Government Failure:
(“Economics” – Chapter 11)
Even in instance of “market failure,” it would be naïve to
conclude that the outcome with government intervention
will always be “better” (smaller DWL) than without
government intervention
Government Failure – situations in which total social
surplus is decreased by government intervention in a
market
Two broad causes of government failure:
1. Government fails to perform a necessary task efficiently
2. Government fails to do only those tasks that it should do
7 specific sources of Government Failure:
1.
Informational Problems
 when formulating government policy, it is often
necessary to choose a “scope” for government activity
 e.g., provision of a public good (such as national
defense)
 absent government provision we will have too little
 2011: U.S. spent $678.1 billion on defense => is
this “too little,” “just right,” or “too much”?
 when buyers and sellers make decisions in markets,
they generally have incentives to truthfully reveal their
benefits and costs
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 however, this is not the case when we abandon or
cannot rely upon markets
 even a well-intentioned government bureaucrat can be
led astray when private citizens misrepresent their true
benefits or costs from different policies
 Economic Calculation Problem – a system of
planning will never be able to achieve efficient
outcomes, precisely because under such a system the
planners do not have the information generated by
market activities available to them
 Argument first made by Ludwig von Mises and
later refined by Friedrich von Hayek
 To see how markets aggregate and reveal distinct
pieces of information, consider artificially created
prediction markets
- “InTrade Prediction Markets” => tradable futures
created in such a way so that “price” provides a
“reflection of the current aggregate perception of
the likelihood of an event”
- Who will be the 2012 Presidential election? To
get an answer, we can “ask the market”!
2.
Costs of Complying with Government Bureaucracy
 when
governments
impose
rules/regulations,
individual households and firms need to expend
resources to comply with the policies
 use of resources for compliance imposes a cost => the
greater the bureaucracy, the higher are these costs
 if the costs are sufficiently large, they will outweigh
any benefits of the regulation
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 “Permit Raj” in India: “a complex, irrational, almost
incomprehensible system of controls and licenses”
under which “everything needed (government)
approval and a stamp.”
 Recall the “Ease of Doing Business” study. Costs of
starting a new business:
 Chad: 11 procedures, 66+ days, costing 208.5% of
annual per capita income
 New Zealand: 1 procedure, as little as 1 day, costing
0.4% of annual per capita income
3.
Corruption or Kleptocracy
 Corruption – an environment in which regulations
are not enforced and decisions are not made evenly
and without bias
 corruption leads to inefficient decisions
 e.g., contract for a bridge
- “Contractor A” has costs of $18 million;
“Contractor B” has costs of $21 million =>
efficiency dictates choosing “Contractor A”
- “Contractor B” could bribe a corrupt bureaucrat,
resulting in higher costs for building the bridge
 Kleptocracy – an environment of extreme corruption
in which government officials unabashedly seek
personal gain at the expense of the public interest
 present day Russia: “an ill-governed kleptocracy” in
which “corruption is not a happy side effect of
power, but the core of the system” and as a
consequence “a small group of people wholly above
the law has, in the past decade, become rich beyond
the wildest dreams of the tsars.”
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The next three sources of government failure (rent seeking,
logrolling, and regulatory capture) can actually occur most
easily under a political process in which citizens have a
voice in formulating policy…
The relevant insights on these next three issues were
realized by scholars working in the field of Public Choice
Public Choice – the academic subfield which uses the tools
and framework of economics to analyze issues that
historically fall within the domain of political science
4.
Rent-Seeking
Rent-Seeking – attempts by individuals and firms to use
government action to make themselves better off at the
expense of others
 e.g., U.S. trade restrictions on imported peanuts
 very beneficial to owners and workers of U.S.
peanut farms (who therefore have a strong incentive
to lobby hard to keep the restrictions in place)
 peanut producers have an incentive to expend
resources to secure these “rents”
 costly to consumers, foreign peanut producers, and
U.S. producers of any goods which use peanuts as
an input
 resources expended to secure such “rents” (or
“surpluses”) are essentially wasted => consider the
decision of “Where to have the 2020 Summer
Olympics?”
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5.
Logrolling
 estimated annual impact of U.S. peanut quota:
 jobs saved = 397
 cost per job saved = $187,223
 How does this clearly inefficient subsidy with benefits
for so few people get enacted?
Why would
Congressman from Ohio, California, Oregon, and
Wisconsin vote to save 397 jobs in Georgia, Alabama,
and Texas at a cost of $187,223 per job!?
Logrolling – the process by which a legislator votes to
approve one bill in exchange for favorable votes from
other members on other bills
 not necessarily a “bad thing” => logrolling can be
potentially beneficial, since it allows for an expression
of “intensity of preference”
 but, particularly when voters are “rationally ignorant,”
the process can give rise to inefficient outcomes
 rational ignorance – since becoming informed on
an issue is costly and the benefits of being informed
are typically very small, it is rational for many
voters to remain uniformed
 Congressman from Ohio, California, Oregon, and
Wisconsin want similarly inefficient trade
protection for machine tools, canned tuna, softwood
lumber, and dairy products
 No single proposal would receive majority support
based on its own merit. But, when voters are
rationally ignorant and representatives engage in
vote trading, all the policies get enacted (clearly
inefficient).
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 More insights on trade protection for peanuts and
other goods:
 total costs to society = $74,327,531
 in a society with 310 million people, this comes out
to 23.98¢ per person per year => most people
probably do not even notice (or would even care to
notice) such a small cost
 average annual per person cost of trade protection
for… dairy products: $5.25, machine tools: $2.41,
softwood lumber: $2.03, canned tuna: 32.41¢
 even though trade protection for peanuts is a “small
net loss” for the average person in the U.S., it appears
to be a “big net gain” for people in GA, AL, and TX
(similar statements apply for these other quotas)
 voters in GA become informed about and recognize
the local benefits of the trade protection for peanuts
but remain rationally ignorant of the costs of all the
other trade protections
 James Buchanan (1919-; Noble Prize in 1986;
currently at George Mason Univ.) argued that
politicians in a democracy often act to maximize the
probability of their reelection.
 it is in the best interest of the representative from GA
to engage in logrolling (i.e., vote trading) with other
representatives to make sure that the trade protection
for peanuts is passed (even if it means passing all the
other programs as well)
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6.
Regulatory Capture
 governments often regulate markets in which
producers have market power or in which there is a
potential for lack of information
 e.g., in the U.S., all prescription drugs must be
approved by the Food and Drug Administration (FDA)
 presumably, we would want the regulatory agency
to conduct a thoughtful cost/benefit analysis based
upon the best interest of the public
 but, the regulated industry has a strong incentive to
influence the decisions of the regulatory body
Regulatory Capture – a situation in which firms in a
regulated industry influence a regulatory agency to the
point where the agency makes decisions that are in the
best interest of the firms being regulated (even if the
decisions are not in the best interest of the public)
 regulators often identify more with those in the
industry they are regulating than with the general
public (perhaps simply because of movement back and
forth over time of people between working in the
industry and working as a regulator)
7.
Deadweight-Loss from Taxes
 Government spending must be financed in some
manner – commonly by way of taxes.
 Almost all taxes distort costs and benefits and
therefore influence economic choices (often in an
inefficient way)
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Market outcome in the presence of a “per unit” tax:
In the presence of a “per unit” (or “quantity”) tax, either:
buyers have to pay a certain amount to the government for
every unit purchased or sellers have to pay a certain amount
to the government for every unit sold (e.g., total per unit
taxes on gasoline of roughly $0.628 per gallon)
Incidence of a Tax – a measure of “who bears the burden
of the tax” in terms of “decreased welfare.”
Two environments to consider and compare:
I. per unit tax of $T imposed on buyers (so that
buyers must “write the check to the government”)
II. per unit tax of $T imposed on sellers (so that
sellers must “write the check to the government”)
Focus of analysis:
1. Precisely why will per unit taxes give rise to a positive
Deadweight-Loss?
2. Precisely how much revenue would a per unit tax of
$T generate?
 Suppose per unit taxes on gasoline are increased by
$1. If 5,000 gallons were being traded per day in
this market, how much additional tax revenue
would this increase generate?
3. If a per unit tax of $T is going to be imposed, is it
“better” to impose it on buyers or sellers? Three
perspectives: buyer’s, seller’s, society’s (e.g., would
buyers prefer this tax to be “imposed on buyers” or
“imposed on sellers”?)
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Example:
 consider a market in which a per unit tax of $T=$1
will be imposed
 before the tax is put in place: 5,000 units are traded,
each at a price of $3.80
$
Supply
= (Seller’s Res. Price)
pM  3.80
Demand
= (Buyer’s Res. Price)
0
quantity
0
qM  5,000
Per unit tax of $T imposed on Buyers:
Effect on Demand => at the “point of sale” any buyer is
now willing to pay exactly $T=$1 less than before =>
Demand curve shifts down by $T=$1
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$
Supply
= (Seller’s Res. Price)
pTB  4.20
pM  3.80
a
b
d
c
e
f
pTS  3.20
Demand
= (Buyer’s Res. Price)
(Buyer’s Res. Price)-(T)
quantity
0
0
qT  4,200
qM  5,000
Outcome with tax in place:
 Outcome at “point of sale” determined by focusing on
“green curve” and “red curve”
 4,200 units traded <= unique quantity at which
“buyer’s reservation price” (height of blue curve) is
exactly $T=$1 above “seller’s reservation price”
(height of red curve)
 Price at the “point of sale” is $3.20
 Sellers receive $3.20 on each unit sold
 Buyers must pay $T=$1 on top of the $3.20 purchase
price, for a total of $4.20 on each unit purchased
 CS decreases by (a)+(b)+(c) <= Incidence for buyers
 PS decreases by (d)+(e)+(f) <= Incidence for sellers
 Government tax revenue of (a)+(b)+(d)+(e) (equal to
($1)(4,200)=$4,200). Note, government tax revenue
is less than $5,000, since they only collect the $1 of
tax on units which are traded when the tax is in place.
 Less than efficient level of trade => DWL of (c)+(f)
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Per unit tax of $T imposed on Sellers:
Effect on Supply => at the “point of sale” any seller must
now be paid exactly $T=$1 more than before => Supply
curve shifts up by $T=$1
(Seller’s Res. Price)+(T)
$
Supply
= (Seller’s Res. Price)
pTB  4.20
a
pM  3.80
d
b
e
c
f
Demand
= (Buyer’s Res. Price)
pTS  3.20
0
quantity
0
qT  4,200
qM  5,000
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Outcome with tax in place:
 Outcome at “point of sale” determined by focusing on
“orange curve” and “blue curve”
 4,200 units are traded <= unique quantity at which
“buyer’s reservation price” (height of blue curve) is
exactly $T=$1 greater than “seller’s reservation price”
(height of red curve)
 Since the same quantity is traded with the tax imposed
on sellers as when the tax was imposed on buyers, it
follows that all other aspects of the two outcomes are
identical as well! That is:
 Sellers receive $3.20 while buyers pay $4.20 on
each of the 4,200 units traded
 The decrease in CS, decrease in PS, amount of
government tax revenue, and magnitude of DWL
are all the same as when the tax was imposed on
buyers instead of sellers
 It makes NO DIFFERENCE in terms of welfare
(to buyers, sellers, or society) if this per unit tax
is imposed on buyers or imposed on sellers!
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