1.4 Government Intervention Flashcards
1
Q
government intervention
A
governments intervene in markets to correct market failure
2
Q
reasons for government intervention
A
- 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)
3
Q
most common methods used by the government to intervene in markets
A
- indirect taxation
- subsidies
- maximum prices
- minimum prices
4
Q
indirect taxation
A
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
5
Q
ad valorem tax
A
- 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
6
Q
ad valorem tax diagram
A
diagram 1
7
Q
specific tax
A
- 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
8
Q
specific tax diagram
A
diagram 2
9
Q
indirect taxes and elasticity of demand
A
- 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
10
Q
advantages of indirect taxation
A
- 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
11
Q
disadvantages of indirect taxation
A
- 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
12
Q
subsidies
A
- 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)
13
Q
subsidy diagram
A
diagram 3
14
Q
advantages of subsidies
A
- 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
15
Q
disadvantages of subsidies
A
- 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
16
Q
maximum prices (price ceiling)
A
- 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
17
Q
maximum prices diagram
A
diagram 4
18
Q
advantages of maximum prices
A
- 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
19
Q
disadvantages of maximum prices
A
- 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
20
Q
minimum prices (price floor)
A
- 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)
21
Q
minimum prices diagram
A
diagram 5
22
Q
advantages of minimum prices
A
- deters consumption of certain demerit goods
23
Q
disadvantages of minimum prices
A
- 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
24
Q
buffer stock scheme
A
- 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.
25
other methods of govt. intervention
- trade pollution permits
- state provision of public goods
- provision of information
- regulation
26
trade pollution permits
- 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
27
advantages of trade pollution permits
- 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
28
disadvantages of trade pollution permits
- 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
29
public goods
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
30
free rider problem
- 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
31
state provision of public goods
governments try to respond to the free rider problem by providing public goods directly and paying for them through taxes
32
state provision of public goods diagram
diagram 6
33
advantages of state provision of public goods
- 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
34
disadvantages of state provision of public goods
- 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
35
alternative to state provision of public goods
- 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
36
provision of information
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
37
advantages of provision of information
- 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
38
disadvantages of provision of information
- 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
39
regulation
- 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
40
advantages of regulation
- 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
41
disadvantages of regulation
- 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
42
government failure
when govt. intervention in the market leads to a more inefficient allocation of resources and a net welfare loss
43
right and left wing schools of thought
- 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
44
causes of government failure
- distortion of price signals
- unintended consequences
- excessive administration costs
- information gaps
45
distortion of price signals
- 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
46
unintended consequences
- 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
47
excessive administration costs
- 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
48
information gaps
- 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
49
govt. failure examples
- 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
