AEI-Brookings Joint Center for Regulatory Studies

Government Failure vs. Market Failure: Microeconomics Policy Research and Government Performance

On what basis is one to conclude that a policy to correct a market failure is as successful as possible? The first consideration is whether government has any reason to intervene in a market: Is there evidence of a serious market failure to correct? The second is whether government policy is at least improving market performance: Is it reducing the economic inefficiency, or "deadweight" loss, from market failure? Of course, the policy could be an "expensive" success by generating benefits that exceed costs, but incurring excessive costs to obtain the benefits. Hence, the final consideration is whether government policy is optimal: Is it efficiently correcting the market failure and maximizing economic welfare?

Government failure, then, arises when government has created inefficiencies because it should not have intervened in the first place or when it could have solved a given problem or set of problems more efficiently, that is, by generating greater net benefits. In other words, the theoretical benchmark of Pareto optimality could be used to assess government performance just as it is used to assess market performance. Of course, the ideal of a completely efficient market is rarely, if ever, observed in practice. From a policy perspective, market failure should be a matter of concern when market performance significantly deviates from the appropriate efficiency benchmark. Similarly, a government failure should call a government intervention into question when economic welfare is actually reduced or when resources are allocated in a manner that significantly deviates from an appropriate efficiency benchmark.

The disappointing outcome of government's current microeconomic policies should be of great concern to everyone interested in public affairs regardless of political persuasion or occupation. By documenting government's performance and indicating how it can be improved, I hope to do more than set a "limit to infinite error."