1.4 Government intervention

Question 1

Why do governments intervene in markets?

Answer 1

To solve market failure by allocating resources more efficiently

Question 2

What is an indirect tax?

Answer 2

A tax imposed on goods and services supplied by firms

Question 3

What are the two types of indirect tax and the difference between them?

Answer 3

1. A specific tax - a fixed amount per unit of good e.g excise tax
2. An ad valorem tax - a percentage of the price of the good

Question 4

What is the impact of an indirect tax?

Answer 4

It causes supply to shift inwards. This results in an increase in the price and a decrease in the quantity consumed.

Question 5

How does an introduction of an indirect tax impact producer and consumer surplus?

Answer 5

It decreases both of them - overall welfare is reduced for consumers and producers. There is a net welfare loss.

Question 6

How can tax revenue and per unit tax be shown on the diagram below? How can welfare loss be shown?

Answer 6

Per unit tax = YZ

Total tax revenue = P2YZW

Net welfare loss = YEZ

Question 7

What is the incidence of an indirect tax?

What does it depend on?

Answer 7

This is the distribution of an indirect tax paid between producers and cosumers.

This depends on the elasticity, as goods that have demand that is more price inelastic means consumers do not respond much to a change in price, and so the tax is passed onto them.

Question 8

What is a subsidy?

Answer 8

A government grant to firms, which reduces costs of production and encourages an increase in output.

Question 9

What is the impact of a subsidy?

Answer 9

It shifts supply outwards, which decreases price and increases quantity consumed.

Question 10

How can susbsidy spending and per unit subsidy be shown on the diagram below? What area represents welfare loss?

Answer 10

Per unit subsidy: LR

Total spending: GLRP₂

Net welfare loss: LER

Question 11

How does a subsidy affect producer and consumer surplus? Why does this still create welfare loss?

Answer 11

Both producer and consumer surplus increase.

However, there is an increase on the diagram caused by the new supply curve that does not affect consumers or producers, it is simply government funds that have been wasted (area LER).

Question 12

What is the incidence of an subsidy?

What determines this?

Answer 12

This is the distrubtion of an subsody between producers and cosumers.

This depends on the elasticity, as goods that have demand that is more price inelastic means that more of the subsidy is passed onto consumers.

Question 13

What are tradeable pollution permits?

How are they issued?

How does this achieve the aim of lower pollution?

Answer 13

Permits that allow firms to pollute a certain amount of pollution - they are issued either through auction or by the proportion of market size to firms.

Unused permits can then be bought and sold to companies that need more.

This reduces the overall level of pollution, as the government can set the level of permits issued each year.

Question 14

What is a maximum price?

Answer 14

A ceiling price set by the government on a good or service, above which it cannot rise.

May be enforced with legislation.

Question 15

How do maximum prices affect demand, supply and quantity consumed?

Answer 15

Assuming the price is set below equilibrium, demand will extend.

However, the lower price will contract supply, and this leads to excess demand in the market and disequilibrium. This means there is a fall in the quantity sold, and a net welfare loss.

Question 16

Give one example of a maximum price

Answer 16

Rent ceilings in cities

Question 17

What is a minimum price?

Answer 17

A price floor set by the government below which the price cannot fall.

It may be enforced via legislation.

Question 18

How do minimum prices affect demand, supply and quantity sold?

Answer 18

Assuming the price is set above equilibrium, demand will contract.

However, the higher price will extend supply, and this leads to excess supply in the market and disequilibrium. This means there is a fall in the quantity sold, and a welfare loss.

Question 19

Give one example of a minimum price

Answer 19

Sugar, alcohol, tobacco.

Question 20

What is a guaranteed minimum price?

What is an example of this?

Answer 20

Where the surplus output created is purchased by a government agency at the min. price. This aims to protect producer incomes.

A prime example of this is agriculture, e.g. in wheat or sugar.

Question 21

What are the advantages of indirect taxes to correct market failure? [3]

Answer 21

• Internalises external costs whilst generating revenue for government
• Difficult to evade as they are included in the market price
• Work with market forces

Question 22

What are the disadvantages of indirect taxes to correct market failure? [4]

Answer 22

• Difficult to quantify external costs, may create welfare loss if tax is too high or low
• Increases costs of production, can therefore reduce competition
• Inelastic demand and supply may mean taxes have little effect on consumption
• Tax is regressive - may fall harsher on lower-income individuals

Question 23

What are the advantages of subsidies to correct market failure? [3]

Answer 23

• Work with market forces to maintain competition and choice
• Doesn’t disproportionately affect lower-income people
• Can promote economic growth with increased production

Question 24

What are the disadvantages of subsidies to correct market failure? [3]

Answer 24

• Difficult to quantify external benefits and so figure out exact subsidy to apply to avoid welfare loss
• Oppurtunity cost of spending government money, really expensive
• Unintended consequences, like dependent firms and inefficiency

Question 25

What are the advantages of minimum prices to correct market failure [3]

Answer 25

• Reduce consumption of harmful goods
• Reduce price fluctuations
• Stabilises and increases producer incomes with agriculture.

Question 26

What are the disadvantages of minimum prices to correct market failure [4]

Answer 26

• Distorts the price mechanism, meaning an inefficent allocation of resources
• Less effective with inelastic demand
• Guaranteed minimum prices are expensive, oppurtunity cost for government
• Less efficient farmers as they are guaranteed income

Question 27

What are the advantages of maximum prices to correct market failure [3]

Answer 27

• Reduce explotation of consumers in markets with little competition
• Reduce inequality
• Helps people on lower-incomes, e.g. with housing

Question 28

What are the disadvantages of maximum prices to correct market failure [3]

Answer 28

• Distorts price mechanism and leads to inefficient allocation of resources
• Reduces supply
• Producers have less incentive and ability to produce as profits are capped

Question 29

What are the advantages of tradeable pollution permits? [3]

Answer 29

• Price mechanism still in effect, internalises pollution
• There is an incentive to pollute less as profit is gained from it
• Pollution is reduced over time

Question 30

What are the disadvantages of trade pollution permits? [4]

Answer 30

• The exact right amount must be issued - too much means too much pollution and too little means higher costs of production
• Costs may be passed on to consumers
• Scheme has to be monitored which comes with a cost
• Permits don’t expire, which means firms can hold onto them and pollute extra.

Question 31

What are advantages of regulation to correct market failure? [3]

Answer 31

• Simple to understand
• Specific and can be imposed on direct things, such as flights
• Can be combined with fines to ensure consumers and producers don’t break the law. These fines can then be used to compensate victims.

Question 32

What are disadvantages of regulation to correct market failure? [3]

Answer 32

• Can be expensive to monitor and hard to enforce, which must be done for the policy to be effective
• Has to be set at the right level
• May increase costs of production and therefore reduce competition

Question 33

What is government failure?

Answer 33

When government intervention leads to an inefficent allocation of resources and a net welfare loss.

Question 34

What are four types of government failure?

Answer 34

1. Distortion of price signals
2. Unintended consequences
3. Administration costs
4. Information gaps

Question 35

Explain the distortion of price signals and give the government intervention that causes this.

Answer 35

The actions of government which distort the operation of the price mechanism and so misallocate resources.

This is found in minimum and maximum prices, which can be expensive and harm long-term production.

Question 36

Explain the law of unintended consequences and give the government interventions that cause this.

Answer 36

• This is the law that states the actions of government, producers and consumers will always have effects that are unintended or unanticipated.
• This is found in indirect taxes and subsidies, as they may create black markets or ineffecient firms.
• It is also found in price controls, as it leads to shortages and surpluses of goods.
• Regulations and TPPs can also be set ineffectively.

Question 37

Explain excessive administration costs and where they are most problematic.

Answer 37

• These are costs which arise in the formulation, monitoring and enforcing of government measures to correct market failure.
• They are most prevelant in state provision of goods, such as healthcare, where there is lots of inefficency due to no profit incentive. The introduction of Universal Credit has seemingly failed.
• Regulation and enforcement is expensive and require constant monitoring, which can be excessive.

Question 38

Explain the problem of information gaps.

Answer 38

• This is where the goverment has insufficient information to make rational economic decisions.
• This means they make non-rational decisons, such as setting the allocation of fish catch quotas being too high and not being effective.