In principle, government policies to reduce market failure make economic sense. They increase the level of economic efficiency in markets and thus must be judged to be economically desirable. However, in practice, all may not work out as planned. Governments may themselves fail. There are reasons why government intervention may in fact create further inefficiencies and thus not improve the use of scarce resources in a society.
There are three main reasons why there may be government failure:
1. Problems of Information
Once the government starts to intervene in the running of markets, it needs information. The correct policies can only be introduced if governments have the correct information. The problem is that governments may have inaccurate information. In the case, they may introduce policies that lead to greater economic inefficiency. Some examples of this problem could be the following:
- A lack of information about the true value of a negative externality. It is often very difficult to give an accurate figure for the value of a negative externality such as pollution. It is difficult both to put an accurate figure to all of the cost imposed and to trace the source of the pollution itself. The problem with this is that it then becomes very difficult to impose the correct value of a tax that attempts to reduce production to an efficient level. The wrong level of tax will lead to the wrong level of production.
- A lack of information about the level of consumer demand for a product. If the government is providing a product free of charge to the consumer then some estimation of the level of consumer demand is required. This could be the case with a public good, such as a lighthouse or a national defence system. Such products may not be provided by the market system and thus the government provides them. However, the government must try to provide the right amount of such products. If it does not estimate the level of demand accurately then the wrong amount of the product will be produced and thus there is inefficiency.
A further problem arises with government intervention in the economy due to the creation of undesirable incentives. These can create inefficiencies. Some examples of the way in which this can happen are as follows:
- The imposition of taxes can distort incentives. The most obvious example of this is the possible impact of an income tax upon the incentive to work. High marginal rates of taxation can create disincentives for people to work harder and gain more income. If this happens then scarce resources are not being used to their best effect and there is inefficiency. A similar point can be recalled from the earlier discussion of the deadweight loss of a tax. The disincentive to consume and produce created by the tax led to the wrong amount of a product being produced.
- Politicians may be motivated by political power rather than economic imperatives. Politicians are often seen as being motivated principally by the desire to remain in government. If this is so then economic policies may be designed by government to try to retain power rather than to try to ensure maximum efficiency in the economy. Thus, an unpopular tax on a product that produces negative externalities, such as car use that creates pollution and environmental damage, may be avoided due to the government's fears that it could lead to a loss of votes.
- Those running public services may have inappropriate incentives. Once products are provided by the government then the profit motive of the private sector is largely removed. The question then remains as to what may motivate those in charge of providing public service. There is no entirely clear answer to this question. At its worst, it could become a total lack of incentive to produce the product well or attempts to defraud the system.
Government intervention in the running of the economy is often justified by the need to reduce inequity. However, it is possible that government intervention might sometimes increase inequity. This is simply understood by recognizing that the imposition of any tax will have a distributional effect. Thus, a tax on energy use that aims to reduce harmful emissions of greenhouse gases will have different effects on different groups of people. If the tax is on the use of domestic fuel then older members of society may feel the greatest effect as they use proportionately more domestic fuel for heating than others in society. This could be seen unfair and increasing inequity in society.
Resource: Colin Bamford, Keith Brunskill, Gordon Cain, Sue Grant, Stephen Munday, Stephen Walton, As Level and A Level ECONOMIC, University of Cambridge, 2002.
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