1.4 Government Intervention

Question 1

government intervention

Answer 1

governments intervene in markets to correct market failure

Question 2

reasons for government intervention

Answer 2

• to support firms (to help them remain competitive)
• to promote equity (to reduce the opportunity gap between the rich and poor)
• to correct market failure (by influencing level of production or consumption)
• to support poorer households (through redistribution of income)
• to collect govt. revenue (so they can provide essential services and public & merit goods)

Question 3

most common methods used by the government to intervene in markets

Answer 3

• indirect taxation
• subsidies
• maximum prices
• minimum prices

Question 4

indirect taxation

Answer 4

these are taxes on expenditure, which can be either ad valorem or specific, and aim to reduce production / consumption of demerit goods, such as alcohol, cigarettes, etc.
- they’re levied by the government on producers hence there’s a shift in the supply curve

Question 5

ad valorem tax

Answer 5

• a tax which occurs as a percentage of the value of a good, e.g. VAT which is currently 20% of the price of goods / services in the UK
• this can encourage consumers to switch to cheaper alternatives of products

Question 6

ad valorem tax diagram

Answer 6

diagram 1

Question 7

specific tax

Answer 7

• when the tax per unit of a good is a fixed price, e.g. excise duty on petrol which is currently 52.95p per litre
• this has a bigger effect on reducing overall demand

Question 8

specific tax diagram

Answer 8

diagram 2

Question 9

indirect taxes and elasticity of demand

Answer 9

• producers may choose to make consumers pay the whole tax (p2-p3 on diagram), but won’t do this if they feel they’ll have lower sales and lose revenue
• the incidence of tax depends on PED of demand of the good
• if demand is more inelastic, it will only fall slightly after the tax is imposed, so consumers will have a larger tax burden
• because demand only falls slightly, govt. revenues are larger from goods with price inelastic demand

Question 10

advantages of indirect taxation

Answer 10

• it internalises the social costs (negative externalities) of a product as the market now produces at the social equilibrium level and social welfare is maximised
• source of govt. revenue which can be used to solve the externality in other ways, e.g. healthcare investment
• provides an incentive to reduce the negative externality effects, e.g. cars have become more fuel efficient due to increased petrol tax
• although it can cause some deadweight welfare loss, the govt. indirect tax revenues can be used for things which have significant social benefits over time, e.g. health campaigns

Question 11

disadvantages of indirect taxation

Answer 11

• hard to set an appropriate tax because of the problem of quantifying the external cost (hard to know the size of the externality)
• ineffective in reducing consumption of a demerit good if demand is price inelastic as demand will only fall slightly
• could lead to the creation of black markets
• indirect taxes are regressive, so the poor will spend a larger proportion of their income than the rich do
• governments may be reluctant to introduce them as they’re politically unpopular
• causes some deadweight welfare loss

Question 12

subsidies

Answer 12

• these are used by governments to encourage production / consumption of merit goods, such as electric vehicles, wind farms, solar panels, healthcare, and education
• they correct market failure where there are positive externalities (underconsumption / underproduction)

Question 13

subsidy diagram

Answer 13

diagram 3

Question 14

advantages of subsidies

Answer 14

• social optimum level is reached and social welfare is maximised
• reduced cost of production, encouraging suppliers to reduce prices
• incentive for people to increase consumption of a merit good
• they can yield further positive impacts, e.g. encouraging small businesses
• easy to implement

Question 15

disadvantages of subsidies

Answer 15

• high opportunity cost for govt. expenditure
• can conflict with other policy objectives
• involves redistribution of income as those who benefit do so at the expense of taxpayers
• hard to target (set an appropriate subsidy) because of the problem of quantifying the external benefit (calculating the size of it) and information gaps
• ineffective in increasing consumption if demand is inelastic
• can cause producers to become inefficient if they become over-reliant on the subsidy
• hard to remove, as those who benefit from them are likely to protest

Question 16

maximum prices (price ceiling)

Answer 16

• a legally imposed price set on goods with positive externalities (merit goods)
• it’s set below the market equilibrium price so sellers can’t legally sell the product at a higher price
• aims to encourage consumption / production of the good as it won’t become too expensive, thus preventing monopolies from exploiting consumers
• can be used in the short-term, e.g. on petrol, or long-term, e.g. on housing

Question 17

maximum prices diagram

Answer 17

diagram 4

Question 18

advantages of maximum prices

Answer 18

• ensures that goods are affordable for consumers on lower incomes
• helps prevent an increase in the country’s rate of inflation
• increase social welfare if it’s set where MSB = MSC, as externalities can be internalised and merit goods will be consumed at the socially optimal level

Question 19

disadvantages of maximum prices

Answer 19

• may lead to black markets where the product is sold illegally at a price significantly higher than the maximum price
• more smuggled goods, so govt. loses tax revenue
• causes excess demand but a shortage of supply of the good, so the amount of consumers are worse off
• producers may exit the market in order to use their resources to produce more profitable goods
• if the govt. subsidises producers to encourage them to maintain output, then this will be at the expense of taxpayers’ money
• hard for govt. to know where to set the price due to the issue of quantifying the externality

Question 20

minimum prices (price floor)

Answer 20

• a legally imposed price on goods with negative externalities (demerit goods)
• it’s set above the market equilibrium price so the price can’t go below this
• aims to discourage consumption / production of the good as it raises prices, e.g. for alcohol, cigarettes, etc.
• they encourage producers to increase production, so may also be set on goods with social benefits that are under-provided in the market
• they’re also used in the labour market to protect workers from wage exploitation (minimum wages)

Question 21

minimum prices diagram

Answer 21

diagram 5

Question 22

advantages of minimum prices

Answer 22

• deters consumption of certain demerit goods

Question 23

disadvantages of minimum prices

Answer 23

• if demand is price inelastic, the effects will be limited and consumers will just be worse off paying a higher price, especially those on lower-incomes
• as they encourage production, if the minimum price is too high and demand is elastic, there will be an excess of supply, which is a waste of resources and may lead to dumping
• an excess supply will also mean there will be a cost for storage, which is also at the expense of taxpayers
• will negatively affect those on lower incomes (regressive)
• hard for govt. to know where to set the price due to the issue of quantifying the externality

Question 24

buffer stock scheme

Answer 24

• where both maximum and minimum prices are implemented at the same time, e.g. in agricultural markets
• govt. will buy up the excess supply when price is below the minimum price and sell their stock to meet excess demand when price exceeds the maximum price
• helps provide stability and prevent price fluctuation
• causes inefficiency as prices often remain below the minimum, as farmers produce whatever they can as they know the govt. will buy whatever they produce at the minimum price
• places a large cost on the govt.

Question 25

other methods of govt. intervention

Answer 25

• trade pollution permits
• state provision of public goods
• provision of information
• regulation

Question 26

trade pollution permits

Answer 26

• used to reduce negative externalities of pollution
• the govt. issue permits to firms which allows them to produce a certain amount of carbon
• these permits are tradeable for money between polluters, i.e. firms can sell excess permits or buy more from other firms
• there’s a fixed amount of permits so an increase in demand will increase prices
• companies exceeding their limit are subject to fines
• this incentivises firms to cut emissions by using greener technology to reduce costs

Question 27

advantages of trade pollution permits

Answer 27

• as the govt. caps the number of permits, it’s guaranteed that pollution will fall, which maximises social welfare
• the govt. can raise revenue by fining firms who exceed their pollution limit
• encourages companies to invest in green technology
• encourages efficiency in firms

Question 28

disadvantages of trade pollution permits

Answer 28

• they can be expensive to implement and monitor, and will only work if monitored well
• fines have to be large enough to ensure firms follow the regulation
• it’ll raise costs for businesses, which are likely to be passed on to consumers
• may be difficult to know how many permits the govt. should allow

Question 29

public goods

Answer 29

public goods are non-rival (using it doesn’t prevent others from using it too) and non-excludable (impossible to exclude others from using it), e.g. street lighting

Question 30

free rider problem

Answer 30

• this is when people can benefit from a good / service without paying anything towards it, or under-paying for their share
• due to this, public goods will be under-provided by the free market, leading to market failure

Question 31

state provision of public goods

Answer 31

governments try to respond to the free rider problem by providing public goods directly and paying for them through taxes

Question 32

state provision of public goods diagram

Answer 32

diagram 6

Question 33

advantages of state provision of public goods

Answer 33

• corrects market failure by providing important goods
• makes merit goods accessible which can increase their consumption and yield positive externalities, e.g. healthcare leads to a healthy workforce which improves economic growth
• improves social welfare

Question 34

disadvantages of state provision of public goods

Answer 34

• high opportunity cost for govt. expenditure
• govt. may be inefficient due to no profit motive, i.e. no incentive to cut costs
• funded through taxes
• the govt. may produce the wrong combination of goods as consumers can’t indicate their preferences

Question 35

alternative to state provision of public goods

Answer 35

• the govt. can pay private contractors to provide these goods / services
• this may increase efficiency as firms compete to win contracts
• however, it may cause firms to pay lower wages to workers to keep costs down and profits high

Question 36

provision of information

Answer 36

information gaps cause market failure, so the govt. provides information to allow people to make informed decisions, e.g. through info portals / campaigns or by forcing companies to provide info, e.g. labels on cigarettes

Question 37

advantages of provision of information

Answer 37

• it helps consumers to act rationally which allows the market to work properly
• can be used by the govt. alongside other policies, e.g. can make demand more elastic in the long-run which can help indirect taxes be more effective at reducing output

Question 38

disadvantages of provision of information

Answer 38

• can be expensive for the govt, incurring an opportunity cost
• govt. may not have all the info themselves, so it may be hard to inform consumers
• consumers may behave irrationally and ignore the info provided

Question 39

regulation

Answer 39

• these are rules created by the govt. which producers are legally required to follow, or else they may be fined / imprisoned
• rules can limit harm from negative externalities e.g. by ensuring that; levels are set at the social optimum (where MSB=MSC), firms don’t exploit customers, companies provide full info, etc
• regulatory agencies monitor that the rules are not broken, e.g. OFCOM for communications

Question 40

advantages of regulation

Answer 40

• ensures consideration of externalities
• helps overcome market failure
• maximises social welfare
• may encourage producers to develop new technologies which avoid a regulated activity, e.g. greener technology to reduce pollution

Question 41

disadvantages of regulation

Answer 41

• there’s a cost of enforcement and laws may be expensive for the govt. to monitor, incurring an opportunity cost
• may be hard to enforce if too many people need to be monitored
• govt. may suffer from regulatory capture if firms can influence regulators to work in their favour rather than in favour of the public
• firms may pass on costs to consumers through higher prices
• excessive regulation can reduce competition and efficiency in a market

Question 42

government failure

Answer 42

when govt. intervention in the market leads to a more inefficient allocation of resources and a net welfare loss

Question 43

right and left wing schools of thought

Answer 43

• free market economists are distrustful of govt. intervention as they believe the price mechanism should be given freedom to operate (right wing beliefs)
• left wing beliefs are that the govt. needs to intervene

Question 44

causes of government failure

Answer 44

• distortion of price signals
• unintended consequences
• excessive administration costs
• information gaps

Question 45

distortion of price signals

Answer 45

• govt. intervention often involves manipulation of prices, (e.g. max/min prices) which can change price signals in the market so resources aren’t allocated efficiently, thus distorting the price mechanism
• e.g. maximum / minimum prices cause excess demand / supply, which makes it hard to allocate resources

Question 46

unintended consequences

Answer 46

• some interventions cause effects which the govt. didn’t anticipate, as the actions of consumers / producers can have unexpected consequences, so the policy doesn’t have the effect it should
• e.g. the creation of black markets by producers / consumers who look to bypass govt. intervention to maximise their own self-interest
• real-life example; NHS patient targets has led to a reduction in quality of care, which is not what the govt. intended when they introduced it

Question 47

excessive administration costs

Answer 47

• sometimes the basic administrative costs of correcting market failure is so large that it outweighs the welfare benefit from the correction of market failure
• e.g. a lot of money given to the NHS is spent on organisation administration rather than on actual medical care

Question 48

information gaps

Answer 48

• some govt. policies may be decided with limited information
• this may require a cost-benefit analysis, which can often be wrong, therefore intervention could move output further away from the socially optimal level
• however, it’s impossible for govts. to gain perfect information, so assumptions need to be made

Question 49

govt. failure examples

Answer 49

• agricultural sector; in 2013 in Cyprus, a maximum milk price was set to keep it affordable, but it instead lead to a shortage of milk due to excess demand
• illegal markets; minimum prices on alcohol in Scotland increased cross-border driving to purchase alcohol elsewhere
• smoking ban; in July 2007 in the UK, an indoor smoking ban was implemented but had unintended consequences, e.g a rise in cigarette stump littering