In the analysis of regulation, government failure (or non-market failure) is imperfection in government performance. The phrase "government failure" emerged as a term of art in the early 1960s with the rise of intellectual and political criticism of regulation. Building on the premise that the only legitimate rationale for government regulation was market failure, economists advanced new theories explaining why government interventions in markets were costly and tend to fail. For example, it was argued that government failure occurs when government intervention causes a more inefficient allocation of goods and resources than would occur without that intervention. In not comparing realized inadequacies of market outcomes against those of potential interventions, one writer describes the "anatomy" of market failure as providing "only limited help in prescribing therapies for government success". Government failures, however, occur also whenever the government performs inadequately, including when it fails to intervene or does not sufficiently intervene. Some use the phrase "passive government failure" to describe the government's failure to intervene in a market failure that would result in a socially preferable mix of output. Just as with market failures, there are different kinds of government failures that describe corresponding economic distortions.
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Overview
An early use of "government failure" was by Ronald Coase (1964) in comparing an actual and ideal system of industrial regulation:
Contemplation of an optimal system may provide techniques of analysis that would otherwise have been missed and, in certain special cases, it may go far to providing a solution. But in general its influence has been pernicious. It has directed economists’ attention away from the main question, which is how alternative arrangements will actually work in practice. It has led economists to derive conclusions for economic policy from a study of an abstract of a market situation. It is no accident that in the literature...we find a category "market failure" but no category "government failure." Until we realize that we are choosing between social arrangements which are all more or less failures, we are not likely to make much headway.Roland McKean used the term in 1965 to suggest limitations on an invisible-hand notion of government behavior. More formal and general analysis followed in such areas as development economics, ecological economics, political science, political economy, public choice theory, and transaction-cost economics.
The idea of government failure is associated with the policy argument that, even if particular markets may not meet the standard conditions of perfect competition required to ensure social optimality, government intervention may make matters worse rather than better.
Just as a market failure is not a failure to bring a particular or favored solution into existence at desired prices but is rather a problem which prevents the market from operating efficiently, a government failure is not a failure of the government to bring about a particular solution but is rather a systemic problem which prevents an efficient government solution to a problem. The problem to be solved need not be a market failure; sometimes, some voters may prefer a governmental solution even when a market solution is possible.
Government failure can be on both the demand side and the supply side. Demand-side failures include preference-revelation problems and the illogics of voting and collective behaviour. Supply-side failures largely result from principal–agent problem.
Economic crowding out
Crowding out is the displacement of private sector investment by way of higher interest rates, when the government expands its borrowing to finance increased expenditure or tax cuts in excess of revenue. Government spending is also said to crowd out private spending by individuals.
Regulatory
Regulatory arbitrage is a regulated institution's taking advantage of the difference between its real (or economic) risk and the regulatory position.
Regulatory capture is the co-opting of regulatory agencies by members of or the entire regulated industry. Rent seeking and rational ignorance are two of the mechanisms which allow this to happen.
Regulatory risk is the risk faced by private-sector firms that regulatory changes will hurt their business.
The World Bank Institute suggests that increased government size is associated with more political corruption even in stable democracies with high income, robust rule of law mechanisms, transparency, and media freedom.