[1.4] Government Intervention

Question 1

What are the three primary methods of government intervention (that you need to know for the Edexcel exam spec)?

Answer 1

• Indirect taxes to correct negative externalities (internalise the cost of the externality to the producer).
• Subsidies to increase consumption of merit goods (i.e. goods with positive externalities).
• Maximum and minimum prices to decrease consumption of demerit goods and increase consumption of merit goods.

Question 2

What are the four secondary methods of government intervention (that you need to know for the Edexcel exam spec)?

Answer 2

• Tradable pollution permits
• State provision of public goods (e.g. NHS)
• Provision of information (e.g. healthy eating advertising campaigns by government).
• Regulation of markets (e.g. worker safety laws).

Question 3

What is government failure?

Answer 3

The failure of government intervention to produce a socially optimal allocation of resources.

In other words, government failure is when government actions result in a net welfare loss.

Question 4

What are the four main causes of government failure?

Answer 4

• Distortion of price signals
• Unintended consequences
• Administration costs of intervening
• Government lacking full information

Question 5

What is an advantage and disadvantage of setting a minimum wage in labour markets?

Answer 5

Advantage:
- Higher wages have positive externalities, such as increased productivity, better health and a greater incentive to find employment.

Disadvantage:
- The market will be operating above the equilibrium price, meaning that supply will exceed demand (there will be a surplus, resulting in unemployment).

Question 6

What are the advantages and disadvantages of tradable pollution permits?

Answer 6

Advantages:

• Environmental benefits as aggregate pollution will be limited by permit availability.
• Government will raise revenue from permits that can be reinvested in green tech.
• Firms with greener production methods will have lower production costs relative to firms with less greener production methods (as they don’t need to buy permits). Greener firms will therefore have more profit which can be invested in even greener technologies.

Disadvantages:

• Firms may relocate to countries without pollution permits.
• Firms may pass permit costs onto consumer (if demand inelastic).
• Reduced competition as permits act as barrier to entry in the market.
• Administration costs of monitoring firms’ emissions.

Question 7

What are the advantages and disadvantages of regulation?

Answer 7

Advantages:

• Firms are forced to reduce negative externalities through regulation of production.
• Consumers are forced to reduce negative externalities through regulation of consumption (e.g. bans on hard drugs).

Disadvantages:

• Firms may relocate to countries with less regulation.
• Regulation may create additional costs of production that may be passed onto the consumer if demand is inelastic.

Question 8

How can information gaps result in government failure?

Answer 8

• Governments need full information to perform cost benefit analysis to decide if intervention can be justified.
• Governments need full information to decide accurately the size of a subsidy or direct tax (it needs to match the size of the external cost/benefit).
• Markets are unpredictable so governments can never perfectly predict the behaviour of the market in response to a new policy.

Question 9

How do subsidies result in government failure?

Answer 9

• Subsidies may distort price signals by encouraging production in a failing market (e.g. subsidising unprofitable coal in the 70s).
• Subsidies may allocated by corrupt government officials in order to enrich themselves or achieve political aims.