1.4 Government Intervention

Question 1

Indirect Taxation Diagram

Answer 1

When a good has a negative externality, the government introduces indirect taxation to prevent market failure
Causes a fall in supply and the costs to the individual rise so S1 has a parallel inward shift to S2 but the social optimum position is P2Q2 where MSB=MSC
Following introduction of tax, equilibrium position is S2=MPB=MSB at P2Q2
Tax internalises the externality and social welfare is now maximised

Question 2

Indirect Taxation Advantages

Answer 2

Internalises the externality meaning the market now produces at the social equilibrium position and social welfare is maximised
Raises government revenue which could be used to solve the externality in other ways such as through education. Helps good to become more elastic in LR.

Question 3

Indirect Taxation Disadvantages

Answer 3

Difficult to know size of externality so difficult to target the tax
Could be conflict between government goal of raising revenue and solving the externality
Could lead to creation of a black market
If demand for goods is inelastic, the tax will be ineffective at reducing output
Taxes are politically unpopular so governments may be reluctant to introduce them
Regressive meaning the poor spend a larger proportion of their income on indirect taxes than the rich

Question 4

Subsidies Diagram to Solve Information Gaps

Answer 4

S1 parallel outwards shift to S2 as it lowers cost of production
Free market would produce where MPC=MPB ar Q1P1, whilst the social optimum position is where MSC=MSB at P2Q2
Introduction of subsidy means the equilbrium point is Q2P3, at the social optimum output
This means social welfare is maximised since the market produces at the output that best allocates resources

Question 5

Subsidies Advantages

Answer 5

Society reaches the social optimum output and welfare is maximised
They can have other positive impacts, such as encouraging small businesses, bringing about equality and encouraging exports

Question 6

Subsidies Disadvantages

Answer 6

Government has to spend a large amount of money, which will have a high opportunity cost
As with taxes, they are difficult to target since the exact size of the externality is unknown
Subsidies can cause producers to become inefficient, especially if they are in place for a long time
Once introduced, subsidies are difficult to remove

Question 7

Maximum Price

Answer 7

Legally imposed price for a good that suppliers cannot charge above
Set on goods with positive externalities
Prevent monopolies from exploiting customers
E.g. set on food as a lack of food will have a negative impact on the NHS
Approach has been applied to rents for accommodation when prices are too high

Question 8

Maximum Price Diagram

Answer 8

The equilibrium position is P1Q1 but the imposition of the maximum price means there is excess demand of QD-QS, shown by the shaded area.

Question 9

Minimum Price

Answer 9

Legally imposed price at which price of good cannot go below
Can be set on goods with negative externalities, so that the price is raised to the social optimum point and consumption is discouraged
Also encourage producers to produce goods, so can be set on goods with social benefits that are under provided by the market

Question 10

Minimum Price Diagram

Answer 10

In the diagram, the market equilibrium price is P1Q1

However, the minimum price is set at P2 and as a result QD is demanded but QS is supplied so there is excess supply of QS-QD, shown by the shaded area

Question 11

Minimum and Maximum Price Advantages

Answer 11

Can be set where MSB = MSC, so allow for some consideration of externalities, and so help to increase social welfare
Maximum price ensures goods are affordable
Minimum price ensures producers get a fair price
Both are able to reduce poverty and can increase equity/equality

Question 12

Minimum and Maximum Price Disadvantages

Answer 12

Distortion of price signals which causes excess supply/demand
Excess demand leads to questions on how to allocate goods
Excess supply leads to questions on what to do with surplus goods
Difficulty for government to know where to set prices => difficulty of knowing size of externalities
Can lead to creation of black markets => maximum prices may also lead to illegal bribes or discriminatory policies in allocating goods

Question 13

Buffer Stock Scheme

Answer 13

Where both maximum and minimum prices are implemented at the same time
Government will buy up excess supply when equilibrium is below minimum price and sell stock to meet excess demand when price exceeds maximum
Helps to prevent price fluctuation and provides stability but causes inefficiency and places large costs on government

Question 14

Tradable Pollution Permits

Answer 14

Allows owner to pollute up to a specific amount of pollution
Government controls amount and size of permits
Companies have to buy permits to pollute
Unused permits can be sold to other companies
Companies exceeding limit face legal action
As fixed supply of permits is allocated, increase in demand will lead to an increase in price for permits, so companies have more incentive to cut emission by using green technology

Question 15

Trade Pollution Permits Advantages

Answer 15

Guaranteed pollution falls to target set by government => maximises social welfare
Government can raise revenue by selling permits and by fining firms who exceed pollution limit
Encourages companies to invest in green technology
Firms able to make own decisions about whether to cut pollution or buy permits => increases efficiency

Question 16

Trade Pollution Permits Disadvantages

Answer 16

Expensive to monitor and police => only works if monitored well => government needs to impose fines that are large enough to ensure firms follow regulation
Raise costs for businesses => passed onto consumers
Difficult to know how many permits government should allow

Question 17

State Provision of Public Goods

Answer 17

Non-excludable and non-rivalry
Free rider problem says they will be under-provided by the free market => market failure
Government provides these goods directly through taxation
Government can also provide merit goods

Question 18

State Provision of Public Goods Advantages

Answer 18

Corrects market failure by providing important foods which would otherwise not be provided => improve social welfare
Help bring about equality => ensures all have access to basic goods
Benefits of the good themselves, e.g. healthcare (NHS)
Using competitive tenders, government can ensure efficiency

Question 19

State Provision of Public Goods Disadvantages

Answer 19

Expensive and represents a high opportunity cost for government
Since market is not involved, government may produce wrong combination of goods as consumers cannot indicate preferences => if provided by market then price signals lead to shift in resources. Democracy aims to reduce problem since consumers can vote for political parties whose aims are similar to their own
Government may be inefficient at productive since they have no incentive to cut costs
Government officials may suffer from corruption and conflicting objectives

Question 20

Provision of Information

Answer 20

When there is asymmetric information, government provides information to allow people to make informed decisions
May also force companies to provide information

Question 21

Provision of Information Advantages

Answer 21

Helps consumers to act rationally => allows market to work properly
Best if government uses this alongside other policies => make demand more elastic in long run and so reduce indirect taxes to become more effective at reducing output

Question 22

Provision of Information Disadvantages

Answer 22

Expensive for government to do => opportunity cost
Government themselves may not always have all information => difficult to inform consumers
Consumers may not listen to information provided => irrational behaviour

Question 23

Regulation

Answer 23

Governments able to impose laws and caps to ensure that levels are set where MSB = MSC or to ensure companies provide full information on products
Government can also introduce regulatory bodies => ensure firms follow regulation and do not exploit their customers or take advantage of market position

Question 24

Regulation Advantages

Answer 24

Ensure consideration of externalities, prevent exploitation of consumers and keep consumers fully informed
=> help overcome market failure and maximise social welfare

Question 25

Regulation Disadvantages

Answer 25

Laws may be expensive for government to monitor => opportunity ost
Don’t take into account different costs of following laws for different companies => less efficient to reduce pollution than TPP
Government can suffer from regulatory capture
Firms may pass on costs to the consumer in the form of higher prices
Excessive regulation may reduce competition in a market and efficiency => increase bureaucracy and reduce innovation

Question 26

Government Failure

Answer 26

When government intervention in the market leads to net welfare loss and a misallocation of resources
Total social costs arising from intervention are greater than social benefits

Question 27

Government Failure Causes

Answer 27

Distortion of Price Signals
Unintended Consequences
Excessive Administration Costs
Information Gaps

Question 28

Government Failure
Distortion of Price Signals

Answer 28

Can change price signals and distort free market mechanism
Keep some companies in business when they are inefficient => resources should be switched to somewhere else or make consumers pay too much for goods
Maximum and minimum prices lead to excess demand/supply make it difficult to allocate resources
Price mechanism aims to allocate resources by best use and where consumers want and value them most

Question 29

Government Failure
Unintended Consequences

Answer 29

Some interventions cause effects which the government did not intend to happen
Consumers and producers may react to new policies in unexpected ways and so the policy doesn’t have the effect it should

Question 30

Government Failure
Excessive Administration Costs

Answer 30

In many cases, a lot of money that is allocated by the government is actually used on basic administration costs
Social costs may be higher than social benefits, once administration costs are taken into account

Question 31

Government Failure
Information Gaps

Answer 31

Any decisions that government makes must be on data but information they have is always going to be limited
Cost and benefit forecasts of investment are often wrong and so the government invests in a system when the costs are higher than benefits => welfare loss
Impractical and usually impossible for government to get every piece of information needed