3.8.9 - Government Intervention in Markets

Question 1

How can economists and politicians be divided?

Answer 1

Interventionists
Non-interventionists

Question 2

What are the arguments against government intervention?

Answer 2

• The market economy is calm and orderly due to the price mechanism.
• Risk-taking businesspeople know better what to produce than civil servants and state planners.
• If markets are sufficiently competitive, what is produced is decided by consumers, who know more about their own situation than governments do.

The government should act as a ‘night-watchman’ that maintains law and order, provides public goods and merit goods when the market fails.

Question 3

What are the arguments for government intervention?

Answer 3

• Markets are too often uncompetitive due to monopoly power and producer sovereignty.
• Uncertainty about the future and the lack of market information are destabilising.
• The government knows better than unregulated market forces.

Question 4

What are the methods to correct market failure?

Answer 4

At the extreme, the government can abolish the market using command or planning mechanism.

At the other extreme, the government can try to influence market behaviour by using economic nudges to provide information.

Between the two extremes, governments can use taxes, subsidies, price ceillings and floor to alter prices in the market to change incentives and economic behaviour.

Question 5

What happens to the price mechanism when free-riding occurs and what often happens after?

Answer 5

The incentive function of prices breaks down.

As a result, governments often step into the gap and provide the goods, funded via general taxation.

Question 6

How do governments encourage / discourage production and consumption of certain goods?

Answer 6

Merit goods can be regulated by the government or have a lower price to incentivise consumption.

Subsidies can be paid to firms to increase production of the goods.

In a similar way, demerit goods can be regulated by the government or have a higher price to decentivise consumption.

Question 7

How can regulation be enforced on the extreme?

Answer 7

Regulation can force people to consume merit goods such as (contentiously) vaccines.

Question 8

What is an example of regulation and subsidisation to increase consumption?

Answer 8

Education.

Compulsory from the ages of 5 to 18.
Completely subsidised from the ages of 5 to 18.

Question 9

Why is the private sector provision of merit goods increasing?

Answer 9

State provision does not necessarily mean good-quality provision of goods.

Question 10

How can the government force firms and consumers to generate positive externalities?

Answer 10

The state can impose law and regulation to force households to maintain the appearance of their properties or order landowners to plant trees.

Question 11

What are the two main ways that government can intervene to correct market failures caused by negative externalities and demerit goods?

Answer 11

Regulation
Taxation

Question 12

How does regulation correct market failures caused by negative externalities?

Answer 12

At the extreme, regulation can be used to completely outlaw consumption of a good such as cocaine or heroin.

This runs into the problem in that production of goods such as electricity generates negative externalities such as pollution. Banning this externality has the perverse effect of preventing production of a good.

In instances such as this, quantity controls prove more effective to allow production of goods, but limit emissions.

Smoking is banned in public places, alcohol cannot be sold to minors etc.

Question 13

How does taxation correct market failures caused by negative externalities?

Answer 13

Recently, politicians have been more likely to use congestion and pollution taxation.

Regulation is an example of market replacement as opposed to market adjustment.

Taxation provides a market-orientated solution to the problems of demerit goods and negative externalities. The taxation compensates for the missing market in the externality.

In the case of pollution, the government calculates a monetary value on the negative externality and charge a pollution tax. The cost of the tax is transferred to the consumer, but if the tax is set so that the price the consumer pays is equal to the social cost then resource allocation in the economy is improved.

Pollution taxation introduces new inefficiencies such as the costs of collecting tax and the incentive to evade tax illegally. (Government failure)

Question 14

What is the less commonly used method to deal with the problem of pollution?

Answer 14

Permits or licences to pollute.

Question 15

Why are permits to pollute good alternatives?

Answer 15

There is still a limit to how much pollution is made, but eventually, a market in traded pollution permits takes over, creating market-orientated incentives for the polluter to reduce pollution because they can make money out of it.

Question 16

What is the market for pollution permits?

Answer 16

Firms that produce below the limit of pollution can sell their spare permits to other power stations that produce pollution above the maximum limit.

In the short-run, they have to buy permits, but remain within the bounds of the law.
In the long-run, they have an incentive to reduce pollution to reduce the extra costs of production.

Question 17

What is a price ceiling?

Answer 17

A price above which it is illegal to trade.

They can distort markets by creating excess demand.

Question 18

Draw a price ceiling diagram.

Answer 18

Question 19

What happens when a price ceiling is imposed on a market?

Answer 19

Excess demand is created from the distance of Q₁ to Q₂.

There is no mechanism to remove the excess demand in the market, so households are forced to ration by quantity rather than price.

Waiting lists occur, and possibly bribery and corruption in which favoured consumers buy the good and others do not.

The price ceiling lowers incentives for new firms to enter the market as there is a lower price incentive to do so.

The emergence of an informal (black) market also becomes more likely, as the primary (free) market no longer works properly. In this market, consumers who purchased the good in the primary market resell at a higher price to those who could not purchase it in the primary market.

Question 20

What is a price floor?

Answer 20

A price below which it is illegal to trade.

Can distort markets by creating excess supply.

Question 21

What price does a price floor need to be at to affect a market?

Answer 21

Above the free-market price.

Question 22

Where is a price floor most commonly used?

Answer 22

Introduction of a NMW.

Question 23

What is the effect of a price floor when it is imposed in a market?

Answer 23

There is excess supply equal to Q₁ and Q₂.

It may cause rogue producers to break the law.

The incentive function of prices is broken as falling prices cause inefficient or high-cost firms to leave the market. The price floor prevents this from happening.

Question 24

What is the effect of a price floor in a labour market?

Answer 24

In this instance, a price floor is a minimum wage.

If set above the free-market wage, unemployment rises to L₁ L₂.

Rogue employers may illegally pay ‘poverty wages’ to vulnerable workers such as migrants.

Question 25

What are the benefits of a price ceiling?

Answer 25

• Keeps prices affordable which is particularly important for merit goods
• Prevents price-gouging in the primary market
• Stimulates demand

Question 26

What are the negatives of the price ceiling?

Answer 26

• Often causes supply shortages
• No such thing as a free lunch, so may induce corner-cutting and a loss of quality
• May lead to extra charges or boosted prices on other goods
• The prevalence of a secondary (black) market may lead to higher prices than before leading to government failure.