AQA A-Level Economics · Revision notes

4.1.8.10 Government Failure

Governments intervene to correct market failure, but intervention does not always work. Sometimes it leaves society worse off than if the market had been left alone. This is government failure, and it can be used as a counterweight to arguments for intervention.

What government failure means

Government failure occurs when government intervention in a market leads to a misallocation of resources and a net welfare loss: the allocation of resources is worse after the intervention than before it.

Watch out: The key word is net. Almost every intervention has some costs. It is only government failure if those costs outweigh the benefits, so that society ends up worse off overall.

Causes of government failure

Distortion of price signals

Prices carry information about scarcity and preferences, and they guide producers and consumers. When the government fixes or changes prices, those signals no longer reflect real conditions.

• A maximum price set below equilibrium creates a shortage. Producers receive a signal to supply less, even though people want more.
• A minimum price guaranteed to farmers can lead to large surpluses that the government must buy and store. The European Union's agricultural policy produced so-called butter mountains and wine lakes for this reason.
• Subsidies can keep inefficient firms in business and encourage over-production of the subsidised good.

In each of these cases the government creates, rather than removes, a market distortion.

Unintended consequences

Intervention can change behaviour in ways the government did not plan for.

• High taxes on cigarettes and alcohol can encourage smuggling and illegal markets, which reduce tax revenue and remove quality controls.
• Rent controls intended to help tenants can lead landlords to leave the market, reducing the supply of housing to rent.
• Fishing quotas intended to protect fish stocks led to fishermen throwing back dead fish they were not allowed to land, so stocks were damaged without the catch being used.

Excessive administrative costs

Every intervention has to be designed, run, monitored and enforced. If those costs are high relative to the benefits, the intervention can cause a net loss even if it changes behaviour in the intended direction. Complex tax reliefs, subsidy schemes with detailed eligibility rules, and regulations that need large inspection teams are examples. Large public projects can also run far over budget.

Information gaps

The government often lacks the information it needs to intervene correctly.

• It is very hard to put a money value on external costs and benefits, so taxes and subsidies may be set too high or too low.
• When the EU first set up its emissions trading scheme, it issued too many permits. The price of permits collapsed and firms had little incentive to cut pollution.
• Policies take time to work, and economic conditions may have changed by the time they take effect.

Conflicting objectives

Governments pursue several objectives at once, and a policy that helps one goal can harm another. A carbon tax that cuts emissions may make energy less affordable for low-income households. A subsidy that protects jobs in one industry may raise costs for the rest of the economy.

Other sources of government failure

Government failure can also arise from:

• Political pressures. Decisions may be driven by short-term electoral considerations rather than long-term welfare.
• Regulatory capture. A regulator may come to act in the interests of the firms it regulates rather than consumers.

Government failure in various markets

• Agriculture: guaranteed minimum prices led to over-production and costly surpluses.
• Housing: rent controls and planning restrictions can reduce the supply of homes.
• Fishing: quotas led to discarding of fish that had already been caught.
• Environment: an over-generous allocation of pollution permits failed to reduce emissions as intended.
• Alcohol and tobacco: high taxes created incentives for smuggling and illegal sales.

In each case, the intervention was a response to a real market failure. The failure lay in how it was designed or carried out.

Market failure versus government failure

Evaluation: The existence of market failure does not automatically mean the government should intervene. The question is always whether intervention will improve on the market outcome once its own costs and risks are taken into account.

Sometimes a well-designed intervention clearly helps. Sometimes the market outcome, imperfect as it is, is better than the likely result of intervention.

Key terms

Common mistakes

• Calling any imperfect policy government failure. It is government failure only if there is a net welfare loss.
• Listing causes without examples. Each cause is more convincing with a real case of how it happened.
• Assuming market failure always justifies intervention. The likely cost of government failure has to be weighed against the market failure.
• Confusing unintended consequences with information gaps. An unintended consequence is a behavioural response; an information gap is a lack of data needed to set the policy.

How this has been examined

In the AQA papers indexed on this site, this topic has appeared in two formats:

• 25-mark "Evaluate" essay — asked once (2022)
• 1-mark multiple choice — asked twice across 2 series (2023 to 2024)

Where this goes next

The interventions that can lead to government failure are covered in 4.1.8.9 Government intervention in markets, and the role of price signals in 4.1.8.1 How markets and prices allocate resources. Government failure reappears when judging 4.1.8.7 Competition policy and 4.1.8.8 Public ownership, privatisation, regulation and deregulation of markets.