1.4 Government Intervention Flashcards
Graph: Indirect taxation
Supply curve/MPC will shift from S1 to S2. The free-market would produce at P1&Q1, where MPC=MPB, but the socially optimal position is P2&Q2, where MSB=MSC. Following the introduction of the tax, the equilibrium position is S2-MPB=MSB, at P2Q2.
Why does the government impose indirect taxation on goods with negative externalities?
To prevent market failure by increasing costs, reducing supply, and internalising the externality.
What is hypothecated tax?
The hypothecation of tax (also known as the ring-fencing or earmarking of tax) is the dedication of the revenue from a specific tax for a particular expenditure purpose.
E.g. a tax on petrol and diesel might be used to fund road and highway construction.
Effectiveness of taxation depends on…
- PED - If a product is very inelastic in demand, a tax will make little difference to quantity consumed and therefore will provide little correction to market failure.
- The size of the tax.
- The reliability of shadow pricing - Has the external cost been valued accurately to ensure a correct tax level? Difficult to achieve accurately as subjective.
What are two advantages of indirect taxation?
- Reduces consumption of goods with negative externalities or demerit goods.
- Raises government revenue, which can be used to address externalities.
What are two disadvantages of indirect taxation?
- Difficult to set correctly due to shadow pricing being complex and subjective.
- Can be politically unpopular as it is a regressive tax (groups on lower incomes pay a higher proportion of their income than high income earners).
Graph: Subsidies
Supply curve will shift from S1=MPC=MSC to S2. The free-market would produce where MPC=MPB, at P1&Q1, but the socially optimal position is where MSC=MSB, at P2&Q2. Following the introduction of the subsidy, the equilibrium position is P3Q2.
Why does the government provide subsidies?
To encourage goods with positive externalities and correct market failure by reducing production costs.
Effectiveness of subsidy depends on…
- PED - If a product is very inelastic in demand, a subsidy will make little difference to quantity consumed and therefore will provide little correction to market failure.
- The size of the subsidy.
- PES - The ability for firms to increase supply (may be difficult if they are operating near full capacity).
- The reliability of shadow pricing - Has the external cost been valued accurately to ensure a correct tax level? Difficult to achieve accurately as subjective.
What are two advantages of subsidies?
- Helps reach the social optimum output.
- Can support small businesses and encourage exports.
What are two disadvantages of subsidies?
- High opportunity cost for the government.
- Can lead to inefficiency if firms become reliant on them.
What is a maximum price?
A legally set price that suppliers cannot charge above, often used for essential goods with positive externalities. E.g. tuition fees.
What is a minimum price?
A legally set price that prevents the price from falling below a certain level, used for goods with negative externalities. E.g. alcohol.
Name one advantage and one disadvantage of price controls.
Advantage: Can increase social welfare by ensuring fair prices.
Disadvantage: Can cause excess demand (for max prices) or excess supply (for min prices).
What is a tradable pollution permit?
A permit that allows firms to emit a set amount of pollution, which can be bought and sold.
Name one advantage and one disadvantage of tradable pollution permits.
Advantage: Encourages firms to adopt greener technologies.
Disadvantage: Can be expensive to monitor and enforce.
Why does the government provide public goods?
Because they are non-excludable and non-rivalrous, meaning the free market would underprovide them.
What is a disadvantage of government provision of public goods?
The government may misallocate resources due to lack of price signals.
Give some examples of government information provision.
Cigarette warning labels, traffic light food labels, or health campaigns.
What is the purpose of government regulation?
To correct market failure by enforcing rules that protect consumers and reduce negative externalities.
What is a disadvantage of regulation?
It can be costly to monitor and enforce, leading to inefficiency.
What is a minimum guaranteed price (MGP)?
A minimum price that producers are guaranteed to receive for their product by the government. E.g. The EU have used MGP to support the agricultural industry for products such as sugar, wheat, and barley.
How does an MGP work?
- An MGP is placed above equilibrium to support producers, leads to demand contracting and supply expanding.
- The excess supply - from QD to DS is purchased by the government and stored.
- This stock could be released to the market if supply runs short one year.
- The total cost to the government is QD, A, B, QS.
- The gain if revenue for producers is shown by the pink shaded area.
Effectiveness of an MGP depends on…
- How high the MGP is set above equilibrium (the greater the difference, the greater he surplus).
- PED and PES (the greater the elasticity, the greater the surplus).
- Whether the government take action to prevent stocks pilling up. E.g. Imposing a quota on each producer allowing a maximum total output.
