Friday, 19 April 2013

Government Failure

Sometimes we see governments intervening in markets in an attempt to make them more efficient. However, it is very often the case that they aren't any better at managing resources than the free market - this is known as government failure. We'll look at example involving land conversion and biodiversity loss.

Land conversion is the main reason for biodiversity loss around the word - both grassland and forest cover is declining rapidly in some parts of the planet. We use a diagram similar to the one used in the last post which looks at the interaction between a firm's marginal net private benefit and the marginal external cost of land conversion. The definitions in this case are as follows:
  • Marginal net private benefit (MNPB) = the profit associated with a one unit increase in land conversion.
  •  Marginal external cost (MEC) =  External cost of a one unit rise in land conversion.

The market for this looks as follows:

Let us describe the market. We have an initial over-conversion because of the market failure. Lp is converted when the socially optimal level would be L*. This is all explained in the last post I made. The government failure, however, comes in the form of the subsidy. The government may be subsidising farmers' incomes, or something of the sort, but this is encouraging more land to be converted. The subsidy increases the marginal net private benefit of land conversion for the firm and therefore the amount of land converted has moved further away from the socially optimal level. We have to remove the government failure before we can remedy the market failure.

We've assumed a constant upwards sloping marginal external cost curve here, but it may be a good time to mention other plausible curves. We could have a curve that increases at a constant rate and once a threshold point is reached it increases faster. Or, we could even have a downwards sloping MEC curve. How? Imagine a view being ruined by a factory. The first factory has a massive effect on the view but subsequent factories have a lesser effect because the damage has already been done by the previous factories.

Government failure occurs a lot in the real world. One example would be with the Common Agricultural Policy. It aimed to provide farmers with a steady income by offering a guarantee price for their goods. This meant overproduction was rife - farmers knew that the best technique was to farm as much as they possibly could to get the most revenue. Land was farmed more intensively and more land was converted to farming to expand production. This will/has caused degradation of the land and biodiversity loss.

Another example is subsidies in developing countries. Governments there tend to impose subsidies to keep prices below the market price so that food and the like is affordable. This encourages over use of the land once again and makes the economic activity look artificially appealing, attracting more firms in. It is also a waste of financial resources that are needed elsewhere.

As we can see government failure is something that is very real. It can occur fairly easily and it needs to be stopped before any market failure can be addressed. How do we stop it, though? I'll be going into this in later posts, stay tuned. Thanks for reading.

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