Government failure and unintended consequences

We have already seen that unregulated markets have a tendency to “fail” by not achieving an allocation of resources that best satisfies societies needs and wants (allocative efficiency).  As a consequence, governments frequently intervene to alter how resources are used within an economy with the intention of improving overall living standards.  However, government intervention frequently comes with unintended consequences that, on balance, potentially leads to a less efficient allocation of resources and reduces overall living standards.

Governments intervene in many ways such as via the use of indirect taxes (e.g. excise tax on fuel, alcohol and tobacco), subsidies (e.g financial incentives to promote consumption or production of certain goods, such as energy efficient appliances) and government regulations (e.g. minimum wage laws or plain packaging laws) and advertising to educate (e.g. sunscreen and smoking) with the intention of improving how efficiently and effectively resources are used.  

However, given that there are typically a variety of potential solutions to overcome any “misallocation of resources” that frequently occurs in unregulated markets, any policy response runs the risk of actually decreasing economic efficiency and creating ‘government failure’.  This will occur if the costs of the intervention outweigh any intended benefits from the intervention, such that overall living standards fall as a consequence of the intervention.  It can also be argued that government failure occurs if the costs of any given government intervention are greater than they could otherwise be (i.e. the opportunity cost of government intervention is not minimised).  For example, if it is accepted that pricing carbon is the ‘best’ way to tackle climate change, then the adoption of any other policy solution could be considered an example of government failure (even if it does manage to reduce carbon emissions) given that the opportunity costs attached to this intervention are not minimised).

Examples of possible government failures

Examples of possible government failures, or at least policies that unintentionally have a negative impact on efficiency in the allocation of resources, includes the provision of government subsidies that have been designed to protect Australian industries and/or promote employment.  For example, subsidies given to companies like Alcoa enabled it to artificially keep its prices lower than otherwise, which granted the company relatively more power to compete, or bid for resources against other (unprotected) Australian producers.  In addition, subsidised companies will be somewhat shielded from the rigours of international competition, which has the potential to create complacency and cause management to be less proactive in seeking efficiency gains (e.g. via reform or restructure).  Inevitably, this can result in a slowdown in productivity growth, adding unnecessarily to production costs and reducing technical and dynamic efficiency.  As a consequence, the allocation of resources (in the economy) will be sub-optimal in the sense that too many resources are being allocated to those industries in which Australia does not have a comparative advantage.

A more recent example relates to the government subsidies provided to private vocational colleges and students [e.g. under the Australian federal government’s now defunct VET FEE-HELP scheme].  The subsidies allowed these colleges to effectively receive thousands of taxpayer dollars per student enrolled, which created huge incentives for the colleges to enrol excessive numbers of students in courses (many of which were either sub-standard or virtually useless) that provided students with very little education and/or skills development.  The private colleges were effectively ‘rorting the taxpayer’, attracting huge amounts of scarce government revenue that could have been put to much more effective use elsewhere in the economy.  This, in itself, is an example of government failure given that the subsidy support came at huge opportunity costs and effectively reduced social welfare.  In addition, the fact that numerous students were left with worthless qualifications increases the likelihood that future students will avoid vocational education altogether, afraid of amassing debts to complete courses that might provide no personal economic benefit.  This is inefficient because well targeted vocational education is actually in the national interest and the failure to allocate an appropriate amount of the nation’s resources to this sector is allocatively inefficient.]