1.4 - Government Intervention

Question 1

Ways a government can intervene in a market

Answer 1

• indirect taxation
• subsidies
• maximum prices
• minimum prices
• trade pollution permits
• regulation
• provision of public goods
• provision of market information

Question 2

What are indirect taxes?

Answer 2

Taxes levied on the expenditure of goods or services. They are often imposed on goods/services which have significant external costs.

Question 3

Advantages of indirect taxation to correct market failure

Answer 3

• helps to internalise external costs
• work with market forces so choice still exists in terms of consumption and production (a nudge not a shove policy)
• the social optimum (MSB=MSC) can be achieved
• tax funds are generated which can be spent on cleaning up damage
• difficult to evade as often included in market price
• convenient as paid in small payments rather than a lump sum

Question 4

Disadvantages of indirect taxes to correct market failure

Answer 4

• its difficult to quantify external cost and place monetary values on them (social optimum may not be reached)
• costs of production for firms increase, so they become less internationally competitive
• widespread use could become inflationary
• firms may relocate to countries with no tax
• demand may be in elastic and so overall reduction in pollution is very small
• tax revenue may not be used to compensate victims
• illegal markets may develop (e.g. cigarettes and alcohol)
• regressive nature of indirect taxes mean that burden of payment tends to fall on low-income groups

Question 5

What are subsidies?

Answer 5

A grant provided by the government to encourage the production and consumption of a particular good or service. They are often applied to goods with significant external benefits.

Question 6

Advantages of subsidies

Answer 6

• reduce external costs
• subsidies on renewable energy promote sustained economic growth
• rate of consumption of ‘bad’ good is reduced
• work with market forces so maintain choice
• the social optimum level of output can be reached

Question 7

Disadvantages of subsidies

Answer 7

• difficult to quantify external benefits so social optimum may not be reached
• there is an opportunity cost to govt subsidies
• may be a waste of money (public transport with few passengers)
• firms may become dependant of subsidy and become inefficient
• renewable energy isn’t as reliable

Question 8

What are maximum price schemes?

Answer 8

A ceiling price set by the govt on a g/s, above which it may not rise. It is likely enforced with govt legislation. Usually a maximum price is set below the free market price, causing shortages/ excess demand.

Question 9

Advantages of maximum price schemes

Answer 9

• they can reduce exploitation of customers, especially where there’s a lack of competition
• can reduce inequality, e.g. salary cap on high paid workers
• helps low income people afford key products, e.g. rental housing

Question 10

Disadvantages of maximum price schemes

Answer 10

• distorts operation of the price mechanism, leading to excess demand and inefficient allocation of resources
• producer surplus falls so firms have less income to invest
• problems over how to allocate supply, first-come basis or seller’s preference (both are unfair)
• difficult for govt to monitor and enforce max price controls in markets
• danger of shadow markets being created, e.g. football matches and theatre tickets
• in housing market, supply of rental property reduces and makes shortage worse in the long run

Question 11

What is a minimum price scheme?

Answer 11

A floor price set by the govt on a g/s, below which it cannot fall. it may be enforce through govt legislation. usually the minimum price is set above the free market price, causing an excess of supply. The surplus is purchased by the govt at the guaranteed minimum price.

Question 12

Advantages of minimum prices

Answer 12

• reduce consumption of good which are harmful and have high external costs
• encourages producers to switch to manufacturing healthier products
• reduce fluctuations in food prices that make it hard to budget
• ensures food supply in time of bad harvest due to surplus stockpiles
• guaranteed min price can stabilise and increase producer incomes, leading to inc investment and employment
• food surplus can be international aid
• national min wage can reduce exploitation of labour and inc incentives to work

Question 13

Disadvantages of minimum prices

Answer 13

• distorts operation of price mechanism, causing excess supply and inefficient allocation of resources
• price of some food/drink will inc, which could be hard for low income groups
• reduces consumer surplus
• govt opportunity cost of buying surpluses
• inc storage and security costs for surpluses, may have to be destroyed due to perishability
• surpluses may be sold overseas at low prices, harming farmers in developing countries
• farmers have guaranteed income which may make them inefficient
• min wage may cause unemployment in low-skilled labour markets
• difficult for govt to monitor and enforce min wage policy

Question 14

What are tradable pollution permits?

Answer 14

Pollution permits that can be bought and sold in a market. They are an attempt to solve the problem of pollution by creating a market for it. The European Commission allocate set amount of CO2 permits to national govt, which divide between firms. The system ‘caps’ carbon emissions for the year, the cap is reduced by 1.7% per year.

Question 15

Advantages of tradable pollution permits

Answer 15

• price mechanism is used to internalise the external costs associated with carbon emissions
• eu permits have been reduced and between 1990 and 2019, greenhouse gas emission has decreased by more then a 20%
• govt can raise funds by selling reserve pollution permits to industry
• firms have incentive to invest in clean technology
• production costs increase for unclean firms who have to but off cleaner ones
• firms can bank permits for future years

Question 16

Disadvantages of tradable pollution permits

Answer 16

• too many permits leads to little incentive to clean up
• too few permits lead to production costs increasing rapidly so become internationally uncompetitive
• disputes over allocation of carbon permits to firms, legal action may be taken
• firms pass costs onto consumers through higher prices (more likely if demand is inelastic)
• less pressure on major polluting firms as they can buy additional permits
• firms may fund cheaper carbon off-setting schemes in developing countries
• prices have fluctuated considerably creating uncertainty among firms
• cost to govt of monitoring
• other countries need to comply or global emissions still rise
• valuation of permits is in exact, some believe carbon treading is leading to a false sense of security

Question 17

State provision of public goods

Answer 17

The government tends to provide public goods in order to correct market failure. It raises funds from general taxation to pay for their provision. Public goods involve a large element of collective consumption. Eg. National defence

Question 18

State provision of information

Answer 18

Information gaps cause market failure amp so require govt intervention to reduce this.
Govt provides information:
-to encourage the production of healthy goods and services, or that yield long-term benefits.
-to discourage the production and consumption of unhealthy goods or services.
-to notify and remind people of laws for their own protection

Question 19

What is regulation?

Answer 19

Govt rules in markets to influence the behaviour of consumers and producers

Question 20

Advantages of regulations

Answer 20

• simple to understand
• limits can be imposed on the operation of firms to protect consumers
• it’s possible to fine or close down companies who have abused the regulations
• fines act as a deterrent for both consumers and producers not to break the law
• regulations could require firms to restore and clean up sites after production
• may help reduce the problem of asymmetric information

Question 21

Disadvantages of regulations

Answer 21

• can be expensive to monitor and enforce
• administration costs can be high
• regulation may be set at the wrong level
• may increase costs of production and make them less internationally competitive
• prevents the operation of the price mechanism (shove not nudge policy)
• regulatory capture: regulator acts in interest of firms not the public

Question 22

What is government failure?

Answer 22

When government intervention leads to an inefficient allocation of resources and a net welfare. There are various types such as the distortion of price signals, unintended consequences, excessive administration costs and information.

Question 23

Distortion of price mechanism

Answer 23

The actions of the govt which distort the operation of the price mechanism and so misallocate resources. Maximum and minimum price controls are good examples.

Question 24

The law of unintended consequences

Answer 24

The actions of govt, producers and consumers will always have effects that are unintended or unanticipated.

• indirect taxes: may lead to development of illegal markets
• subsides: firms may become dependant and inefficient
• max prices: leads to shortages of goods
• min prices: surpluses of goods and services
• trade pollution permits: large firms find it easier and cheaper to buy spare permits
• regulation: regulatory capture

Question 25

Excessive administration costs

Answer 25

The costs which arise in the formulation, monitoring and enforcing of govt measures to correct market failure.

• tax administration and collection can be expensive and difficult
• regulations require constant monitoring to ensure they are adhered to

Question 26

Information gaps causing govt failure

Answer 26

The govt has insufficient information to make rational economic decisions.

• all govt failure is linked to info gaps
• allocation of fishing quotas appears to be set too high
• setting high income tax can lead to decreased revenue as tax evasion increases