4.1.8.9 government intervention in markets

Question 1

why do governments intervene in the market?

Answer 1

• to correct market failure
  eg) they might provide healthcare and education which the free market would under provide

Question 2

what are indirect taxes?

Answer 2

• 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

eg) the government could impose a £1 tax per packet of cigarettes

Question 3

there are two types of indirect tax
ad valorem and specific tax
explain ad valorem tax?

Answer 3

ad valorem
- taxes are %s 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, or if they feel this would lower sales and lose them revenue, they could choose to pay part of the tax
- the incidence of the tax depends on the price elasticity of demand of the good
- 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 tax

Question 4

explain specific taxes

Answer 4

• they’re 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
• they could reduce the Q 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
  ie) the polluter pays for the damage

Question 5

what is a subsidy?

Answer 5

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

Question 6

what do subsides do?

Answer 6

they encourage the consumption of merit goods
- this included the full social benefit in the market price of the good
- therefore, the external benefit is internalised

Question 7

how are the effects of a subsidy shown on a diagram?

Answer 7

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

Question 8

who gains more from the subsidy when demand is inelastic and elastic?

Answer 8

• consumers gain more from the subsidy when demand is price inelastic
• producers supply more when demand is price elastic

Question 9

what are the disadvantages of subsidies?

Answer 9

include
- the opportunity cost to the government
- 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 10

when is a maximum price set?

Answer 10

• the government might set a maximum price where the consumption or production of a good is to be encouraged
• this is so the good doesn’t become too expensive to produce or consume
• have to be set below the free market price, otherwise they’d be ineffective

Question 11

how are maximum prices shown on a diagram?
where is the free market equilibrium?

Answer 11

if suppliers only produced at Q3, some consumers would be willing to pay P2
- the shaded area shows the consumer surplus producers can take with the higher price

a quantity of Q3 would require rationing or auctioning, since QD is Q2
- they prevent monopolies exploiting consumers

Question 12

what do max prices do?
what could they lead to?

Answer 12

• control the market price
• but this could lead to gov failure if they misjudge where the optimum market price should be
• 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
• but it could reduce a firm’s profits, which could lead to less investment in the long run
  -> firms might raise the prices of other goods, so consumers might have no net gain

Question 13

why do governments set minimum prices?
what can they lead to?

Answer 13

• the government might set a minimum price where the consumption or production of a good to be discouraged
• this ensures the good never falls below a certain price
• the national minimum wage is an example of a minimum price
• they 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

Question 14

how are minimum prices shown on a diagram?
explain it

Answer 14

Question 15

what do tradable pollution permits do?

Answer 15

• 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

Question 16

what are some advantages of pollution permits?

Answer 16

• 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’ll have to purchase more permits from firms which didn’t use their whole permit
  -> this raises revenue for greener firms, who might then invest in green production methods

Question 17

what are some disadvantages of pollution permits?

Answer 17

• 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 for potential firms
• it could be expensive for governments to monitor emissions

Question 18

what is state provision of public goods?

Answer 18

• the government could provide public goods which are under-provided in the free market, like 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 19

what is the provision of information?

Answer 19

• by providing information, governments can ensure there’s no info failure, so consumers and firms can make informed economic decisions
• eg) 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 20

what is regulation?

Answer 20

• the government could use laws to ban consumers from consuming a good
• they could also make it illegal not to do something

eg) minimum school leaving age means young ppl have to be in school until 16yrs old, and education/training until they turn 18
- this has positive externalities in the form of a higher skilled workforce

• if there was a compulsory recycling scheme, it would be difficult to police and there could be high administrative costs
  -> bans could be enforced for harmful goods, although they can still be consumed on the black market
• 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 21

study this summary sheet of pros and cons for policies that reduce consumption/production

Answer 21

Question 22

study this summary sheet of pros and cons for policies that increase consumption/production

Answer 22