrollingLogrollingLogrolling is the trading of favors, or quid pro quo, such as vote trading by legislative members to obtain passage of actions of interest to each legislative member...
- The process by which legislators trade votes - Pork barrel spending - The tendency by legislators to encourage government spending in their own constituencies, whether or not it is efficient or even useful. Senior legislators, with greater status and ability to "bring home the bacon", may be reelected for this reason, even if their policy views are at odds with their constituency.
- Rational ignoranceRational ignoranceRational ignorance occurs when the cost of educating oneself on an issue exceeds the potential benefit that the knowledge would provide.Ignorance about an issue is said to be "rational" when the cost of educating oneself about the issue sufficiently to make an informed decision can outweigh any...
- because there are monetary and time costs associated with gathering information
Regulatory
- Regulatory arbitrage - Where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position.
- Regulatory captureRegulatory captureIn economics, regulatory capture occurs when a state regulatory agency created to act in the public interest instead advances the commercial or special interests that dominate the industry or sector it is charged with regulating. Regulatory capture is a form of government failure, as it can act as...
- The co-opting of regulatory agencies by members of or the entire regulated industry. Rent seekingRent seekingIn economics, rent-seeking is an attempt to derive economic rent by manipulating the social or political environment in which economic activities occur, rather than by adding value...
and rational ignoranceRational ignoranceRational ignorance occurs when the cost of educating oneself on an issue exceeds the potential benefit that the knowledge would provide.Ignorance about an issue is said to be "rational" when the cost of educating oneself about the issue sufficiently to make an informed decision can outweigh any...
are two of the mechanisms which allow this to happen. - Regulatory risk - A risk faced by private-sector firms that regulatory changes will hurt their business.
- Rent seeking - see above.
Information assessment
- Environmental impact - Public support for roads lowers the cost of operating a vehicle; farm subsidies and programs like the Soil Conservation program encourage farmers to use fields which require more intense application of fertilizer and irrigation. Both of these have an adverse impact on the environment.
- Imperfect information - Especially in Pigouvian application, gathering sufficient information is no easier for the regulatory agency than for individual actors
- Market distortionMarket distortionIn neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for an item that is substantially different from the price that a market would achieve while operating under conditions of perfect competition and state enforcement of legal contracts and...
- By tax structures - by organizing taxation in a particular way, investments may be directed so as to avoid those taxes even though the investments are inferior
- By regulatory ordering - mandating a particular solution may prohibit all other solutions, some of which may be superior
- By subsidization - by subsidizing particular goods, these may force other, nonsubsidized, but superior substitutes from the market
- Risk assumption - by promising to relieve risk-takers, the government encourages risk-taking whose benefits accrue to a minority while spreading the assumption of that risk across the populace. The Savings and Loan crisisSavings and Loan crisisThe savings and loan crisis of the 1980s and 1990s was the failure of about 747 out of the 3,234 savings and loan associations in the United States...
of the 1980s is one example; federal assumption of responsibility for the Mississippi RiverMississippi RiverThe Mississippi River is the largest river system in North America. Flowing entirely in the United States, this river rises in western Minnesota and meanders slowly southwards for to the Mississippi River Delta at the Gulf of Mexico. With its many tributaries, the Mississippi's watershed drains...
leveeLeveeA levee, levée, dike , embankment, floodbank or stopbank is an elongated naturally occurring ridge or artificially constructed fill or wall, which regulates water levels...
system. See also moral hazardMoral hazardIn economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
- Unintended consequenceUnintended consequenceIn the social sciences, unintended consequences are outcomes that are not the outcomes intended by a purposeful action. The concept has long existed but was named and popularised in the 20th century by American sociologist Robert K. Merton...
- An unintended consequence comes about when a mechanism that has been installed with the intention of producing one result is used to produce a different (and often conflicting) result. (e.g. rent controlRent controlRent control refers to laws or ordinances that set price controls on the renting of residential housing. It functions as a price ceiling.Rent control exists in approximately 40 countries around the world...
leads to shortages in housing)