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Government failure

Government intervention to resolve market failures can also fail to achieve a socially efficient allocation of resources. Government failure is a situation where government intervention in the economy to correct a market failure creates inefficiency and leads to a misallocation of scarce resources.

Examples of government failure include:

  1. Government can award subsidies to firms, but this may protect inefficient firms from competition and create barriers to entry for new firms because prices are kept ‘artificially’ low. Subsidies, and other assistance, can lead to the problem of moral hazard.

  2. Taxes on goods and services can raise prices artificially and distort the efficient operation of the market. In addition, taxes on incomes can create a disincentive effect and discourage individuals from working hard.

  3. Governments can also fix prices, such as minimum and maximum prices, but this can create distortions which lead to:

  • Shortages, which may arise when government fixes price below the market rate. Because public healthcare is provide free at the point of consumption there will be long waiting lists for treatment.

  • Surpluses, which may arise when government fixes prices above the natural market rate, as supply will exceed demand. For example, guaranteeing farmers a high price encourages over-production and wasteful surpluses. Setting a ‘minimum wage’ is likely to create an excess of supply of labour in markets where the ‘market clearing equilibrium’ is less than the minimum.

  1. Information failure is also an issue for governments, given that government does not necessarily ‘know’ enough to enable it to make effective decisions about the best way to allocate scarce resources. Many economists believe in the efficient market hypothesis, which assumes that the market will always contain more information than any individual or government. The implication is that market prices and market movements should be free from interference because markets cannot be improved upon by individuals or governments.

  2. Excessive bureaucracy is also a potential government failure. This is caused by the public sector when it tries to solve the principal-agent problem. Government must appoint bureaucrats to ensure that its objectives are pursued by the managers of public sector organisations, such as the NHS.

  3. Finally, there is the problem of moral hazard associated with the payment of welfare benefits. If individuals know that the state will provide unemployment benefit, or free treatment for their poor health, they are less likely to take steps to improve their employability, or to avoid activities which prevent poor health, such smoking, a poor diet, or lack of exercise.