Government Failure

What It Means

When the government intervenes in the economy and the end result is to make the economy less efficient or to create new problems, economists say that “government failure” has occurred. Economists generally believe that markets, those real or virtual places where buyers and sellers come together to do business freely with one another, provide the best way of organizing economic life. Prices dictate how much of a product a seller will be willing to supply and how much of that product buyers will demand. When there is competition among both buyers and sellers, the market ensures that the correct quantities of the product are produced by the most efficient methods.

There are some situations, however, in which markets fail to produce the results that society wants. For instance, markets cannot be relied upon to provide for national defense. The government must intervene to make sure that the right amounts of military equipment and training are produced, and to make sure that its military forces can respond effectively in case of threats from other countries.

The government’s role in the economy is not always so clear-cut, though. Government leaders may genuinely want to improve social and economic conditions, but even with the best intentions inefficiency is sometimes unavoidable. In other cases government policies are simply ill-considered, or they are manipulated by interested parties, with the end result of increasing inefficiency and other problems.

When Did It Begin

Economists of the eighteenth and nineteenth centuries tended to argue that markets were almost always more efficient than governments, and that governments should not interfere with the forces of supply, demand, and prices. But the Great Depression, the severe economic crisis that affected North America and Europe in the 1930s, presented society with problems that markets did not seem able to solve. In response to these problems, British economist John Maynard Keynes suggested new economic theories justifying the government’s intimate involvement in the economy.

From the 1930s to the 1970s, the U.S. government generally followed Keynes’s theories, attempting to intervene in situations where the market did not perform effectively. But during the 1970s the country’s economy grew stagnant, and many economists began blaming the government. Bad government policies, it was believed, had interfered with the efficient functioning of markets. Since that time the U.S. government has reduced its role in the economy considerably, primarily due to the widespread belief that government intervention usually fails to increase efficiency.

More Detailed Information

Government involvement in the economy takes many forms, so there are many different types of government failure. Generally, economists use cost-benefit analysis to determine whether or not government failure has occurred. According to this standard, government failure results when government action causes more harm than good.

Governments frequently interfere in the pricing system in some industries, and this can result in a significant change in the quantity supplied and quantity demanded of a product. For example, the government might provide subsidies to corn farmers, giving them money that makes it easier for them to produce corn at a profit. While this benefits corn farmers and even consumers of corn (by keeping corn prices low), these benefits come at the expense of taxpayers, who provide the government with the money that it passes on to the corn industry.

Subsidies are not always ill-advised, however. For instance, when one person gets vaccinated against a disease, the entire population benefits because the overall risk of disease drops. By subsidizing the prices of vaccines, the government makes the individual better off, while also benefiting large numbers of other people.

On the other hand, government funding of products that most people see as obviously useful, like new roads, can result in economic inefficiency that harms society. When taxpayers fund the construction of roads in national forests that make it easier for logging companies to extract lumber from forests, taxpayers have essentially subsidized the logging industry. If cutting trees costs less money, then the industry is likely to cut more of them than it should.

Other types of government policies can have large-scale, but less obvious, effects on the economy. When the government borrows money to pay for its expenses, it can create a greater demand for money across the economy, which leads to higher interest rates (the fees charged to all people who borrow money). When interest rates are high, companies are less likely to take out loans that will allow them to expand, buy new equipment, or open for business in the first place. These activities, forms of what economists call business investment, make up one of the key elements in a country’s economic well-being. When business investment is crowded out by higher interest rates caused by government borrowing, government failure has occurred.

Additionally, the U.S. Congress may pass laws that affect the economy without prioritizing whether or not the end result will increase efficiency. The steel industry, for example, might pressure the government into placing high tariffs (taxes paid on imported goods) on foreign steel. By making foreign steel more expensive, Congress essentially encourages domestic steel-makers to increase its production of a good that can be more easily and efficiently produced elsewhere.

Recent Trends

During the 1990s and into the first decade of the twenty-first century, the longstanding practice of the government giving subsidies (or support payments) to farmers was a source of significant political and public debate in both the United States and in Europe.

Agricultural subsidies have a number of effects. First, the money acts as an income supplement for farmers whose crops (and therefore yearly earnings) are vulnerable to fluctuations due to changes in the weather and other uncontrollable circumstances. Farm subsidies also guarantee a price floor (lowest possible price at which it will be sold) for each crop. Suppose, for example, that the subsidy for soybeans is $1.19 per bushel and the price floor is set at $5.26 per bushel; by adding those two numbers, that would effectively guarantee a farmer $6.45 a bushel. If the market price of soybeans were to dip down to $5.16 per bushel, then the government would offset that price by giving a total subsidy (or price support) of $1.29 ($6.45 - $5.16) per bushel. Again, one of the primary concerns with these subsidies (which totaled $21 billion in 2005) is that they are paid for by taxpayers. Further, while U.S. farm subsidies originated during the 1930s as a way to keep small family farmers afloat and protect the national food supply during the financial crisis of the Great Depression, the makeup of the American agricultural industry has changed significantly since then. Nowadays many of the farmers who receive subsidies are wealthy owners of massive industrial farms.

Farm subsidies also have the effect of encouraging overproduction. According to the law of supply and demand, market prices fall as a result of declining demand, and producers respond accordingly by reducing their supply. When subsidies guarantee crop prices, however, farmers have no incentive to cut back their production. The result is a glut of harvested crops, which are sold on the international market at very low prices. Although it can be argued that the low prices are good for poor people in developing countries, the problem is that farmers in those countries, who cannot compete with international prices, are often forced out of business.

Because government farm subsidies interfere with market pricing and lead to a more inefficient allocation of goods and resources than the market would otherwise dictate, they are often used as an example of government failure. Arguments against this idea often focus on the need to provide stability in the agricultural industry and on the desire to help those farmers who are not rich and at risk of going out of business. Some people are also concerned that if the United States eliminated farm subsidies and did not produce enough food to feed itself, it would be vulnerable—in the event of a worldwide political change or crisis—to food shortages.