1.4.2 - Government failure

Meaning of Government Failure

Economists judge intervention by outcomes, not intentions. If a market failure creates a welfare loss, the government may try to reduce it with taxes, subsidies, regulation, or direct provision. But if the policy creates costs that are even larger than the original problem, society is worse off overall.

That is why government failure does not mean "the government meant badly". It means the final allocation is less efficient than before once the full costs of intervention are taken into account.

Distorted Signals and Unintended Effects

One major cause of government failure is that intervention can distort price signals and incentives. In markets, prices help coordinate decisions by telling consumers how scarce something is and telling producers whether extra supply is worthwhile. If policy pushes price away from the market equilibrium, behaviour changes, and the change may create a new inefficiency.

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With a rent ceiling at $P_{max}$, below the equilibrium rent $P_e$, tenants want to rent more housing so quantity demanded rises from $Q_e$ to $Q_D$, but landlords are willing to supply less so quantity supplied falls to $Q_S$. The gap between $Q_S$ and $Q_D$ is the shortage. Some landlords may also cut maintenance or leave the market altogether. That means a policy designed to improve affordability can end up reducing the quantity and quality of housing available.

This is where the welfare loss comes from. Only $Q_S$ homes are now let, fewer than $Q_e$, so homes that tenants value more than they would cost landlords to supply are no longer provided. Because price can no longer ration the scarce homes, something else does: waiting lists, landlords choosing between applicants, or illegal side payments. If these losses outweigh the gains to the tenants who pay less, the rent cap has caused government failure.

Unintended consequences can appear in other markets too. For example, biofuel subsidies were meant to support cleaner energy use, but they also encouraged some land to switch from food crops to fuel crops, which put upward pressure on food prices. In the United States, about a quarter of the corn crop was being used to make ethanol by 2007-08, and the Congressional Budget Office estimated that this extra demand explained 28-47% of the rise in corn prices between April 2007 and April 2008.