Definition

Government failure occurs when a measure of economic policy or the inactivity of the government worsens the market allocation of resources reducing economic welfare.

Government Failure

From a reading of the first few chapters of textbooks of Principles of Economics, we have learned that under the assumption of a perfect competitive market, for each good (or bad) exchanged, the economy achieves its maximum level of welfare as a result of the Smithian theory of the “invisible hand” (Smith 1776). This means that in such a Pareto-optimal situation, there is no room for economic policy measures that, if adopted, may only constitute an obstacle to the proper functioning of the market.

Despite this unlimited confidence in the market virtues, the same Adam Smith was forced to recognize the limits of the market, regarding national defense, justice, and public services (i.e., waterworks, hospitals, schools, roads, etc.), for which there is no profit in producing at an individual level, because the costs are always greater than the revenues (Smith 1776). Although one of the fathers of the modern economic theory recognized the limits of the market, the dominant view, up until the 1940s, was that the government should not interfere with the market to modify or change market allocation or income distribution.

The Great Depression started in the late 1930s and the subsequent Keynesian theory (Keynes 1936) was further instrumental in destroying the myth of the free market. After the Second World War, the economic theory started to consider than before the existence and causes of market failure more seriously (Bator 1958) and saw the need for some government intervention, the so-called visible hand (Chandler 1977), to improve market allocation and raise the level of social welfare.

During the second half of the last century, the broad consensus regarding the positive consequences of adopting economic policy to correct the effects of market failures on economic welfare Coase (1964) introduced into the economic literature the expression “government failure,” as opposed to “market failure,” to express some concern about the continual assumption of Pareto-improving consequences of economic policy measures (Posner 1969, 1974). (Ronald Coase (1964) agreed with the approach which evaluated the effects of economic policy measures comparing regulated industries with industries not subject to regulation, although this approach cannot be followed because it is difficult to find industries that are comparable regardless of the degree of regulation.)

Coase drew inspiration from the talk of Professor Roger C. Cramton, a law scholar, held in Boston during the Seventy-Sixth Annual Meeting of the American Economic Association: Cramton stated that lawyers “…focus on the fact that public officials and tribunals are going to be fallible at best and incompetent or abusive at worst….” Coase (1964) remarks that this statement is completely opposed to the assumption that the economists make about the government. In the economic theory, the government is seen as a benevolent planner who wants to correct the defects of the invisible hand, to improve market allocation, and to raise the level of welfare. The opinion of the government expressed by Professor Crampton would probably have been considered provocative, but for the economist, it was an alarm bell underlining the necessity to rethink the assumption about the government bodies and the impact of economic policy measures on the level of welfare. (In general, about the measure of economic policy, we can report the words of Milton Friedman (1975): “…The government solution to a problem is usually as bad as the problem and very often makes the problem worse….”) Moreover, Coase (1964) emphasizes the inability of the government to supply an immediate answer to the changes in economic conditions and the crucial role of “detailed knowledge” (or information) of the economic phenomenon addressed by a measure of economic policy, as an indefectible condition of government intervention. (Winston (2006) has recently affirmed that government failure “…arises when government has created inefficiencies because it should not have intervened [in the market] in the first place, or when it could have solved a given problem or set of problems more efficiently, that is, by generating greater net benefits…”; such a definition empathizes the inability of the government to improve market allocation.)

It is possible to affirm that a government policy is worth adopting in the presence of a market failure that is a source of not negligible social costs (see Datta-Chaudhuri (1990), Krueger (1990), Wallis and Dollery (1999, 2001), and Wiesner (1998) about the policy measures adopted in developing countries, since the 1960s, as sources of economic inefficiency which worsen the welfare level) where the government policy is at least improving market performance and efficiently correcting the market failure and optimizing the economic welfare (for normative economic theories of government failure, see Dollery and Worthington 1996).

The first possible source of government failure is the dynamic nature of an economic process such that the government in charge cannot commit itself for future measures which will be adopted by the subsequent government. (The dynamic nature of the economic process makes it necessary to consider the discount rate in the analysis: this is a task that we leave to future and more detailed analysis.) Stiglitz (1998) offers the example of hydroelectricity plants to produce electricity which need to be subsidized for a period of time longer than the duration of the legislature, while the hydroelectricity industries have no guarantee that successive governments will leave unaltered the subsidies and the legislation. (The inability to make commitments causes another set of inefficiencies: the cost of creating next-best credibility-enhancing mechanisms. While those in the government at one date cannot commit future governments, they can affect the transaction costs of reversing policies (Stiglitz 1998, p. 10).)

The economic policy measures worsen market allocation whenever there is imperfect information between the policy maker and the private parties involved. Imperfect information may represent an obstacle to improving Pareto efficiency, if the policy maker does not have access to all the relevant information to adopt the correct policy measure or establish the magnitude of the measure (e.g., the amount of the rate of taxation).

The third source of government failure is the so-called destruction competition, a process that occurs in the presence of imperfect competition. Firms can get ahead not just by producing a better product at lower costs but also by raising the costs of their rivals (Salop and Scheffman 1983). Destructive competition is a zero-sum game where the profit of one is at the expense of another (see, e.g., the political games, with positions to be won or lost). This means that under the imperfect competition market structure, the liberalization of the market or the inactivity of the policy maker (Orbach 2013), as a result of a rational choice, determines the achievement of a suboptimal level of social welfare.

Another source of government failure is uncertainty about the consequences of policies: this may be due, as in the case of economic policy measures taken under asymmetric information, to the inability to predict the future impact of economic policies adopted now. A lesson we learned is that to be effective, economic policy measures should have well-defined objectives to achieve; otherwise, the measures taken by the government without a clear and precise statement of the objectives to be pursued and of the resources to meet them are just a way to leave unchanged the allocation of resources and the distribution of income (Cramton 1964). This means that some cases that may be attributable to the concept of government failure are just from the point of view of social welfare, because the government policies worsen market allocation but satisfy the real will of the policy maker to protect some established interests, without displeasing public opinion.

Finally, the last point we address is that government policies may be constrained in their action and worsen welfare due to the complexity of the economic measures that are hard for public opinion to understand, so Stiglitz (1998) empathizes the “simplicity constraint” in economic policies. Simple policies are easily explained to, and approved by, public opinion.

In a more interdisciplinary environment, considering laws, institutions, and economics, the theory of government failure has recently been enriched, affirming that it may also be due to the inefficient designing of rules for the economy that may be excessively specific (i.e., standard), too broad, conflicting, and unfair (Dolfsma 2011). (In general, on inefficient regulation as a source of government failure, see Posner (1974).)

The theories of government failure have played a different role in the United States and in the Old Continent because in the former they have been used to justify the limited adoption of economic policy measures and a reduced role of the state within the economy. In Europe, the limits of government action have been used to justify a reduction of the weight of the public sector in the economy (Vickers and Yarrow 1991).

Despite the differences between Europe and the United States in the role of the state in the economy that can be measured by the tax burden (Romer and Romer 2010), the government follows the business cycle in its policies because during crises, it is forced by public opinion to adopt stronger measures to curb the crisis (Rajan 2009), while during periods of prosperity, it is more prone to pander to the desire of firms for freedom.

Winston (2006), basing his theories on an empirical research limited to antitrust, monopsony policy, and economic regulation to curb market power, so-called social regulatory policies to correct imperfect information and externalities, and public production to provide socially desirable services, reached the conclusion that government intervention in markets has either been unnecessary or has missed significant opportunities to improve performance. (For recent development of the theory of “government failure,” see Mitchell and Simmons (1994) and Winston (2006).)

The economic policy measures to correct the limitations of markets have played a significant role in economic history (Datta-Chaudhuri 1990) and will probably continue to be useful in the future, but to improve market allocation, the policy maker should be aware of the limits of the “visible hand” (Winston 2012).

Cross-References