ⓘ Government failure


ⓘ 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 by definition 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 a Pareto improvement 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.


1. 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 1964 in comparing an actual and ideal system of industrial regulation:

Contemplation of an optimal system may provide techniques of analysis that would otherwise have been missed and, in certain special cases, it may go far to providing a solution. But in general its influence has been pernicious. It has directed economists’ attention away from the main question, which is how alternative arrangements will actually work in practice. It has led economists to derive conclusions for economic policy from a study of an abstract of a market situation. It is no accident that in the literature.we find a category "market failure" but no category "government failure." Until we realize that we are choosing between social arrangements which are all more or less failures, we are not likely to make much headway.

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.


2.1. Sources of government failures 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.


2.2. Sources of government failures 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.


2.3. Sources of government failures 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.


3.1. Examples Economic crowding out

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.


3.2. Examples Regulatory

Regulatory arbitrage is a regulated institutions taking advantage of the difference between its real or economic 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.

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