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Government Failure Is Intervention That Makes the Allocation of Resources Worse

Definition

Government failure: a situation in which government intervention in a market leads to a net welfare loss, creating a misallocation of resources worse than, or additional to, the market failure it was intended to correct.

  1. Government failure is intervention that leads to a net welfare loss.
  2. That means a worse allocation of resources than the original market failure.
  3. It is the key risk to weigh against any intervention.
Note
  • The test is a genuine net welfare loss, not just an unpopular outcome.
  • Intervention can leave society worse off than before.

Inadequate Information, Conflicting Objectives and Admin Costs Are the Main Sources

  1. Intervention can distort price signals and create unintended consequences.
  2. Administrative costs and information gaps limit what policy can achieve.
  3. Conflicting objectives, regulatory capture and corruption can make things worse.
    1. For example, a central bank raising interest rates to hit a low-inflation target can conflict with the government's objective of full employment, so if it misjudges the trade-off, unemployment rises without inflation falling by much.
Example
  • A price cap can cause shortages that harm the very people it aimed to help.
  • Subsidies can prop up inefficient producers for years.

Intervention Can Create Distortions Rather Than Remove Them

  1. Price controls can cause shortages or surpluses.
  2. Subsidies can encourage overproduction and waste.
  3. Taxes can create unintended incentives or black markets, especially when people dodge or game the policy.

Worked Example: A Price Floor Can Create a Costly Surplus

  1. Suppose the free-market equilibrium for a crop is £150\pounds 150£150 per tonne, with farmers supplying and consumers demanding 100100100 tonnes.
  2. The government sets a minimum price of £200\pounds 200£200 per tonne to support farm incomes.
  3. At £200\pounds 200£200, farmers supply 120120120 tonnes but consumers demand only 808080 tonnes, creating a surplus of 404040 tonnes.
  4. If the government then buys up the surplus to maintain the price floor, that costs at least 40×£200=£8,00040 \times \pounds 200 = \pounds 8{,}00040×£200=£8,000, plus storage and eventual disposal costs, so the policy keeps adding to the fiscal bill the longer it runs.
  5. This is government failure: the original problem (low farm incomes) is replaced by over-production, resources tied up growing a crop that is not consumed, and a rising ongoing cost to taxpayers.
Example
  • Notice that the £8,000\pounds 8{,}000£8,000 cost of buying up the surplus is on top of the higher price consumers or taxpayers already pay, so a minimum price is rarely a low-cost way to raise producer income.
  • The same logic explains the European Union's historical "butter mountains" and "wine lakes" under the Common Agricultural Policy, where guaranteed minimum prices led to chronic surpluses that had to be stored, exported at a loss, or destroyed.
Case study
  • Northern Ireland's Renewable Heat Incentive (the "cash-for-ash" scandal) is a well-known UK example of government failure from inadequate information and unintended consequences.
  • The subsidy paid businesses more for each unit of heat generated from burning wood pellets than the pellets themselves cost, so some recipients had a financial incentive to run boilers constantly, even to heat empty sheds, pushing the projected overspend above £700 million\pounds 700\text{ million}£700 million.

Government Failure Does Not Mean Intervention Is Always Wrong

  1. Government failure does not mean intervention is always wrong.
  2. It means the likely costs of acting must be weighed against the market failure.
  3. On balance, intervention is justified only when it is likely to do more good than harm.

Prove a Genuine Net Welfare Loss

Exam technique
  • Name the specific cause, then show the welfare loss it creates.
  • Compare that loss with the original market failure.
Common Mistake
  • Do not label any disliked outcome as government failure.
  • It requires a genuine net welfare loss.
Self review
  • Define government failure.
  • Name three sources of government failure.
  • How can intervention create distortions rather than remove them?
  • Give an example of a policy causing net harm.
  • Why is not every bad outcome government failure?
  • A £200\pounds 200£200 minimum price creates a surplus of 404040 tonnes that the government buys up. Calculate the direct cost of buying the surplus.
  • What made Northern Ireland's Renewable Heat Incentive an example of government failure rather than just an expensive policy?

Recap questions

Test yourself with 5 quick questions on this guide. Answer them all correctly to complete it.

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