1.4.1 Government Intervention in Markets

Question 1

Explain what laissez faire economics is.

Answer 1

In a free market system, governments take the view that markets are best suited to allocating scarce resources
and allow the market forces of supply and demand to set prices. The role of the government is mainly to
protect property rights, uphold the rule of law and maintain the value of the currency. Competitive markets
often deliver improvements in allocative, productive and dynamic efficiency. But there are occasions when
they fail – providing a case for intervention.

Question 2

Explain government intervention

Answer 2

Government intervention is when the state gets involved in markets and takes action to try to correct market
failure, improve economic efficiency, impact upon the macroeconomic performance of the economy, and/or
change the distribution of income and wealth. The government can use regulations, taxes, subsidies, maximum and minimum prices to change price signals, better information or direct provision to change resource allocation. In recent years, several governments have also tried to use interventions designed to create behavioural nudges to change the behaviour of consumers and businesses

Question 3

Explain the consequences of these types of market failure and an example of government intervention

Answer 3

Question 4

What is tax relief?

Answer 4

The government may offer financial assistance such as tax credits for business investment
in research and development. Or a reduction in corporation tax (a tax on company profits) designed
to promote new capital investment and extra employment

Question 5

What is a stakeholder?

Answer 5

any person or organisation that has an interest in a specific project or policy decision.

Question 6

What are examples of stakehoders?

Answer 6

1. Employees of a business / organisation (who may / may not be members of a union)
2. Communities where a business is located or affected directly by a decision
3. Suppliers to a business (e.g. back down the supply chain)
4. Shareholders and other investors / financiers
5. Creditors (people owed money)
6. Government (and through them – taxpayers)
7. Trade unions (and the workers they represent)
8. Professional associations
9. NGOs and other advocacy groups (i.e. World Bank, IMF, individual Pressure Groups)

Question 7

How can value judgements be used as evaluation on government intervention?

Answer 7

many people want intervention because of their own vested interests.

Question 8

How can changing prices to change incentives and behaviour be used as evaluation on government intervention?

Answer 8

• Many interventions work though the price
  mechanism by changing the relative prices / relative costs of day-to-day decisions:
  a. E.g. raising the price of fuel to curb consumption
  b. Offering a subsidy to bio-fuel producers
  c. Using tariffs to change the relative prices of imports in a domestic economy

Question 9

How can the fact that economics is a social science be used as evaluation on government intervention?

Answer 9

Economics is a social science and the effects of intervention cannot be calibrated /
forecast with great accuracy – people’s behaviour is subject to change – remember the ‘law of
unintended consequences’

Question 10

How can combinations of policies be used as evaluation on government intervention?

Answer 10

One single intervention is unlikely to produce a solution to deep-rooted economic and social problems – e.g.
policies that work on market demand and market supply

Question 11

How can the power of markets be used as evaluation on government intervention?

Answer 11

Market forces can be powerful in finding
profitable solutions to problems – don’t underestimate the importance of innovation and invention –
government’s rarely have all the answers and the new economics of collaboration offers insights into
the impact that collusive behaviour can have e.g. in fast-tracking ideas linked to reducing carbon
emissions

Question 12

How can the costs and benefits be used as evaluation on government intervention?

Answer 12

some of the costs and benefits only become apparent over long time periods

Question 12

How can the law of unintended consequences be used as evaluation on government intervention?

Answer 12

Government intervention does not always work in the way in
which it was intended or the way in which economic theory predicts it should. the “law of unintended consequences” often comes into play as events
can affect a policy, and consumers and businesses rarely behave precisely in the way in which the
government might want!

Question 13

What are questions used to judge the effects of intervention?

Answer 13

1. Efficiency of a policy: Does an intervention lead to a better use of scarce resources? E.g. does it
   improve allocative, productive and dynamic efficiency?
2. Effectiveness of a policy: Which policy is most likely to meet a specific economic or social objective?
   For example, which policies are likely to be effective in reducing road congestion?
3. Sustainability of a policy: Does a policy reduce the ability of future generations to engage in economic
   activity? Inter-generational equity is an important issue in many current policy topics for example
   decisions on which sources of energy we rely on in future years.
4. Does the policy need to be used alongside something else?

Question 14

Show how indirect taxation can solve market failures

Answer 14

In each case, the indirect tax has been set such that the socially optimal level of output (Qstar) is achieved, and
therefore the government intervention has, in each case, effectively tackled the market failure. In reality, setting
the tax at exactly the ‘right’ amount is virtually impossible because we cannot easily put a value on the
externalities.

Question 15

What is the aim of an indirect tax?

Answer 15

The aim of an indirect tax is to internalise a negative externality; in other words, make those directly involved
in the market transaction bear the cost of the externality.

Question 16

Explain how implementing these taxes can be difficult.

Answer 16

1. Setting the ‘right’ tax rate e.g. if the monetary value of a negative externality is hard to measure
2. Cost of collection: e.g. road charging requires expensive infrastructure e.g. IT system of billing
3. Price inelastic demand: higher petrol prices via higher indirect taxes has little effect on demand for
   fuel, likewise, would a tax on sugar get people to cut their consumption of high-sugar products?
4. Redistribution effects: Indirect taxes are regressive and affect low-income households most (i.e. even
   if rich and poor households pay exactly the same amount in tax, it will be a greater proportion of the
   income of the poor household)
5. Increased costs: Higher indirect taxes may cause inflation affecting consumers who did not pollute
   and international competitiveness if taxes are higher in one country than another

Question 17

What is the sugar tax?

Answer 17

In the 2016 Budget, the former
Chancellor of the Exchequer, George Osborne announced the introduction of a levy on soft drinks. The levy would apply to manufacturers and importers of sugar added soft drinks, to be implemented in April 2018.
There would be exemptions for fruit juices and milk-based drinks and for small producers.

Question 18

What are the arguments in favour of the sugar tax?

Answer 18

1. Makes clear the external costs of consuming sugary drinks – a cause of market failure
2. less information failures – less people under-estimate the long-term costs of consumption
3. Tax encourages drink manufacturers to re-formulate their drinks and offer healthier alternatives e.g.
   in vending machines

Question 19

What are the arguments against the sugar tax?

Answer 19

1. Might be regressive on lower income families – the tax might be inequitable
2. Other policies might be more effective in cutting consumption
3. People might simply switch to other sugary products – i.e. the tax might be ineffective
4. Risk of lost jobs in pubs and shops that rely heavily on drink sales
5. Risk of producers swapping low-calorie sweeteners for sugar, but these could have other detrimental
   health effects

Question 20

Show how can subsidies can solve market failures

Answer 20

In this case, the subsidy increases supply by lowering the
Marginal Social Cost, so that the socially optimal quantity Q* is achieved

Question 21

Give some evaluation points for govt subsidies

Answer 21

• Are subsidies effective in meeting their aims?
  o Might other incentives be needed as well as price? e.g. improved information for consumers?
• Will a subsidy affect productivity / efficiency?
  o Subsidies for investment and research can bring positive spill overs
  o But firms may become dependent on state aid / financial assistance, leading to higher
  internal production costs and a lack of innovation
• How much does a subsidy cost and who benefits?
  o Is a subsidy part self-financing? Will it create more tax revenue?
  o Or does a subsidy create an expensive extra burden for taxpayers who may not have
  benefitted?
• Does the subsidy help to correct one or more market failure(s)?
  o For example – do more people find work with child-care subsidies?
  o Or does a subsidy lead to undesired / unintended consequences leading to government
  failure?

Question 22

What is a maximum price?

Answer 22

This is a legally-imposed maximum price (or price ceiling) in a market that suppliers cannot exceed - in an
attempt to prevent the price from rising above a certain level. To be effective a maximum price has to be set
below the existing free market equilibrium price.

Question 23

What are examples of maximum prices?

Answer 23

Question 24

Show a maximum price on a S-D diagram

Answer 24

In the diagram below the free market price is P1. If a maximum price is imposed, quantity supplied contracts
from Q1 to Q3 whilst quantity demanded expands from Q1 to Q2. Therefore, a maximum price drawn beneath
the equilibrium price leads to a disequilibrium with excess demand equal to the quantity Q3-Q2.

Question 25

How can maximum prices lead to secondary (unofficial) markets developing?

Answer 25

Maximum prices often lead to secondary (unofficial) markets developing because a scarcity of supply means
that some consumers are willing and able to pay above the regulated price. A good example of this might be
a rent ceiling imposed on rented properties in towns and cities.

Question 26

Show how imposing rent controls might lead to a possible shadow market for rented
property

Answer 26

Question 27

What is a minimum price?

Answer 27

A minimum price is a price floor. It is a legally imposed price floor below which the normal market price cannot
fall. To be effective the minimum price has to be set above the normal equilibrium price

Question 28

What are advantages of a minimum price on alcohol sold in supermarkets?

Answer 28

1. Reduces some of the externalities from people pre-loading cheap supermarket alcohol at home
2. In the long term, a minimum price intervention would cut premature deaths, reduce workplace
   absenteeism and also reduce the burden of treating chronic illnesses linked to alcoholism. Alcohol is
   estimated to cost the NHS over £billion a year and there is an estimated £11 billion annual cost of
   alcohol-related crime.
3. Pubs may benefit from higher minimum prices in supermarkets
4. A minimum price might target cheaper, higher-strength drinks often used by younger drinkers

Question 29

What are disadvantages of a minimum price on alcohol sold in supermarkets?

Answer 29

1. Minimum price is a tax on responsible drinkers – this is inequitable
2. Might be better for drinks producers to agree voluntary policies on alcohol price / strength
3. Better to raise alcohol duties which will raise tax revenues to be used for socially beneficial projects
4. Demand for alcohol among problem-drinkers is likely to be inelastic and, thus, any increase in price
   is likely to have little effect upon their consumption
5. Imposing a minimum price will require extra spending on enforcement e.g. across every drinks retailer

Question 30

What is carbon trading?

Answer 30

Carbon trading is a form of pollution control that uses the market mechanism to change relative
prices and the incentives of producers and consumers to reduce their carbon emissions

Question 31

What is the EU Carbon Emissions Trading Scheme?

Answer 31

The EU Carbon Emissions Trading Scheme is cap-and-trade scheme for carbon dioxide. It operates
in 31 countries (the 28 EU countries, Iceland, Liechtenstein and Norway). It covers the 45% of the EU’s
greenhouse gas emissions that come from energy intensive sectors.

Question 32

What is the tradeable pollution permits scheme?

Answer 32

The tradeable pollution permits scheme sets a decreasing cap (i.e. maximum limit) for CO2 from
energy intensive industries, and then allocates or auctions emissions allowances (permits) which can
be traded on the open market.

Question 33

How does tradable pollution permits disincentivise high carbon use by businesses?

Answer 33

• Businesses need to buy enough emissions allowances to cover their CO2 emissions – the higher the
  price, the greater the incentive to cut pollution. Increasing the scarcity of carbon permits leads to an
  increase in price. This is one reason why the cap is reduced over time – it forces up the price of CO2
  (think about this as the impact of a decrease in supply on a market diagram).
• This makes it more expensive for firms to emit carbon which in turn increases the incentive for
  investment in low carbon technologies.
• Carbon trading provides a quantity adjustment to the volume of CO2 emissions.

Question 34

What happens if the carbon price is high?

Answer 34

If the carbon price is high, power generators might decide to shift some investment towards renewable
projects since this will have a lower carbon impact. And smaller businesses might also switch to small-scale
wind and solar schemes to reduce the expenses of buying carbon permits in the market.

Question 35

What is the main problem with the EU carbon trading scheme?

Answer 35

The main problem with the EU carbon trading scheme is that the price per tonne of CO2 has been volatile
and, in recent years, extremely low at less than Euro 5 per tonne. This is partly because initially there were
simply too many permits – the cap was set too high. This means that incentives to use renewable energy are
weak and some power companies have gone back to burning imported coal.

Question 36

What is the UK Carbon Price Floor?

Answer 36

The UK Carbon Price Floor applies to fossil fuels used for electricity generation. The minimum price for carbon
emissions is designed to provide a stable carbon price signal as a way of internalising externalities.

Question 37

What are the advantages of a carbon price floor?

Answer 37

1. Reduces risks, and thus costs, of investing in new nuclear capacity
2. Helps to reduce carbon price volatility – sends a clear signal to polluters
3. Makes low carbon electricity more competitive – gives boost to renewables

Question 38

What are the disadvantages of a carbon price floor?

Answer 38

1. Better to restrict more tightly the total supply of carbon permits to increase market price
2. A carbon tax is perhaps a more effective alternative and also raises useful tax revenues
3. Price floor might damage international competitiveness e.g. of the UK steel industry compared to China/Poland and lead to lower exports and lost jobs

Question 39

What does a carbon tax do?

Answer 39

A tax on carbon increases the private cost of emitting carbon – in theory this will cause output to contract
towards the social optimum. It will also raise tax revenues that might be used by the government to fund other projects or use as a rebate to those affected (e.g. consumers).

Question 40

What are the advantages of a carbon tax?

Answer 40

1. A pollution tax internalizes the externality and makes the polluter pay – it is fairly easy to administer,
   and the tax is predictable for businesses affected
2. Carbon fee on imported products will help reduce risk of domestic businesses re-locating to avoid
   paying a national carbon tax
3. A tax raises extra revenue which can be ear-marked for other uses e.g. research in cleaner energy
4. Might be offsetting tax cuts on employment / childcare or tax rebates to lower-income families

Question 41

What are the disadvantages of a carbon tax?

Answer 41

1. Low price elasticity of demand – the tax may not change behaviour, there might be more effective
   alternative policies on offer
2. Risk of higher structural unemployment among workers in carbon intensive sectors such as mining,
   oil and gas – renewables employs relatively few people
3. Risk that the burden of new / higher carbon taxes will fall more heavily on lower-income families
4. Might damage the competitiveness of domestic businesses in overseas markets e.g. UK steel industry
   complaining about carbon price floor

Question 42

Why should the state both fund and provide public goods?

Answer 42

One argument is that the state needs to provide public
goods to help overcome the free-rider problem.
Because (pure) public goods are non-excludable it is difficult to charge people for benefitting once a product
is available. The free rider problem can lead to the non-provision of a good and thus causes market failure.
Free riders have no incentive to reveal what they are willing and able to pay for a public good because they
enjoy a benefit without paying.

Question 43

What are the grounds that pure public goods are provided?

Answer 43

1. Fairness – the (normative) view that everyone should have equitable access to good quality public
   goods such as sanitation systems, public service broadcasting, flood defence systems, the rule of law
   and open access to justice.
2. Efficiency – collective provision funded through taxation can lead to economies of scale and a more
   efficient use of scarce resources.
3. Social welfare – there are positive externalities (social benefits) from good quality public services not
   all of which can be measured by a market price

Question 44

Why might there also be inefficiencies in relying on the state to provide public goods?

Answer 44

Those who favour a smaller role for the government believe that the private sector is more efficient and innovative and that high government spending on public goods leads in the long run to a rising tax burden which might crowd-out or
hinder the growth of private sector businesses. Technological change is also changing the degree to which public goods are non-excludable. Not all public goods need providing – think of fireworks displays, for
example. And some can be provided on a local small scale by local organisations able to collect fees. Others
are provided by charitable organisations, for example the RNLI.

Question 45

What are many examples of intervention designed to change the perceived benefits and costs for consumers
when making their choices in markets?

Answer 45

• Compulsory labelling on products (cigarettes)
• Improved nutritional information on food & drinks
• Campaigns to raise awareness of risks of drink-driving
• Gambling addiction awareness campaigns
• Performance league tables for schools & colleges

Question 46

What are regulations the government can use to correct market failure?

Answer 46

Question 47

What are advantages of regulation as a way of correcting for market failures?

Answer 47

1. Regulations act as a spur for business innovation e.g. to cut the level of carbon emissions
2. Regulations may be more effective if demand is unresponsive to price changes
3. Regulations can be gradually toughened each year – this will help stimulate capital investment
4. They are often straightforward to understand and for businesses to apply e.g. minimum purchase
   age for cigarettes, alcohol, lottery tickets etc.
5. Regulations can often be imposed quickly – other policies, such as taxes and subsidies, may take a
   long time to be approved by government / parliament

Question 48

What are disadvantages of heavy use of regulation?

Answer 48

1. High cost of enforcement / administration
2. Regulations can lead to unintended consequences / Government failure
3. The cost of meeting regulations can discourage small businesses and also lead to less competition in
   markets
4. Policies such as tax can lead to more tax revenue for the government, whereas regulation is usually
   just a cost
5. Total bans are rarely justifiable by economic theory (i.e. the socially optimal level of output where
   MSC = MSB must be zero or below)
6. Tight / strict regulation can lead to more illegal trade, increasing the time / cost of the police and lawenforcement
   agencies