1.4.1 Government intervention in markets

Question 1

Government intervention

Question 2

Types of govt intervention

Answer 2

1) Indirect taxation
2) Subsidies
3) Maximum and minimum prices

Question 3

Indirect taxation

Answer 3

When the good has a negative externality, the government can introduce indirect taxation to prevent market failure (overproduction: goods with negative externalities are overproduced when only private costs are involved and not social costs incurred by others). This will cause a fall in supply and increase the costs to the individual, so the supply curve/MPC curve will shift from S1 to S2 (inwards/left).

Question 4

Indirect taxation advantages

Answer 4

• It internalises the externality (process of incorporating the external costs or benefits of an economic activity into the decision-making process of the parties involved) - the market now produces at the social equilibrium position and social welfare is maximised.
• It raises government revenue, which could be used to solve the externality in other ways such as through education. This may help goods to become more elastic in the long run. The effect will depend on what the government does with the revenue they raise.

Question 5

Indirect taxation disadvantages

Answer 5

• Imperfect information: the government suffers from imperfect information when setting the tax: it is difficult to know the size of the externality and so it is difficult to target the tax; the effect depends on where the tax is set.
• There could be conflict between the government goal of raising revenue and solving the externality, which makes setting the tax difficult.
• Illegal transactions: it could lead to the creation of a black market (trading in violation of publicly imposed regulations such as rationing laws, laws against certain goods, and official rates of exchange among currencies.)
• Inelastic demand: if demand for the good is inelastic, then the tax will be ineffective at reducing output.
• Politics: taxes are politically unpopular and so governments may be reluctant to introduce them.
• Regressive: the poor spend a larger proportion of their income on indirect taxes than the rich do.

Question 6

Indirect tax as a govt intervention example

Answer 6

Some examples of indirect taxes used for externalities in the UK are: landfill taxes, fuel duties, alcohol duties, tobacco duties, air passenger duties and sugar taxes.

Question 7

Subsidies

Answer 7

In order to solve positive externalities, the government can introduce subsidies. Subsidies can also be introduced in order to fix information gaps. This will shift the supply curve to the right as it will lower the cost of production.

Question 8

Subsidies advantages

Answer 8

• Society reaches the social optimum output and welfare is maximised.
• Encourages small businesses, bringing about equality and encouraging exports.
Lower costs allow them to produce more

Question 9

Subsidies disadvantages

Answer 9

• The government has to spend a large amount of money, which will have a high opportunity cost.
• As with taxes, they are difficult to target since the exact size of the externality is unknown.
• Subsidies can cause producers to become inefficient, especially if they are in place for a long time.
• Once introduced, subsidies are difficult to remove
• There could be government failure, if the government provides an inefficient subsidy or if the subsidy distorts the market price.
• Government revenue could be better spent elsewhere. The opportunity cost of the subsidy should be considered.
• It is usually the tax payer who pays for the subsidy, and they might not receive any
direct benefit from the subsidy.

Question 10

Subsidies as a govt intervention example

Answer 10

Some examples of subsidies are those on: biofuels, solar panels, apprenticeship schemes, wind farms and rail industries.
- the government might provide apprenticeship schemes or help farmers by contributing towards their production costs.

Question 11

Maximum and minimum prices

Answer 11

For a maximum price to have an effect, it must be set below the current price equilibrium.
For a minimum price to have an effect, it must be above the current price equilibrium.

Question 12

Maximum price

Answer 12

A legally imposed price for a good that the suppliers cannot charge above. They are set on goods with positive externalities. For example, they are set on food as a lack of food will have a negative impact on the NHS. This approach has sometimes been applied to rents for accommodation when prices are too high. They can prevent monopolies from exploiting customers.

Question 13

Minimum price

Answer 13

A legally imposed price at 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. They also encourage producers to produce goods, so can be set on goods with social benefits that are underprovided by the market.

Question 14

Min/Max prices advantages

Answer 14

• They can be set where MSB=MSC, so allow for some consideration of externalities, and so help to increase social welfare.
• A maximum price will ensure that goods are affordable, whilst a minimum price will ensure that producers get a fair price. Both of these are able to reduce poverty and can increase equity/equality.

Question 15

Min/Max prices disadvantages

Answer 15

• There is a distortion of price signals and this causes excess supply/demand.
Excess demand will lead to questions about how to allocate goods and excess supply will lead to questions about what to do with the surplus goods.
• Imperfect information: It is difficult for the government to know where to set the prices, because of the difficulty of knowing the size of externalities and because it will have implications on the size of excess supply/demand
• Black markets: Both can lead to the creation of black markets. Maximum prices may also lead to illegal bribes or discriminatory policies in allocating goods.

Question 16

Maximum price as a govt intervention example

Answer 16

Maximum prices have been implemented in Manhattan in the form of rent controls on properties. On top of this, there are price caps on milk, toilet paper, medicine, petrol and other key goods in Venezuela: this has led to the creation of a black market and the goods are no longer sold in supermarkets as the firms are unable to make a profit at those prices.
- the government might impose a minimum price on alcohol, so it is less affordable to buy it. The National Minimum Wage is an example of a minimum price.

Question 17

Minimum price as a govt intervention example

Answer 17

In Scotland, a minimum price has been imposed on alcohol. It targets the cheapest drinks, which aims to cut down on binge drinking, but it will have negative effects on poverty for those who are addicted. Minimum prices on Limousines in Nashville have stifled competition as the most price competitive firms are forced out of business.

Question 18

Buffer stock scheme (govt intervention) - Synoptic point *

Answer 18

A buffer stock scheme is where both maximum and minimum prices are implemented at the same time. This is often the case with agricultural products whose prices fluctuate massively, such as in the EU Common Agricultural Policy.
- The government will buy up the excess supply when the equilibrium price is below the minimum price and sell their stock to meet the excess demand when price exceeds the maximum price. This helps to prevent price fluctuation and provides stability but causes inefficiency and places a large cost on the government.
- Often, prices remain below the minimum price since farmers produce as much as they can as they know the government will buy whatever they produce at the minimum price.

Question 19

Tradable pollution permits - other methods of govt intervention

Answer 19

A pollution permit allows the owner to pollute up to a specific amount of pollution and the government controls how many permits there are so limits the maximum amount of pollution.
- Companies have to buy permits in order to pollute so, in an attempt to cut costs and increase profits, companies may use greener technology.
- Unused permits can be sold to other companies, hence why they are tradeable. Companies exceeding their limit of pollution will face legal action.
- As a fixed supply of permits is allocated, an increase in demand will lead to an increase in price for the permits, so companies will have more incentive to cut emissions by using green technology.

Question 20

Trade pollution permits advantages

Answer 20

• Since the government caps the number of permits, it is guaranteed that pollution will fall to the targets set by the government. This will maximise social welfare.
• The government can raise revenue by selling permits and by fining firms who exceed their pollution limit.
• This encourages companies to use and invest in green technology.
• Firms are able to make their own decisions about whether to cut pollution or buy more permits. This helps encourage efficiency, as seen by the numerical example (this is not necessary in an exam but helps to understand the concept).

Question 21

Tradable pollution permits disadvantages

Answer 21

• This can be expensive to monitor and police, but it will only work if it is monitored well. The government needs to impose fines that are large enough to ensure firms follow the regulation.
• It will raise costs for businesses, and it is likely that these higher costs will be passed onto consumers
• It may be difficult to know how many permits the government should allow.

Question 22

Tradable pollution permits example

Answer 22

One successful example is the US Sulphur trading scheme, which reduced sulphur dioxide by 40%. The EU Emissions Trading Scheme (ETS) was launched in 2005 and it represents a 21% reduction in greenhouse gases. Since then, other greenhouse gases like nitrous oxide have been included and the scheme has been extended to the airline industry. The permit scheme has also been introduced in China.

Question 23

State provision of public goods - other methods of govt methods

Answer 23

Public goods are non-excludable and non-rivalry and so the free rider problem says they will be under-provided by the free market, leading to market failure. As a result, the government provides these public goods directly through taxation. Similarly, the government can provide merit goods.

Question 24

State provision of public goods advantages

Answer 24

• This corrects market failure by providing important goods which would otherwise not be provided. It will lead to improved social welfare.
• It can help to bring about equality, by ensuring everyone has access to basic goods.
There will be benefits of the goods themselves, for example by providing healthcare, the government ensures that the workforce is healthy and so this can improve economic growth.
• By using competitive tenders (looked at in Theme 3), the government can ensure efficiency.

Question 25

State provision of public goods disadvantages

Answer 25

• This is expensive and represents a high opportunity cost for the government.
Administration costs are a problem
• Since the market is not involved, the government may produce the wrong combination of goods as consumers cannot indicate their preferences. For example, there may be too many soldiers and too few hospital beds: if they were provided by the market, price signals would lead to a shift in resources. Democracy aims to reduce this problem, since consumers can vote for political parties whose aims are similar to their own.
• The government may be inefficient at production since they have no incentive to cut costs.
• Government officials may suffer from corruption and conflicting objectives.

Question 26

State provision of public goods example

Answer 26

In the UK, the government provides a number of goods including roads, education and healthcare. The NHS suffers from severe underfunding and many schools are having their budgets cut. Moreover, more money is spent on improving railways than roads, even though 92% of all journeys in the UK are made on roads, suggesting incorrect resource allocation.

Question 27

Provision of information - other methods of govt intervention

Answer 27

When there is asymmetric information, the government provides information to allow people to make informed decisions. They may also force companies to provide information.

Question 28

Provision of information advantages

Answer 28

• This helps consumers to act rationally, which allows the market to work properly.
• It is best if the government uses this alongside other policies. For example, it can make demand more elastic in the long run and so help indirect taxes to become more effective at reducing output.

Question 29

Provision of information disadvantages

Answer 29

• This can be expensive for the government to do, incurring an opportunity cost.
• The government themselves may not always have all the information, so it may be difficult to inform consumers.
• Consumers may not listen to the information provided due to irrational behaviour.

Question 30

Provision of information (govt intervention) example

Answer 30

Some examples of information provision are labels on cigarette packages and information campaigns on speeding, obesity, drinking and smoking. Consumer protection laws and industry standards help to overcome problems relating to second hand products. The ‘traffic light system, where foods are rated green, orange or red on calories, sugar, salt etc. helps to easily show consumers the healthier options. Despite these information campaigns, many consumers still undertake harmful and dangerous activities.

Question 31

Regulation - other methods of government intervention

Answer 31

Governments are able to impose laws and caps to ensure that levels are set where
MSB=MSC or to ensure that companies provide full information on products. The government can also introduce regulatory bodies such as OFCOM for communications and OFGEN for energy. These ensure firms follow regulation and do not exploit their customers or take advantage of market position.

Question 32

Regulation advantages

Answer 32

• This can ensure consideration of externalities, prevent exploitation of consumers and keep consumers fully informed. This will help to overcome market failure and maximise social welfare.

Question 33

Regulation disadvantages

Answer 33

• Laws may be expensive for the government to monitor, incurring an opportunity cost.
They don’t take into account the different costs of following the laws for different companies. Compared with tradable pollution permits, regulation is a less efficient method of reducing pollution.
• The government can suffer from regulatory capture (looked at in Theme 3).
• Firms may pass on costs to the consumer in the form of higher prices.
• Excessive regulation may reduce competition in a market and efficiency, by increasing bureaucracy and reducing innovation.

Question 34

Regulation (govt intervention) example

Answer 34

A number of regulations are in place to correct market failure in the UK such as: EU fishing quotas, smoking bans, minimum ages laws and maximum vehicle CO2 emissions.

Question 35

Government intervention - Synoptic point **

Answer 35

Government intervention in individual markets often has macroeconomic consequences. It will clearly impact the government budget, as the government will either raise revenue or spend money be undertaking these policies. Policies which push business costs up, for example indirect taxes, regulation and tradable pollution permits, will reduce international competitiveness and LRAS.