1.4. Government intervention to correct market failure

Question 1

Methods of government intervention to correct market failure

Answer 1

1) Indirect taxes
2) Subsidies
3) Tradable pollution permits
4) Establishing property rights
5) Regulation
6) Prohibition
7) Provide information
8) Direct provision
9) Nudge Theory

Question 2

Indirect taxes

Answer 2

payments to the government by producers and consumers

Question 3

Subsidies

Answer 3

payments from the government to producers and consumers)

Question 4

Tradable pollution permits

Answer 4

license that allows a certain level of pollution

Question 5

Establishing property rights

Answer 5

ownership of resources

Question 6

Regulation

Answer 6

government imposes laws and rules e.g. minimum standards, levels of pollution.

Question 7

Prohibition

Answer 7

An outright ban on the most harmful goods / services.

Question 8

Provide information

Answer 8

reduce / close asymmetric information

Question 9

Direct Provision

Answer 9

goods free at the point of use, funded by taxation

Question 10

Nudge Theory

Answer 10

the provision of information to change behaviour.

• Present choices in better ways, people will make better decisions.
• Avoids the need for formal intervention.
• Individuals retain their freedom to choose.
• Growing area of economics (CIE love it).
• Best used alongside other policies.

Question 11

Government intervention of negative production externalities:

Answer 11

1) Indirect tax
2) Regulation
3) Tradable pollution permits
4) Establish property rights

Question 12

Indirect tax in reducing negative production externalities (draw the diagram)

Answer 12

• Tax increases costs (S1 to S2).
• P2dbP3 = tax revenue.
• P2dcP1 = consumer pays.
• P1cbP3 = producer pays.
• PED determines burden of tax on consumer / producer.
• Negative externality is internalised.
  BUT: Very difficult to calculate correct size of tax AND tax creates its own DWL (dab).

Question 13

Regulations in reducing negative production externalities:

Answer 13

• Government imposes laws and rules e.g. minimum standards, levels of pollution.
• Government needs to regulate / inspect producers to make sure regulations are enforced.
• Government can impose fines on producers that break rules.
• BUT: needs to be consistently enforced and fines must be deterrents

Question 14

Tradable pollution permits in reducing negative production externalities (draw the diagram)

Answer 14

• S1 = initial supply of permits (Q1).
• P1 = initial price of permits.
• Over time, demand for permits rise (D1 to D2).
• Price of permits increase (P1 to P2).
• Incentives to firms to become environmentally efficient.
• Over time, govt reduces supply of permits (S1 to S2).
• Price of permits increases again (P2 to P3).
• Producers again encouraged to improve environmental efficiency.
• Firms with spare permits can sell to other producers - provides a profit motive environmental efficiency.

Question 15

Property rights in reducing negative production externalities:

Answer 15

If polluting firm has property rights:

• Those who are affected could pay the polluter to - reduce its the pollution.
• Polluter would require payment equal to the loss of profit.
• BUT: firm might refuse to reduce pollution.

If those affected have property rights:

• Firm must compensate the affected people.
• BUT: firm might be more powerful than the property owners.

Question 16

Government intervention of negative consumption externalities

Answer 16

1) Indirect tax
2) Regulation
3) Information
4) Prohibition

Question 17

Indirect Taxes in reducing negative consumption externalities (draw the diagram)

Answer 17

• Tax increases costs (S1 to S2).
• P2dbP3 = tax revenue.
• P2dcP1 = consumer pays.
• P1cbP3 = producer pays.
• PED determines burden of tax on consumer / producer.
• Negative externality is internalised.
• BUT: Very difficult to calculate correct size of tax AND tax creates its own DWL (dab).

Question 18

Regulations in reducing negative consumption externalities

Answer 18

• Rules and legislation can be imposed e.g. no smoking in public places.
• BUT: Enforcement is crucial and fines must act as a deterrent.

Question 19

Providing information in reducing negative consumption externalities

Answer 19

• Provide consumers with information to encourage changes in behaviour e.g. warning signs on packets of cigarettes.
• BUT: Difficult to change behaviour

Question 20

Prohibition in reducing negative consumption externalities

Answer 20

• An outright ban on the most harmful goods / services.

- BUT: difficult to enforce and may lead to black markets.

Question 21

Government intervention of positive production externality:

Answer 21

1) Subsidies

Question 22

Subsidies in reducing positive production externality (draw the diagram)

Answer 22

• Subsidy decreases costs (S1 to S2).
• P3edP2 = cost of subsidy.
• P3efP1 = subsidy to producer.
• P1fdP2 = subsidy to consumer.
• PED determines incidence of subsidy to consumer / producer.
• Positive externality is internalised.
• BUT: Very difficult to calculate correct size of subsidy AND subsidy creates its own DWL (aed).

Question 23

Government intervention of positive consumption externality:

Answer 23

1) Subsidies
2) Regulation
3) Information
4) Direct provision

Question 24

Subsidies in reducing positive consumption externality (draw the diagram)

Answer 24

• Subsidy decreases costs (S1 to S2).
• P3dcP2 = cost of subsidy.
• P3deP1 = subsidy to producer.
• P1ecP2 = subsidy to consumer.
• PED determines incidence of subsidy to consumer / producer.
• Positive externality is internalised.
• BUT: Very difficult to calculate correct size of subsidy AND subsidy creates its own DWL (adc).

Question 25

Regulations in reducing positive consumption externality

Answer 25

Laws that force consumption e.g. education until a certain age.

Question 26

Providing information in reducing positive consumption externality

Answer 26

Advertise the benefits of consumption.

Question 27

Direct provision in reducing positive consumption externality

Answer 27

Free at point of use but funded through taxes e.g. street lights.

Question 28

Market-based measures

Answer 28

Tax
Subsidies
Pollution permits
Property rights

Problems:
Size of tax / subsidy / permits.

Question 29

Command and control measures

Answer 29

Regulation
Bans
Provide information

Problems:
No incentive to improve further.
Inflexible (same for everyone).
Exploit loopholes in laws.

Question 30

Government Failure

Answer 30

when government intervention to correct market failure causes further inefficiencies

Question 31

Causes of Government failure

Answer 31

1) Imperfect information
2) disincentive effects
3) policy conflicts

Question 32

Imperfect information causing government failure

Answer 32

Imperfect information:

• About the externality: difficult to value the source, the impact and the correct level of tax / subsidy.
• About the level of demand e.g. direct provision of public / merit goods.
• Market distortion e.g. may create surpluses / shortages.
• The cost of intervention: cost might be greater than benefit.

Question 33

Disincentive effects causing government failure

Answer 33

• Self-interest: political motivations rather than economic motivations.
• Corruption.
• May lead to the creation of black markets.
• Unintended consequences.

Question 34

Policy conflicts causing government failure

Answer 34

• Distributional impacts: certain groups (e.g. the poor) may be impacted more than others (e.g. the rich).
• Subsidies to encourage competitiveness may impact sustainability.
• Environmental policies may impact economic growth and employment.