1.3.6 government intervention Flashcards
why does the government intervene?
to correct market failure
- when the benefits gained from intervention are greater than the cost of intervention, the total welfare will be increased
- the market equilibrium moves closer to the optimum level
- there will be allocative efficiency
what are the methods of government intervention?
- indirect taxation
- subsidies
- maximum prices
- minimum prices
- traceable pollution permits
- extension of property rights
- state provision
- regulation
- provision of information
indirect taxation
to internalise the externality, & getting the firm to pay for the external costs they created
taxes discourages consumption/ production by increasing the firm’s private costs and corrects the negative production externalities
(MPC curve shifts upwards to equal MSC curve)
what is the ideal amount of tax imposed?
it should be the same as the external cost per unit, so the firm to produce at the social optimum quantity, eliminating the negative externality by removing the source of allocative inefficiency
=> the market failure would be fully corrected
how to decide what kind of tax to impose?
constant marginal external cost per unit -> specific tax
rising marginal cost per unit -> ad valorem tax
what are some examples of indirect taxes used to correct the negative externalities?
cigarettes, alcohol, tobacco, sugar
benefits of indirect taxes (4)
- internalise the externality by making suppliers (and indirectly, consumers) pay taxes, which is the external cost, reducing production and consumption
- government has higher tax revenue and can provide better public services
- more flexible than regulation since the tax rate can be changed as conditions change
- can influence people to switch to substitutes with external benefitsby incentivising good behaviour (eg taxing petrol to encourage consumers to switch to electric cars)
disadvantages of indirect taxes (7)
- difficult to measure the external cost, so it is hard to determine the best amount to tax. the government may tax too much or too little
- unpopular among consumers since they will have to pay more. they may get angry at the government and protest, causing political unrest and problems
- *big impact on profit and employment. since the cost or production increases and profit decreases, the quantity demand would decrease. firms may try to cut costs, so workers will get less pay/ unemployment increases
- regressive as it causes inequality. since everybody pays the same amount of tax, it hurts poor people more as the tax is a higher % of their income than it is to rich people
- does not fix the problem it the demand is inelastic. there will be little change in behaviour and the problem will not be fixed
- encourages black market, people would smuggle and sell products illegally so they don’t need to pay tax
- administrative costs may be high, and may outweigh the benefits
subsidy
encourages production and corrects positive production externalities by reducing the firm’s private costs (MPC curve shifts to the MSC curve). If the subsidy is the same as the external benefit, the firm would produce at the social optimal quantity
what is the purpose of providing subsidies to producers?
- encourages production and corrects positive production externalities
- reduces the firm’s private costs (shifts MPC rightwards to MSC)
- if the subsidy is the same as the external benefit, the firm would produce at the social optimum quantity
- the source of allocative inefficiency is removed, resource allocation is improved
—> can fully correct market failure
what is the purpose of providing subsidies to consumers?
- encourages consumption and corrects the positive consumption externalities
- reduces the private rice to consumers (shifts MPB upwards to MSB)
benefits of subsidies (4)
- increase quantity of product since the production cost is decreased, the firm is incentivised to produce more and pass on cost savings to consumers. if the price is decreased, it is more affordable, the consumers would buy more and there would be an extension in demand
- there would be financial injection into the economy because money is directly given to producers, they can produce more and there would also be higher profits
- encourages consumption by reducing the private price to customers since the costs are lower, more producers are attracted and consumers have more options, increasing the consumer surplus
- internalises the externality by correcting the positive production externalities. it internalises the external benefits since more private consumers directly receive the benefits, resource allocation is improved
disadvantages of subsidies (4)
- hard to measure the external benefit since the subsidy should be equal to the external benefit. the government may subsidise too much/ too little because of imperfect market information
- there is an opportunity cost. the gov has a limited budget and it could have spent the money on something else
- it causes political concerns because the gov may subsidise big donors of political parties, so this may be made for political and not economic reasons
- the administrative costs, eg distributing cost, background checks, monitoring costs may outweigh the benefits
minimum price
an effective minimum price is set higher than the equilibrium price
what happens with the excess products? why do they occur?
they are produced as a result of the higher price available in the market
the excess could be thrown away, sold in the black market at lower prices, or exported to other countries at lower prices (local farmers cannot compete), stored or donated
advantages of minimum prices (4)
- decrease the consumption of harmful products as higher prices discourage consumption
- there will be greater producer surplus because the qty supplied would increase as the price increases. the extension of supply increases and more profits are gained because the price is above the market price
- income support for low-wage workers as they can get above market wages
- if the good has inelastic demand, it would benefit suppliers. the higher prices would have a proportionally smaller impact on consumers, so the total revenue of producers would increase
disadvantages of minimum prices (5)
- people would go to black markets to sell the excess supply at a price that is lower than the minimum price so government loses potential tax revenue
- it is difficult to set the appropriate minimum price, it may be too high or low as it is hard to quantify external cost
- may encourage inefficient production & misallocation of resources. if the minimum price is higher than the cost, the producers would make a profit and stay in business despite being inefficient.
- there would be lower consumer surplus as there would be a higher price but a smaller quantity demanded
- elastic demand hurts producers as the higher prices would have a proportionally bigger impact on consumers, the total revenue of producers would decrease
price support
minimum prices for farm produce
agricultural products have low income elasticities of demand, and prices are unstable
there is a surplus and the government buys the excess supply at the price floor and stores, exports, donates or throws it away
disadvantages of government buying excess supply (3)
- there is an opportunity cost, they could’ve spent the money on education and healthcare. buying the excess supply is a burden on the government’s budget
- some farmers may become inefficient since they know they’re going to get really high prices anyways so there is no incentive for them to be effective (supports inefficient production)
- administrative costs are expensive, eg transport and storage costs
maximum prices
an effective maximum price is set lower than the equilibrium price (there is a price ceiling)
benefits of maximum price (3)
- there is greater consumer surplus because the good has become more affordable, there will be an extension in demand
- government popularity would increase which may lead to a stable political climate that encourages spending and investment. however, the government may lose support from businesses as well.
- inelastic demand of the god would lead to a smaller shortage since lower price has little impact on demand, the problems of shortages are reduced
disadvantages of maximum prices (7)
- elastic demand leads to a greater shortage because when lower prices has a big impact on demand, there will be a big problem of shortage and lots of people may not get the goods
- there might not be enough supply because of shortages (lower price high demand). consumers won’t be able to get the products and this might lead to black market issues
- producer surplus would be reduced because of lower prices leading to lower quantity supplied so their total revenue decrease
- unemployment may rise because as profit for firms decrease, they may try to cut costs
- suppliers/ people may sell/ resell the goods in the black market at a price that is higher than the market price
- it is difficult to determine the appropriate maximum price, it may be to high/ low
- investment from suppliers may fall because their total revenue has decreased and they have to cut costs, cannot afford to spend money on other investments
regulations
rules or laws put in place to influence behaviour
how does maximum prices work?
encourages more consumption so society can benefit from the positive externalities in consumption
as the price falls, the quantity demanded increases (there is an extension in demand), bringing the private equilibrium quantity demanded closer to the social optimum quantity
since the price is lower, the product will become more affordable and the market failure would be corrected
however, there would be persisting market disequilibrium because the market doesn’t reach a market-clearing price
there is an excess demand and too few resources lead to allocative inefficiency