1.4.1 Government Intervention In Markets Flashcards
Why do they intervene?
They intervene to correct market failure.
Indirect Taxes
> Indirect taxes are taxes on expenditure. They increase production costs, so producers supply less. This increases market price and demand contracts. Used to discourage consumption/production of demerit goods.
If the tax is equal to the external cost of each unit, then the supply curve becomes the MSC curve, so the free market equilibrium becomes the socially optimum equilibrium.
Ad valorem tax - when the difference between the MSC and MPC curves increases with output, an ad valorem tax is appropriate because the tax rises as price rises.
Specific tax - the amount of tax per unit stays the same even when price increases. Used when the MSC and MPC curves are parallel.
Indirect taxes diagrams
Diagram Sheet 2
> When a good has a negative externality, the government can introduce indirect taxation to prevent market failure.
> The free market level of output is Q1, where MPC = MPB. The optimum level of output is Q2 where MSC = MSB.
> To achieve this level of output, the government could impose a tax of AB per unit. This will increase costs and shift the supply/MPC curve upwards to meet the MSC curve at output Q2.
> The tax internalises the externality and social welfare is maximised.
> Ad valorem and specific taxes slightly differ.
Indirect Taxes Advantages + Disadvantages.
Advantages:
> Internalises the externality, the market now produces at the social equilibrium position and welfare is maximised.
> Raises government revenue, which can be used to solve the externality in other ways, hopefully making them more elastic. The effect will depend on what the government do with the revenue.
Disadvantages:
> It is difficult to target the tax, and the effect depends on where it is set. They won’t know the exact size of the externality so it’ll be hard to fully correct the market failure. Imperfect information.
> If governments use the tax to raise revenue as well as reduce market failure, there can be conflicts when setting the tax.
> Taxes are politically unpopular.
> If demand is inelastic, that tax will not be very effective at reducing output.
> Indirect taxes are regressive.
Subsidies (+ diagram)
(Diagram sheet 3)
>The government can solve positive externalities by introducing subsidies.
> The free market would produce at Q1 while the socially optimum position is where MSB = MSC at Q2
> The subsidy will shift the supply/MPC=MSC curve to S2 as it will lower the cost of production. The introduction of the subsidy means that the equilibrium point is Q2P3, at the socially optimum output level. The value of the subsidy per unit is AB.
> Social welfare is now maximised because the market produces at the output that best allocates resources.
Subsidies Adv + Disadv
Advantages:
> Production/consumption is at the socially optimum level and welfare is maximised.
> They have other small impacts like encouraging small businesses, bringing about equality and encouraging exports.
Disadvantages:
> Government has to spend a large amount of money, (ABP2P3 in diagram), which will also have a high opportunity cost. If they have to borrow money they may raise taxes in the future.
> They are also difficulty target since the exact size of the externality is unknown.
> Can cause producers to become inefficient, especially if they’re in place for a long time. Can reduce a firms incentive to cut costs.
> Once introduced, can be difficult to remove.
Maximum and Minimum prices.
For a maximum price to have effect it must be set below the current price equilibrium.
For a minimum price to have an effect it must be set above the current price equilibrium.
Maximum price + diagram
(Diagram sheet 3)
> A maximum price is a legally imposed price on a good that suppliers cannot charge above.
> They are set on goods with positive externalities. It will make them more affordable.
> They can prevent monopolies from exploiting consumers too.
> The equilibrium price is P1 and Q1 is demanded. When the maximum price is imposed, there is excess demand of Qd-Qs, shown by the shaded area.
Minimum Prices + diagram
(Diagram sheet 3)
> A minimum price is a legally imposed price which the price of the good cannot go below.
> They can be set on goods with negative externalities, so that the price is raised to the social optimum point and consumption is discouraged.
> In the diagram, the market equilibrium is at P1 with output Q1. However, the minimum price is set at Pmin and as a result Qd is demanded and Qs is supplied so there is excess supply of Qs-Qd, shown by the shaded area.
Max/Min Prices Adv/Disadv
Advantages:
>Can be set where MSB = MSC, which will increase social welfare and fix externalities.
> A minimum price will help prevent the use of demerit goods, while a maximum price will make things more affordable. This can reduce poverty and increase equality.
Disadvantages:
> There is a distortion of price signals causing excess supply/demand. There will be surplus goods or not enough.
> Difficult to know where to set prices. This is because it’s Difficult to know size of externality and because it will effect the size of excess supply or demand.
> Both can lead to the creation of black markets.
Examples of indirect taxes, subsidies and min/max prices.
Taxes - fuel duties, alcohol duties, sugar taxex, etc.
Subsidies - green energy, technology, apprenticeship schemes.
Max prices - rent control on properties, price caps on necessities in Venezuela (caused black market).
Min prices - on alcohol in Scotland (negative effects on poverty for people that are addicted), i
Buffer stock scheme - min and max price at once, used in agriculture where prices fluctuate massively.
Tradable Pollution Permits
Allows the owner to pollute up to a specific amount of pollution and the government controls how many permits there are, limiting the maximum amount of pollution.
Companies have to buy permits in order to pollute, so to cut costs and make more profit they may use greener technology.
Unused permits can be sold to other companies.
Because there is a fixed supply of permits, an increase in demand will lead to an increase in price for the permits, so companies will have more incentive to cut emissions and use greener technology.
Advantages:
- Because the permits are capped, it is guaranteed that pollution will fall to the target set by the government.
- Government can raise revenue through selling permits and by fining firms that exceed their limit.
- Encourages firms to use green technology.
Disadvantages:
- Expensive to monitor and police, and will only work if monitored well.
- Raises costs for businesses, and these are likely to be passed on to consumers.
- May be difficult to know how many permits are necessary.
Examples:
-US sulphur trading scheme reduced sulphur dioxide by 40%.
State Provision of Public Goods
Public goods are non-excludable and non-rivalry, so the free-rider problem says they will be under-provided by the free market, leading to market failure.
Therefore the government provides these public goods through taxation.
Advantages:
- Corrects market failure by providing important goods that otherwise not be provided. Improved social welfare.
- Can help bring about equality, ensuring everyone has access to basic goods.
- Benefits of the goods themselves, e.g. healthcare ensures the workforce is healthy.
Disadvantages:
- Expensive and represents a large opportunity cost.
- The government at produce the wrong combination of goods because consumers cannot indicate their preferences. Democracy aims to solve this problem.
- The government may be inefficient at production since they have no incentive to cut costs.
- Government officials may suffer from corruption or conflicting objectives.
Example:
- In the UK the government provides a number of goods. However the NHS suffers from severe underfunding and many schools have their budget cut.
Provision of Information
When there is asymmetric information, the government provides it to allow people to make informed decisions.
Advantages:
- Helps consumers act rationally which allows the market to work properly.
- Can be helpful alongside other policies. E.g. it can make demand more elastic in the long run, making indirect taxes more effective at reducing output.
Disadvantages:
- Can be expensive, incurring an opportunity cost.
- The government themselves may not always have all the information, making it impossible to inform consumers.
- Consumers may not listen due to irrational behaviour.
Examples:
- information on cigarette packaging.
- consumer protection laws.
Regulation
Governments can impose laws and caps to ensure levels are set to where MSB = MSC or to ensure that companies provide full information on products.
They can introduce regulatory bodies that ensure firms follow regulation and don’t exploit customers.
Advantages:
- Can ensure consideration of externalities, prevent exploitation of consumers and keep customers informed. This will help overcome market failure and maximise social welfare.
Disadvantages:
- Laws may be expensive for the government to monitor, incurring an opportunity cost.
- It is less efficient than tradable pollution permits at reducing pollution. It doesn’t take into account the different costs of following the laws for different companies.
- Firms may pass on costs to consumers in the form of higher prices.
- Excessive regulation may reduce competition and efficiency in a market, by increasing bureaucracy and reducing innovation.
Examples:
- EU fishing quotas
- minimum ages laws
- maximum vehicle CO2 emissions.
