4.1.8 Market Mechanism, Market Failure and Government Intervention in Markets

Question 1

Briefly outline price mechanism in the market

Answer 1

The price mechanism determines the market price. Adam Smith called this ‘the invisible hand of the market’.

Resources are allocated through the price mechanism in a free market economy. The economic problem of scarce resources is solved through this mechanism. The price
moves resources to where they are demanded or where there is a shortage, and removes resources from where there is a surplus.

Question 2

Outline the three functions of price in allocating resources

Answer 2

Rationing- When there are scarce resources, price increases due to the excess of demand. The increase in price discourages demand and consequently rations
resources. For example, plane tickets might rise as seats are sold, because spaces are running out. This is a disincentive to some consumers to purchase the tickets, which rations the tickets.

Incentive- This encourages a change in behaviour of a consumer or producer. For example, a high price would encourage firms to supply more to the market, because it is more profitable to do so.

Signalling- The price acts as a signal to consumers and new firms entering the market. The price changes show where resources are needed in the market. A high price signals firms to enter the market because it is profitable. However, this encourages consumers to reduce demand and therefore leave the market. This shifts the demand and supply curves.

Question 3

The advantages and disadvantages of the price mechanism and of extending its use into new areas of activity

Answer 3

Advantages
* The price mechanism is an impersonal method of allocating resources.
* Introducing the price mechanism into some fields of human activity could be undesirable.
* In the price mechanism, the invisible hand can signal what the cost of purchasing a good is to a consumer. It also acts as a signal to producers to tell them what revenue they will receive.
* The price mechanism allows the consumer to gain sovereignty in the market. They have ‘spending votes’ in the market, which enables them to choose what is bought and sold. Generally, the free market allows for an efficient allocation of resources

Disadvantages
* However, there may be inequality in income and wealth with the price mechanism. It does not consider what the distribution of income is. Those with money have buying power, whilst those without money are left out. Essentially, the price mechanism and the free market ignore equality. To evaluate, it can be argued that inequality exists, but the degree of inequality may vary between capitalist societies.
* In a free market, there is the under-provision of public and merit goods, which requires government intervention.

Question 4

Market Failure

Answer 4

This occurs when there is an inefficient allocation of resources in a free market. Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less output), negative externalities (over-consumed and costs to third party) and public goods (usually not provided in a free market)

Question 5

Types of Market failure

Answer 5

Positive externalities – Goods/services which give benefit to a third party, e.g. less congestion from cycling.
Negative externalities – Goods/services which impose a cost on a third party, e.g. cancer from passive smoking.
Merit goods – People underestimate the benefit of good, e.g. education. It may also have positive externalities
Demerit goods – People underestimate the costs of a good, e.g. smoking. It may also have negative externalities.
Public Goods – Goods which are non-rival and non-excludable – e.g. police, national defence. Public goods are often not provided in a free market.
Monopoly Power – when a firm controls the market (with high market share) and can set higher prices.
Inequality – unfair distribution of resources in free market, e.g. some experiencing poverty and homelessness
Factor Immobility – E.g. geographical / occupational immobility. For example, when there are pockets of high unemployment, but it is difficult for the unemployed to move and get a job.
Agriculture – Agriculture is often subject to market failure – due to volatile prices, fluctuating weather and externalities.
Information failure – where there is a lack of information to make an informed choice.
Principal-agent problem – Two agents with different objectives and information asymmetries. For example, adverse selection where a buyer has less information than the seller.
Moral hazard. When individuals have incentive to change their behaviour when others take the risk. For example, when banks are insured by the government, bankers take risky decisions which can cause bank losses.
Macroeconomic instability – When an economy enters into prolonged recession and high unemployment – or inflationary boom which is unstable.

Question 6

Define complete market failure

Answer 6

Complete market failure occurs when there is a missing market. The market does not supply the products at all.

Question 7

Define Partial market failure

Answer 7

Partial market failure occurs when the market produces a good, but it is the wrong quantity or the wrong price. Resources are misallocated where there is partial market failure.

Question 8

Market failure and behavioural economics

Answer 8

Behavioural economics examines how individuals often act in a non-rational manner – contrary to the expectation of conventional economic models. These types of ‘irrational behaviour’ can lead to a type of market failure where people make poor choices.

Question 9

Outline public goods

Answer 9

Public goods are missing from the free market, but they offer benefits to society. For example, street lights and flood control systems are public goods. They are non-excludable so by consuming the good, someone else is not prevented from consuming the good as well, and they are non-rival, so the benefit other people get from
the good does not diminish if more people consume the good.

Public goods are also underprovided because it is difficult to measure the value consumers get from public goods, so it is hard to put a price on the good. Consumers will undervalue the benefit, so they can pay less, whilst producers will overvalue, so they can charge more.
Governments provide public goods, and they have to estimate what the social benefit of the public good is when deciding what output of the good to provide. They are funded using tax revenue, but the quantity provided will be less than the socially optimum quantity

Question 10

Outline the free rider problem

Answer 10

The non-excludable nature of public goods gives rise to the free-rider problem. Therefore, people who do not pay for the good still receive benefits from it, in the same way people who pay for the good do. This is why public goods are underprovided by the private sector: they do not make a profit from providing the good since consumers do not see a reason to pay for the good, if they still receive the benefit without paying.

Question 11

Outline private goods

Answer 11

Private goods are rival and excludable. For example, a chocolate bar can only be consumed by one consumer. Moreover, private property rights can be used to prevent others from consuming the good.

Question 12

Outline quasi-public goods

Answer 12

Quasi (non-pure) public goods have characteristics of both public and private goods. They are partially provided by the free market. For example, roads are
semi-excludable, through tolls and they are semi-non-rival, because consumers can benefit from the road whilst other consumers are using it (unless it is rush hour).

Question 13

Outline the Tragedy of the commons

Answer 13

The tragedy of the commons refers how individuals prioritise personal gain over the well-being of society. When resources are held in common, it means that no one owns the resource, but everyone can access it. For example, no one owns the air, but everyone can use it. This unlimited use leads to the negative externality of air pollution. This is a market failure that results from common access.

Question 14

Define externality

Answer 14

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, it is the spill over effect of the production or consumption of a good or service.
Externalities can be positive (external benefits) or negative (external costs).

Question 15

Outline Negative externalities

Answer 15

Negative externalities are caused by demerit goods. These are associated with information failure, since consumers are not aware of the long run implications of consuming the good, and they are usually overprovided. For example, cigarettes and alcohol are demerit goods. The negative externality to third parties of consuming cigarettes is second-hand smoke or passive smoking.

Question 16

Outline Positive externalities

Answer 16

Positive externalities are caused by merit goods. These are associated with information failure too, because consumers do not realise the long run benefits to consuming the good. They are underprovided in a free market. For example, education and healthcare are merit goods. The positive externality to third parties of education is a higher skilled workforce.

Question 17

Outline value judgments in externalities

Answer 17

The extent to which the market fails involves a value judgement, so it is hard to determine what the monetary value of an externality is. For example, it is hard to decide what the cost of pollution to society is. Different individuals will put a different value on it, depending on their own experiences with pollution, such as how polluted their home town is. This makes determining
government policies difficult, too.

Question 18

Outline private costs in externalities

Answer 18

Producers are concerned with private costs of production. For example, the rent, the cost of machinery and labour, insurance, transport and paying for raw materials are private costs. This determines how much the producer will supply. It could refer to the market price which the consumer pays for the good.

Question 19

Outline social costs in externalities

Answer 19

This is calculated by private costs plus external costs
On a diagram, external costs are shown by the vertical distance between the two curves. In other words, external costs are the difference between private costs and social costs. It can be seen that marginal social costs (MSC) and marginal private costs (MPC) diverge from each other. External costs increase disproportionately with increased output.

Question 20

Outline private benefit

Answer 20

Consumers are concerned with the private benefit derived from the consumption of a good. The price the consumer is prepared to pay determines this. Private benefits could also be a firm’s revenue from selling a good.

Question 21

Outline Social benefits

Answer 21

Social benefits are private benefits plus external benefits.
On a diagram, external benefits are the difference between private and social benefits. Similarly to external costs, external benefits increase disproportionately as output increases.

Question 22

Outline the external costs of production

Answer 22

They are shown by the vertical distance between MSC and MPC. The market equilibrium, where supply = demand at a certain price, ignores these negative externalities. This leads to over-provision and under-pricing. With negative externalities, MSC>MPC of supply.

At the free market equilibrium, therefore, there are an excess of social costs over benefits at the output between Q1 and Qe. The output where social costs > private benefits is known as the area of deadweight welfare loss, shown by the triangle in the diagram. The market fails to account for the negative externalities that occur from the
consumption of this good, which would reduce welfare in society if it was left to the free market.

Question 23

Outline the external benefits of production

Answer 23

An example of an external benefit from the production or consumption of a good or service could be the decline of diseases and the healthier lives of consumers through
vaccination programmes. Since consumers and producers do not account for them, they are underprovided and under consumed in the free market, where MSB>MPB. This leads to market failure. The triangle in the diagram shows the excess of social benefits over costs. It is the
area of welfare gain.

Question 24

Why the absence of property rights leads to externalities in both production and consumption and hence market failure

Answer 24

Markets become inefficient where there are no property rights. For example, it is practically impossible to establish property rights on goods such as sea water and air. This means that free-riders can have unlimited access, which results in the exploitation of the good.

The moral hazard assumes someone else will pay the consequences for a poor choice. For example, some people might litter the street if they think that other
people will clear up after them. Scarce resources could be over-used or exploited. For example, rainforests are
depleting and many species of fish are becoming endangered. This is because the environment cannot be protected by applying property rights.

Question 25

Outline Demerit goods

Answer 25

Negative externalities are caused by demerit goods. These are associated with information failure, since consumers are not aware of the long run implications of
consuming the good, and they are usually overprovided. For example, cigarettes and alcohol are demerit goods. The negative externality to third parties of consuming
cigarettes is second-hand smoke or passive smoking.

Question 26

Outline Merit goods

Answer 26

Positive externalities are caused by merit goods. These are associated with information failure too, because consumers do not realise the long run benefits to
consuming the good. They are underprovided in a free market. For example, education and healthcare are merit goods. The positive externality to third parties of
education is a higher skilled workforce.

Question 27

Define Symmetric Information as a market imperfection

Answer 27

Symmetric information means that consumers and producers have perfect market information to make their decision. This leads to an efficient allocation of resources.

Question 28

Outline Asymmetric Information as a market imperfection

Answer 28

Asymmetric information leads to market failure. This is when there is unequal knowledge between consumers and producers. For example, a car dealer might
know about a fault with the car that the consumer is unaware of. This could lead to a misallocation of resources. Consumers can also know more information than the producer, such as when purchasing insurance policies.

There could also be imperfect information, where information is missing, so an informed decision cannot be made. This leads to a misallocation of resources. Consumers might pay too much or too little, and firms might produce the incorrect amount. For example, monopolies might exploit the consumer by charging them more than they need to.

Question 29

Outline the principle agent problem in the asymmetric information

Answer 29

Asymmetric information can be linked with the principal-agent problem. This is when the agent makes decisions for the principal, but the agent is inclined to act in their own interests, rather than those of the principal. For example, shareholders and managers have different objectives which might conflict. Managers might choose to make a personal gain, rather than maximise the dividends of the shareholders.

Information could be made more widely available through advertising or government intervention. For example, the harmful effects of smoking could be made public through adverts and messages on cigarette boxes.

Question 30

Define the mobility of labour

Answer 30

The mobility of Labour is the ability of workers to change between jobs. Unemployment is evidence that labour markets do not work efficiently

Question 31

Define frictional unemployment

Answer 31

Frictional unemployment may exist whilst people move between jobs and search for new ones

Question 32

Define structural unemployment

Answer 32

Structural unemployment occurs when there is a decline in an industry. This can mean worker skills do not match the location and skills required for the job. This is more serious.

Question 33

Outline geographical immobility as a market imperfection

Answer 33

The geographical immobility of the factors of production refers to the obstacles which prevent the factors of production moving between areas. For example, labour
might find it hard to find work due to family and social ties, the financial costs involved with moving, imperfect market knowledge on work and the regional variations in house prices and living costs across the UK.

Question 34

Outline occupational immobility as a market imperfection

Answer 34

The occupational immobility of the factors of production refers to the obstacles which prevent the factors of production changing their use. For example, labour
might find it difficult to change the occupation. This occurred in the UK with the collapse of the mining industry, when workers did not have transferable skills to find other work. The causes include insufficient education, training and skills.

Question 35

Outline Monopoly and Monopoly power as a market imperfection

Answer 35

The basic model of monopoly suggests that higher prices and profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive
market. Monopolies could exploit the consumer by charging them higher prices. This means the good is under-consumed, so consumer needs and wants are not fully met. This loss of allocative efficiency is a form of market failure. Monopolies have no incentive to become more efficient, because they have few or no competitors, so production costs are high. There is a loss of consumer surplus and a gain of producer surplus.

Question 36

What are the aims of competition policy

Answer 36

The main aims of competition policy are to promote competition; make markets work better and contribute towards improved efficiency in individual markets and enhanced competitiveness of UK businesses within the European Union (EU) single market.

Competition policy aims to ensure
Technological innovation which promotes dynamic efficiency in different markets
Effective price competition between suppliers
Safeguard and promote the interests of consumers through increased choice and lower price levels

Question 37

What are the four key pillars of competition policy in the UK and in the European Union

Answer 37

Antitrust & cartels: This involves the elimination of agreements that restrict competition including price-fixing and other abuses by firms who hold a dominant market position (defined as having a market share in excess of forty per cent)
Market liberalisation: Liberalisation involves introducing competition in previously monopolistic sectors such as energy supply, retail banking, postal services, mobile telecommunications and air transport
State aid control: Competition policy analyses state aid measures such as airline subsidies to ensure that such measures do not distort the level of competition in the Single Market
Merger control: This involves the investigation of mergers and take-overs between firms (e.g. a merger between two large groups which would result in their dominating the market)

Question 38

What are the main roles of the regulators

Answer 38

Regulators are the rule-enforcers and they are appointed by the government to oversee how a market works and the outcomes that result for producers and consumers
The main competition regulator in the UK is the Competition and Markets Authority (CMA)
The European Union Competition Commission is also an important body for the UK

Question 39

Examples of competition policy in action

Answer 39

De-regulation - laws to reduce monopoly power. Preventing mergers/acquisitions that create a monopoly, Laws to introduce competition into the postal services industry and Forced sales of assets e.g. BAA and airports in the UK

Privatisation - transferring ownership. Stock market floatation of the Royal Mail, Part-privatisation of Network Rail similar to the sell-off of HS1 - the high-speed link that connects London’s St Pancras to the Channel tunnel, on a long-term concession

Tough laws on anti-competitive behaviour
Strong laws and penalties against proven cases of price fixing or collusion that involves market sharing, Companies breaching EU and UK competition rules risk hefty fines of up to 10 per cent of global turnover - senior executives can be jailed

Reductions in import controls. A reduction in import tariffs encourages cheaper products from overseas Increasing or eliminating import quotas can also have the same effect and Allowing new countries into the European Union single market increases contestability

Question 40

Define Privatisation

Answer 40

Privatisation means that assets are transferred from the public sector to the private sector. In other words, the government sells a firm so that it is no longer in their control. The firm is left to the free market and private individuals.

Question 41

Define public ownership

Answer 41

Ownership of enterprises by the government, or a government-controlled body

Question 42

The arguments for and against the public ownership of firms and industries

Answer 42

The railway industry in the UK was nationalised after 1945.

By nationalising an industry, natural monopolies are created. This is because it is
inefficient to have multiple sets of water pipes, for example. Therefore, only one
firm provides water.

Some nationalised industries yield strong positive externalities. For example, by
using public transport, congestion and pollution are reduced.

Nationalised industries have different objectives to privatised industries, which are
mainly profit driven. Social welfare might be a priority of a nationalised industry.

Question 43

Define Nationalisation

Answer 43

Nationalisation occurs when private sector assets are sold to the public sector. In other words, the government gains control of an industry, so it is no longer in the hands of private firms

Question 44

The arguments for and against the privatisation of state-owned
enterprises

Answer 44

It also covers the deregulation of the market. For example, British Airways was privatised in the UK and now operates in the
competitive market. Free market economists will argue that the private sector gives firms incentives to operate efficiently, which increases economic welfare. This is because firms operating on the free market have a profit incentive, which firms which are nationalised do not. Since they are operating on the free market, firms also have to produces the goods and services consumers want. This increases allocative efficiency and might mean goods and services are of a higher quality.
Competition might also result in lower prices. By selling the asset, revenue is raised for the government. However, this is only a one-off payment.

Question 45

Benefits of Regulation

Answer 45

By using regulation, the government could use laws to ban consumers from consuming a good. They could also make it illegal not to do something. For example, the minimum school leaving age means young people have to be in school until the age of 16, and education or training until they turn 18.

This has positive externalities in the form of a higher skilled workforce.

Firms which fail to follow regulations could face heavy fines, which acts as a disincentive to break the rule.

It could raise costs of firms, who might pass on the higher costs to consumers.

Question 46

Benefits of deregulating

Answer 46

By deregulating the public sector, firms can compete in a competitive market, which should also help improve economic efficiency.

Question 47

Explain the problem of regulatory capture

Answer 47

There is the risk of regulatory capture. This is when regulators start acting in the interests of the company, due to impartial information, rather than in consumer interests. This information disadvantage is a problem for regulators.

The problem of asymmetric information can make it hard to determine what level a price cap should be imposed at.

Without sufficient information, governments could make poor decisions and it could lead to a waste of scarce resources.

Question 48

Define Government intervention

Answer 48

Governments intervene in markets to try and overcome market failure. The government may also seek to improve the distribution of resources (greater equality).

The aims of government intervention in markets include
Stabilise prices
Provide producers/farmers with a minimum income
To avoid excessive prices for goods with important social welfare
Discourage demerit goods/encourage merit good

Question 49

Define Indirect taxes

Answer 49

Indirect taxes are taxes on expenditure. They increase production costs for producers, so producers supply less. This increases market price and demand contracts. They could be used to discourage the production or consumption of a demerit good or service. For example, the government could impose a £1 tax per packet of cigarettes

Question 50

What are the types of indirect taxes

Answer 50

Ad valorem taxes are percentages, such as VAT, which adds 20% of the unit price. This is the main indirect tax in the UK. The incidence of tax might fall differently on consumers and producers. Producers could make consumers pay the whole tax (P3 – P2), or if they feel this would lower sales and lose them revenue, they could choose to pay part of the tax. Producers might pay P1 – P2, whilst consumers might pay P3 – P1. The incidence of the tax depends on the price elasticity of demand of the
good. For cigarettes, since the demand is fairly price inelastic, consumers might have the larger burden of tax. This should, in theory, discourage consumption of the demerit good and reduce negative externalities. Government revenue from ad valorem taxes is larger if demand is price inelastic. This is because demand falls only slightly with the tax

Specific taxes are a set tax per unit, such as the 58p per litre fuel duty on unleaded petrol. The more inelastic the demand, the higher the tax burden for the consumer,
and the lower the burden of tax for the producer. Indirect taxes could reduce the quantity of demerit goods consumed, by increasing the price of the good. If the tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, so the free market equilibrium becomes the socially optimum equilibrium. This internalises the externality. In other words, the polluter pays for the damage.

Question 51

Outline Subsidies as a government intervention in markets

Answer 51

A subsidy is a payment from the government to a producer to lower their costs of production and encourage them to produce more.

Subsidies encourage the consumption of merit goods. This includes the full social benefit in the market price of the good. Therefore, the external benefit is internalised.
For example, the government might subsidise recycling schemes so it is cheaper for consumers to recycle waste, which will yield positive externalities for the environment.
The supply curve shifts to the left. More of the merit good is produced and the price falls from P1 to P2. The vertical distance between the supply curves shows the value of the subsidy per unit. Consumers gain more from the subsidy when demand is price inelastic, whilst
producers supply more when demand is price elastic. The disadvantages of subsidies include the opportunity cost to the government and potential higher taxes, the potential for firms to become inefficient if they rely on
the subsidy and government failure, if they subsidise less efficient industries.

Question 52

Outline Maximum price as a way of Government Intervention

Answer 52

The government might set a maximum price where the consumption or production of a good is to be encouraged. This is so the good does not become too expensive to produce or consume. Maximum prices have to be set below the free market price, otherwise they would be ineffective.

They prevent monopolies exploiting consumers. For example, in the EU, price caps on roaming charges are in place to make sure it is not too expensive for consumers
to use their mobile phones abroad. Maximum prices control the market price, but this could lead to government failure if they misjudge where the optimum market price should be. Maximum prices could lead to welfare gains for consumers by keeping prices low,
and they could increase efficiency in firms, since they have an incentive to keep their costs low to maintain their profit level. However, it could reduce a firm’s profits, which could lead to less investment in the long run. Moreover, firms might raise the prices of other goods, so consumers might have no net gain.

Question 53

Outline Minimum price as a government intervention

Answer 53

The government might set a minimum price where the consumption or production of a good is to be discouraged. This ensures the good never falls below a certain price.
For example, 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. Minimum prices would reduce the negative externalities from consuming a demerit good, such as alcohol.
Minimum prices have to be set above the free market price, otherwise they would be ineffective. The minimum wage could be used as an example.

Question 54

Outline Tradeable pollution permits in Government intervention

Answer 54

These could limit the amount of negative externalities, in the form of pollution, created in industries. Firms will be allowed to pollute up to a certain amount, and any surplus on their permit can be traded. This means firms can buy and sell allowances between themselves. For example, there could be a limit on the quantity of carbon dioxide emissions released from the steel industry.

Question 55

What is the advantages and disadvantages of Tradeable pollution permits in government intervention

Answer 55

Advantages
This should benefit the environment in the long run, by encouraging firms to use green production methods.
The government could raise revenue from the permits, because they can sell them to firms. This revenue could then be reinvested in green technology.
If firms exceed their permit, they will have to purchase more permits from firms which did not use their whole permit. This raises revenue for greener firms, who might then invest in green production methods.

Disadvantages
However, it could lead to some firms relocating to where they can pollute without limits, which will reduce their production costs.
Firms might pass the higher costs of production onto the consumer.
Competition could be restricted in the market, if the permits create a barrier to entry or potential firms. It could be expensive for governments to monitor emissions.

Question 56

Outline the State provision of public goods in government intervention

Answer 56

The government could provide public goods which are underprovided in the free market, such as education and healthcare. These have external benefits. This makes merit goods more accessible, which might increase their consumption and yield positive externalities. It could be expensive for governments to provide education, and the government will incur an opportunity cost of spending their revenue.

Question 57

Outline the Provision of information in government intervention

Answer 57

By providing information, governments can ensure there is no information failure, so consumers and firms can make informed economic decisions. For example, governments might make it illegal for second-hand car dealers not to reveal the entire history of a car, so consumers know exactly what they are buying. This could be expensive to police.

Question 58

Definitions of government failure

Answer 58

This occurs when government intervention in the economy causes an inefficient allocation of resources and a decline in economic welfare. Often government failure arises from an attempt to solve market failure but creates a different set of problems.

Question 59

Reasons for government failure

Answer 59

Lack of incentives: In the public sector, there is limited or no profit motive. Because workers and managers lack incentives to improve services and cut costs it can lead to inefficiency. For example, the public sector may be more prone to over-staffing. The government may be reluctant to make people redundant because of the political costs associated with unemployment.
Poor information, politicians may have poor information about the type of service to provide. Politicians may not be experts in their department but concentrate on their political ideology.
Political interference Decisions made for short-term political gain – rather than sound economics, e.g. keep on unproductive workers. e.g. politicians may take the short-term view rather than considering the long-term effects
No consistency. Change of government often leads to change of approach and new political initiatives
Moral hazard. The government may offer a guarantee to all bank deposits to protect the financial system, but this could encourage banks to take risks – because they know they can be bailed out by the government.
Regulatory capture – When government agencies become too friendly with business/groups they are trying to regulate
Unintended consequences. Policies to reduce relative poverty ‘means-tested benefits’ can create ‘welfare dependency.’ For those on means-tested benefits, moving from benefits to work could lead to very little extra income because of lost benefits and higher taxes. Benefits can then solve one problem of relative poverty but create new problems of higher spending and lower levels of labour market participation.
Special interest groups. In the US, many types of business have special tax credits for their industry; this makes it difficult to reform the tax system, and leads to horizontal inequality – business with same income can be treated differently. In the Europe, farmers receive substantial financial support from the EU, making it difficult to reform CAP. Once people are used to receiving subsidies it can be politically difficult for the government to take it away.

Question 60

Examples of government failure

Answer 60

White elephant projects. Concorde supersonic airliner was a joint venture between British and French government. It was seen as a prestigious venture, so even when studies suggested it was uneconomic, politicians didn’t want to back-track but kept putting in public money. Developing Concorde cost the British and French governments £1.1 billion (about £11 billion in 2003 prices) before it even went into service—nearly ten times what was budgeted. (Economist)
Tax leads to fly-tipping. A tax on rubbish is a policy to overcome market failure. To try and include the external cost of rubbish in the price. However, a tax on rubbish can lead to illegal dumping of rubbish on the roads. This creates a different problem of fly-tipping.
Common Agricultural Policy. The CAP was intended to solve market failure in agriculture and protect farmers incomes, but the EU didn’t take into account minimum prices would lead to over-supply; there were also unintended consequences of trade wars and environmental problems from farmers trying to supply as much as they could. See: CAP.
Prohibition strengthened the mafia. When the government banned alcohol in the US, it caused the mafia to supply alcohol, leading to a rise in organised crime.

Question 61

Overcoming government failure

Answer 61

There are various things the government can try and do to overcome government failure
Give performance targets/profit incentives
Competitive tendering – where public sector bodies face competition from the private sector for the right to run a public service.
Employing outside private sector consultants to make decisions about how to cut costs.
Delegating certain decisions to non-political bodies. For example, setting interest rates was given to the Bank of England as politicians often set interest rates for political reasons.

Question 62

Evaluation of government failure

Answer 62

It should be remembered many public services are not subject to the same profit goals. It is difficult to give a profit motive in health or education because the goal is not profit but the quality of service.

Also, although government failure is a real issue, it is often much less than the problems arising from market failure. Just because government intervention may be inefficient, doesn’t mean we should try to tackle problems of pollution e.t.c.