1.4.2 Government Failure

Question 1

Government Failure

Answer 1

Government failure is when government intervention in the market leads to net welfare loss and and a misallocation of resources.
The total social costs arising from the intervention are greater than the social benefit.

Question 2

Distortion of Price Signals

Answer 2

• Some types of intervention change price signals and distort the free market mechanism.
• This can keep inefficient companies in business, even if resources should be allocated somewhere else, or if they charge their customers too much due to a tax.
• Subsidies keep firms in employment when they cannot produce cheaply enough to be competitive. The government therefore keeps them in business when they should close down and find an alternative use for their resources.
• Max/min prices lead to excess demand/supply and make it difficult to allocate resources.
• The government intervention distorts the mechanism which can make resources be allocated inefficiently.

Question 3

Unintended Consequences

Answer 3

• Some interventions cause effects which the government did not intend to happen. Consumers and Producers may react to new policies in unexpected ways so the policy doesn’t have the effect it should.
• E.g. buffer stock scheme in the EU was supposed to smooth out price fluctuations, but ended up leading to overproduction and a fall in agricultural prices in other parts of the world as the EU surpluses were disposed of at cheap prices outside of Europe.

Question 4

Excessive Administration Costs

Answer 4

• A lot of the money that is allocated by the government is used up on administrative costs. The administrative costs may outweigh the welfare benefit from from the correction of the market failure.
• E.g. a lot of money given to the NHS, etc. is actually spent on organisational administration rather than into medical care.

Question 5

Information Gaps

Answer 5

• Governments rarely possess complete perfect information to base decisions on.
• In some cases the information may be positively misleading, resulting in the government making the wrong policy decision
• Cost and benefit projections are often wrong, so the government invests in a policy where the costs are actually higher than the benefits. There is then welfare loss.