Government failure

Meaning

Government failure occurs when government intervention leads to a net welfare loss: resources are allocated less efficiently than before the intervention, or the intervention costs more than the benefits it brings. It is the mirror image of market failure and the key evaluation idea for any question on intervention.

Causes named in the specification

The specification names five causes: information gaps, lack of incentives, unintended consequences, excessive administrative costs and moral hazard.

• Information gaps (inadequate information): the government does not know the true size of external costs and benefits or consumers' preferences, so taxes, subsidies or permit caps are set at the wrong level (for example a tax lower than the external cost, or too many permits).
• Lack of incentives: state-run providers and subsidised firms do not face the profit motive or competition, so they have little reason to cut costs, innovate or respond to consumers. A subsidy that covers losses whatever happens removes the pressure to be efficient.
• Excessive administrative costs: collecting taxes, running subsidy schemes, monitoring permits and enforcing regulations use resources. If these costs exceed the welfare gain, intervention is a net loss.
• Unintended consequences: people react in ways the policy did not plan for: high taxes encourage smuggling and black markets; maximum prices cause shortages and black markets; landfill taxes encourage illegal dumping (fly-tipping).
• Moral hazard caused by intervention: guarantees and rescues encourage risk-taking (banks expecting bailouts, farmers over-producing because minimum prices guarantee their income).

Two further ideas are useful in evaluation although they are not on the specification list: conflicting objectives (a fuel tax cuts pollution but hits low-income rural households) and distortion of price signals (intervention changes prices, so they no longer reflect true scarcity).

Using government failure in evaluation

In 14-mark and 20-mark answers, evaluation should weigh the benefits of intervention against the risk of government failure. Good evaluation:

• names a specific cause (for example inadequate information) and explains its likely effect in this market
• considers magnitude: how big is the market failure compared with the likely government failure?
• considers time: effects in the short run and long run
• considers elasticities and the design of the policy
• reaches a judgement: on balance, is intervention likely to improve welfare, and under what conditions?

Worked example

A government sets a very high tax on cigarettes. Explain how this might lead to government failure.

1. Unintended consequence: the large price gap between taxed and untaxed cigarettes makes smuggling profitable.
2. Some smokers buy cheaper illegal cigarettes, so consumption does not fall much.
3. Tax revenue falls and the illegal products may be more harmful.
4. Enforcement adds administrative cost, so welfare may not improve.

Answer: Smuggling and black markets (unintended consequences) plus enforcement costs may mean a net welfare loss.

Check yourself

1. Government failure occurs when
   • a government runs a budget deficit
   • a free market under-provides a public good
   • a firm goes out of business
   • government intervention leads to a net welfare loss
   Show answer

   government intervention leads to a net welfare loss. Intervention makes the allocation of resources worse.

2. The government sets a pollution tax lower than the true external cost because it cannot measure the damage. This is government failure caused by
   • lack of incentives
   • information gaps
   • moral hazard
   • excessive administrative costs
   Show answer

   information gaps. The government lacked the information to set the right tax.

3. A state-owned bus company receives a subsidy that always covers its losses, so it makes no effort to cut costs or improve its service. Which cause of government failure does this show?
   • Unintended consequences
   • Excessive administrative costs
   • Information gaps
   • Lack of incentives
   Show answer

   Lack of incentives. Without the profit motive or the threat of losses, managers have little reason to be efficient.

4. A landfill tax leads some people to dump rubbish illegally in the countryside. This is an example of
   • an unintended consequence
   • a positive externality
   • the free-rider problem
   • consumer surplus
   Show answer

   an unintended consequence. The policy changed behaviour in a way that was not planned.

5. A government cuts fuel duty to help households with living costs, but this raises pollution from cars. This illustrates
   • symmetric information
   • a public good
   • conflicting objectives
   • perfectly inelastic supply
   Show answer

   conflicting objectives. Helping households with costs conflicts with environmental aims.

6. A subsidy scheme costs more to run and monitor than the welfare gain it creates. The cause of government failure is
   • excessive administrative costs
   • herding
   • speculation
   • a free good
   Show answer

   excessive administrative costs. Running costs exceed the benefits.

7. Explain how a guaranteed minimum price for farmers could lead to government failure.
   Show answer

   Because farmers know the government will buy any surplus at the guaranteed price, they have an incentive to over-produce regardless of demand (moral hazard). Surpluses build up and must be bought and stored at taxpayers' expense, wasting resources.. Incentive created by the guarantee, then the waste.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.