Government failure

Overview

Government failure, moral hazard and intervention that distorts price signals misallocate resources.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is meant by government failure, and how is it distinguished from a policy that is merely unpopular?

   Model answer

   Government failure occurs when intervention leaves the allocation of resources worse than it would have been without it, so that the costs of intervening exceed the benefits. The test is a comparison of two outcomes, the one with the policy and the one without, measured in welfare rather than in approval. A policy can be deeply unpopular and still improve allocation, and a popular one can misallocate resources badly. Nor is failure the same as imperfection: a policy that improves matters but falls short of the ideal has not failed.

2. 2

   Analyse how an information gap leads to government failure.

   Model answer

   Every instrument has to be set at a level, and the right level depends on quantities the government cannot observe: the true marginal external cost, firms' abatement costs, the elasticity of demand, the number of homes the market would build. Those figures have to be estimated, and the people who know them best have an incentive to misreport them. If the tax rate, the cap or the price control is set at the wrong level, output overshoots or undershoots the social optimum and a fresh welfare loss appears. The larger the error, the more likely it is that the loss created exceeds the loss corrected.

3. 3

   A scheme raises £1,800 a year in revenue and costs £2,100 a year to administer and enforce. Explain why this is an example of government failure.

   Model answer

   The net position is £1,800 minus £2,100, which is a loss of £300 a year, so the scheme consumes more resources than it collects. Those resources, the inspectors' time and the systems behind them, have an opportunity cost in other uses. Unless the scheme also changes behaviour enough that the external harm avoided is worth more than £300 a year, society is worse off than if the government had done nothing. Administrative and enforcement costs are a real cost of intervention and must be set against the benefit, not treated as an overhead.

4. 4

   Why are administrative costs a bigger threat to some interventions than to others?

   Model answer

   The cost of running a policy rises with the number of participants to be monitored, the difficulty of measuring what matters, and the incentive to cheat. A duty collected from a handful of large importers is cheap to administer relative to the sum raised; a means-tested payment assessed household by household, or an emissions rule policed across thousands of small sites, is not. The relevant comparison is the administrative cost against the benefit the policy delivers, so a small scheme with high per-unit costs is far more vulnerable than a large one with the same costs spread thinly.

5. 5

   Analyse how an unintended consequence turns a well-intended price control into government failure.

   Model answer

   A maximum price set below the market-clearing level is intended to make the good affordable. It holds quantity supplied below quantity demanded, so a shortage appears and something other than price must ration the good. Unsatisfied buyers who value the good above the cap create a profit opportunity outside the legal market, and trade moves there, at prices that can exceed the free-market level. The households the policy meant to protect end up paying more, in an unregulated market, and fewer of them are served than before. Allocation is worse than it was, which is the definition of failure.

6. 6

   What is moral hazard, and how can an intervention create it?

   Model answer

   Moral hazard is the change in behaviour that follows when someone no longer bears the full consequences of their own risk-taking, because another party has agreed to cover the loss. An intervention creates it whenever it insures against an outcome people can influence. Guaranteeing to compensate for flood damage weakens the incentive to avoid building on a flood plain; guaranteeing to rescue a failing firm weakens its incentive to manage risk prudently. The intervention then raises the frequency of the very event it was designed to relieve, so the cost grows over time and resources are drawn into activities that should have shrunk.

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