1.4. Government intervention to correct market failure Flashcards
Methods of government intervention to correct market failure
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
Indirect taxes
payments to the government by producers and consumers
Subsidies
payments from the government to producers and consumers)
Tradable pollution permits
license that allows a certain level of pollution
Establishing property rights
ownership of resources
Regulation
government imposes laws and rules e.g. minimum standards, levels of pollution.
Prohibition
An outright ban on the most harmful goods / services.
Provide information
reduce / close asymmetric information
Direct Provision
goods free at the point of use, funded by taxation
Nudge Theory
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.
Government intervention of negative production externalities:
1) Indirect tax
2) Regulation
3) Tradable pollution permits
4) Establish property rights
Indirect tax in reducing negative production externalities (draw the diagram)
- 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).
Regulations in reducing negative production externalities:
- 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
Tradable pollution permits in reducing negative production externalities (draw the diagram)
- 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.
Property rights in reducing negative production externalities:
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.
Government intervention of negative consumption externalities
1) Indirect tax
2) Regulation
3) Information
4) Prohibition
Indirect Taxes in reducing negative consumption externalities (draw the diagram)
- 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).
Regulations in reducing negative consumption externalities
- Rules and legislation can be imposed e.g. no smoking in public places.
- BUT: Enforcement is crucial and fines must act as a deterrent.
Providing information in reducing negative consumption externalities
- Provide consumers with information to encourage changes in behaviour e.g. warning signs on packets of cigarettes.
- BUT: Difficult to change behaviour
Prohibition in reducing negative consumption externalities
- An outright ban on the most harmful goods / services.
- BUT: difficult to enforce and may lead to black markets.
Government intervention of positive production externality:
1) Subsidies
Subsidies in reducing positive production externality (draw the diagram)
- 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).
Government intervention of positive consumption externality:
1) Subsidies
2) Regulation
3) Information
4) Direct provision
Subsidies in reducing positive consumption externality (draw the diagram)
- 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).
Regulations in reducing positive consumption externality
Laws that force consumption e.g. education until a certain age.
Providing information in reducing positive consumption externality
Advertise the benefits of consumption.
Direct provision in reducing positive consumption externality
Free at point of use but funded through taxes e.g. street lights.
Market-based measures
Tax
Subsidies
Pollution permits
Property rights
Problems:
Size of tax / subsidy / permits.
Command and control measures
Regulation
Bans
Provide information
Problems:
No incentive to improve further.
Inflexible (same for everyone).
Exploit loopholes in laws.
Government Failure
when government intervention to correct market failure causes further inefficiencies
Causes of Government failure
1) Imperfect information
2) disincentive effects
3) policy conflicts
Imperfect information causing government failure
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.
Disincentive effects causing government failure
- Self-interest: political motivations rather than economic motivations.
- Corruption.
- May lead to the creation of black markets.
- Unintended consequences.
Policy conflicts causing government failure
- 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.
