Saturday, 24 January 2009

Governemnt failure

In a previous posting I said
"Now there may be something wrong with the price system, but there is a lot more wrong with the government system."
In the comments to that posting Matt Nolan, of The Visible Hand in Economics fame, takes issue with me
"That's really your key value judgment isn't it. I'm not sure I agree. I am not a fan of "multipliers" - but in the face of a large, sustained, market failure I find it hard to conclude that there is no role for government."
Let me try and explain a part of my comment above. In particular the "more wrong with the government system" bit. It's important to realise that even if you accept the "market failure" idea you also have to deal with "government failure".

Why might government fail? In short, it's because people run governments and people aren't perfect. We tend to assume that in the economic area people act in their own best interests and that they have imperfect knowledge. The important point to note is that in the political sphere people have the same characteristics. This is not to say that altruism is impossible in either arena, but it seems prudent to adopt, as a working assumption, that voters, politicians and bureaucrats will be driven, at least to some degree, by self-interest.

A number of implications follow from this assumption.
  • Bureaucrats cannot 'correct' market failure, even if they wished to do so, because they lack the information to know what the outcome of the market process would have been had the so-called 'failure' not existed.
  • As argued above, bureaucrats will act in their own best interests. They will take actions that lead to promotion and advancement for themselves. In an effort to avoid problems, like public scandals, they may well become risk-averse, and thus they may regulate to reduce risks to a greater extent than consumers desire. They may also wish to increase there own power and prestige and the size of their regulatory bureau.
  • Rational voters have, in general, no interest in being perfectly informed about political issues because the probability of an individuals vote impacting on the result of an election is so small. This means that there will be information asymmetries between regulatory bodies and those to whom they are (should be) ultimately accountable: us, the voters. Thus electors are at a relative disadvantage when assessing the merits of proposed regulations.
  • While voters in general have little incentive to be actively involved in policy formation, in cases where the benefits of government actions are concentrated among particular voter groups, or institutions or companies, such groups have an increased incentive to lobby for expanded regulatory protection. Where the cost of such regulation is dispersed among voters, the losers from such regulation, will have no incentive to oppose the increased controls because the expected cost of lobbying to the individual voter will be large relative to the expected benefit.
  • Politicians will, all other things being equal, respond to the preferences of the 'median voter' rather than act to create regulatory institutions that might address genuine problems of market failure.
For all of these reasons government failure will result. We will get a level of regulation greater than that which would lead to welfare maximisation. Political institutions will also be biased towards forms of intervention that benefit the interest groups on which benefits are concentrated. And my view would be that government failure is at least as much, if not more of, a problem as market failure.

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