A-Level Economics Notes on Government Failure

Definitions

1. Government Failure: Occurs when government intervention aimed at correcting market failure results in a net loss of economic welfare[1].
2. Market Failure: A situation where the market fails to allocate resources efficiently.
3. Economic Welfare: The overall well-being and standard of living of people in an economy.
4. Net Loss: The loss incurred when the costs of an action outweigh the benefits.
5. Net Gain: The gain achieved when the benefits of an action outweigh the costs.
6. Indirect Taxation: Taxes levied on goods and services rather than on income or profits.
7. Subsidies: Financial support provided by the government to make products more affordable.
8. Price Controls: Government-imposed limits on the prices that can be charged for goods and services.
9. State Provision: The supply of goods and services by the government.
10. Regulation: Rules set by the government to control market behavior[5].
11. Welfare Net Loss: Occurs when government intervention results in a worse outcome than the original market failure[3].

Government Failure vs Market Failure

1. Market Failure: This happens when the free market doesn’t allocate resources efficiently. For example, pollution is a classic case of market failure. Companies might not consider the environmental cost, leading to over-pollution.
2. Government Failure: Occurs when government policies worsen the problem they aim to solve or allocate resources inefficiently. For instance, rent control can lead to housing shortages[2].

Why Some Policies Work and Others Don’t

1. Alignment with Incentives: Successful policies align with market incentives. For example, a carbon tax can make companies internalize the cost of pollution, thus solving the market failure.
2. Misalignment: Policies fail when they don’t consider the full picture. Rent control, intended to make housing affordable, can result in landlords exiting the market, causing a housing shortage.

Real-World Examples

1. Carbon Tax: A solution to the market failure of pollution. It makes companies pay for their environmental impact.
2. Rent Control: A government failure example. Intended to make housing affordable, it often leads to less investment in housing and poorer quality homes.

Government Failure and Price Controls

Price control refers to the government setting minimum or maximum prices for specific goods or services. This is usually done to make essential items more affordable or to ensure fair trade.

Types of Price Control

1. Price Ceiling: A maximum price sellers can charge for a product. For example, rent control aims to make housing affordable.
2. Price Floor: A minimum price buyers must pay. Minimum wage laws are an example.

How Price Control Can Lead to Government Failure

1. Shortages and Surpluses: Price ceilings, like rent control, can lead to housing shortages. When the price is too low, demand exceeds supply, and not everyone who wants a house can get one.
2. Black Markets: Price controls can lead to illegal trading at higher prices. For example, if the government sets the price of bread too low, a black market may emerge where bread is sold at higher prices[3].
3. Reduced Quality: In the case of rent control, landlords might not maintain properties well because they can’t charge higher rents to cover costs[5].
4. Resource Misallocation: Price floors, like minimum wage laws, can lead to unemployment. Employers might not hire as many workers if they have to pay each one a minimum amount.

Real-World Example

Rent control in New York City is a classic example. While it aims to make housing affordable, it often leads to less investment in housing maintenance and development, causing a decline in the quality and availability of housing[4].

Government Failure and Subsidies

Subsidies are financial aids provided by the government to support specific industries or activities. The aim is often to make goods or services more affordable or to encourage certain behaviors.

How Can Subsidies Lead to Government Failure?

1. Resource Misallocation: Subsidies can distort market signals, leading to overproduction or underutilization of resources. For example, agricultural subsidies can result in farmers growing crops that are not in high demand.
2. Unintended Consequences: Sometimes, subsidies can have the opposite effect of what was intended. For instance, making public transport cheaper might not reduce the number of cars on the road, as people might still prefer the convenience of their own vehicles[2].
3. Inefficiency: Subsidies can also encourage inefficiency in the market. Companies that know they will receive government support may not strive for efficiency, knowing that their losses will be covered.
4. Wrong Intervention: The government might implement subsidies in response to incorrect market conditions, exacerbating the problem rather than solving it[3].

Real-World Example

A classic example is the U.S. farm subsidies. While intended to support small farmers, they often disproportionately benefit large agricultural corporations. This can discourage small farmers from competing, leading to less diversity in the market.

Government Failure and Trade Barriers

Trade barriers are restrictions that a government places on the import or export of goods and services. Common types include tariffs, quotas, and subsidies.

How Can Trade Barriers Lead to Government Failure?

1. Inefficiency: Trade barriers can distort market signals, leading to inefficient allocation of resources. For example, tariffs on imported goods might protect local industries but can also lead to higher prices for consumers.
2. Unintended Consequences: Sometimes, trade barriers can have the opposite of the intended effect. For instance, imposing tariffs to protect local jobs might lead to retaliation from other countries, harming exports and thus causing job losses.
3. Equity Issues: Trade barriers can create winners and losers. While they may protect certain industries, they can harm others and lead to inequality[4].
4. Rent-Seeking and Corruption: The process of establishing trade barriers can be influenced by special interest groups, leading to policies that benefit a few at the expense of many[3].

Real-World Example

A classic example is the U.S.-China trade war. Tariffs were imposed to protect American industries, but they led to higher costs for American consumers and retaliatory tariffs from China, affecting American exports.

Government Failure and Regulations

Regulations are rules set by the government to control the behavior of individuals and organizations, often to correct what is known as “market failure.”

How Can Regulations Lead to Government Failure?

1. Inefficiency: Regulations can sometimes be too restrictive or poorly designed, leading to inefficiencies. For example, stringent environmental regulations might protect nature but can also stifle business growth.
2. Unintended Consequences: A regulation meant to solve one problem may create another. For instance, rent control aims to make housing affordable but can lead to a shortage of quality housing.
3. Costs and Benefits: The costs of implementing and enforcing regulations might outweigh the benefits, making the cure worse than the disease[4].
4. Special Interests: Regulations can be influenced by special interest groups, leading to rules that benefit a few but harm the general public[2].

Real-World Example

The Dodd-Frank Wall Street Reform Act in the U.S. aimed to reduce risks in the financial system. While it did introduce some safeguards, critics argue that it also led to increased compliance costs for smaller banks, making it harder for them to compete.