4.1.8.9 Govt Intervention In Markets

Question 1

What does market failure provide an argument for?

Answer 1

Government intervention

Question 2

Why might governments intervene in a market?

Answer 2

To correct a market failure, such as the underprovision of healthcare and education

Question 3

In what ways can governments intervene to influence the allocation of resources in a market?

Answer 3

Indirect taxes, subsidies, regulation and provision

Question 4

What are the effects of indirect taxation on markets supplying demerit goods?

Answer 4

They increase production costs for producers, so supply decreases (shifts up) and demand contracts, increasing the price and decreasing the quantity produced, closer to the social optimum quantity where MSB = MSC

Question 5

What does the impact of an indirect tax depend on?

Answer 5

• The extent of the tax needed is normative, due to the impact of the externality or information failure
• The size of the tax
• The price elasticity of demand and supply, as it determines by how much the resource allocation is changed, and the bearing of incidence
• The time the tax is enacted, as elasticity tends to increase over time
• The market structure, as monopolies can make consumers pay all the incidence
• The use of the tax revenue gained, so is it hypothecated: is it used to fix the negative externality or information failure

Question 6

What is incidence?

Answer 6

Who becomes worse off from the introduction of a tax, so who pays more of the tax

Question 7

What are the 2 different categories of indirect taxation and how do they differ when illustrated on a diagram?

Answer 7

• Ad valorem taxes, which are percentages, such as VAT which adds 20% of the unit price, and is the main indirect tax, shown on a diagram by a steeper (more inelastic) supply curve shifted upwards
• Specific/flat taxes, which are a set tax per unit, shown on a diagram by shifting the supply curve upwards with the same gradient

Question 8

On a diagram showing an indirect tax, what price of the tax is paid by the consumer and what price of the tax is paid by the producer?

Answer 8

Consumers pay Pt-Pe of tax (above Pe), and producers pay Pe-Ps of tax (below Pe)

Question 9

If Pt - Pe is greater than Pe - Ps, who bears more of the incidence?

Answer 9

The consumers

Question 10

If Pt - Pe is less than Pe - Ps, who bears more of the incidence?

Answer 10

The producers

Question 11

What is the relationship between the elasticity of supply and demand and incidence beared by producers and consumers as a result of an indirect tax?

Answer 11

The less elastic of supply and demand pays more of the incidence

Question 12

What must be true if all incidence is paid by the consumers?

Answer 12

Supply is perfectly elastic

Question 13

What must be true if all incidence is paid by the producers?

Answer 13

Demand is perfectly elastic

Question 14

What is the relationship between the elasticity of supply and demand, and the impact of an indirect tax on resource allocation?

Answer 14

The less elastic either supply and demand are, the smaller the impact of the tax in resource allocation

Question 15

What are the main concerns in analysing an indirect tax?

Answer 15

If it internalises the externality, meaning if the externality cost is shifted from the third party to the producer, so they pay the cost of it instead of creating it. Also, if it shifts the quantity of price equilibrium to the social optimum quantity where MSB = MSC

Question 16

What is a subsidy?

Answer 16

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

Question 17

What is the aim of a subsidy?

Answer 17

To encourage the consumption of merit goods, by including the full social benefit in the market price of the good, therefore internalising the external benefit, and moving the quantity towards the social optimum where MSB = MSC

Question 18

What are the effects of subsidising a market supplying a merit good?

Answer 18

The supply is increased (shifted down), extending demand and moving the price-quantity equilibrium towards the quantity where MSB = MSC

Question 19

What does the impact of a subsidy depend on?

Answer 19

• The positive externality, as its extent is normative
• Possible inefficiency from businesses depending on the subsidy
• The opportunity cost of the government spending

Question 20

On a diagram showing a subsidy, what price of the subsidy is received by the producer and what price of the subsidy is received by the consumer?

Answer 20

P2 - Pe is received by the producer, Pe - Ps is received by the consumer

Question 21

If P2 - Pe is greater than Pe - Ps, who gains more of the benefit?

Answer 21

The producers

Question 22

If P2 - Pe is less than Pe - Ps, who gains more of the benefit?

Answer 22

The consumers

Question 23

What is the relationship between the elasticity of supply and demand and benefit gained by producers and consumers as a result of a subsidy?

Answer 23

The greater benefit is gained by the less elastic of supply and demand

Question 24

What is the relationship between the elasticity of supply and demand, and the impact of a subsidy on resource allocation?

Answer 24

If demand and supply are more elastic, the quantity increases by more

Question 25

What is the relationship between the elasticity of supply and demand, and the cost of a subsidy?

Answer 25

The higher the PED/PES, the higher the cost of the subsidy

Question 26

What is another term for a maximum price?

Answer 26

A price cap or ceiling

Question 27

What is the purpose of a maximum price?

Answer 27

To encourage the consumption or production of a good, by making sure it does not become too expensive to produce or consume

Question 28

Where do maximum prices have to be set?

Answer 28

Below the free market price

Question 29

What are the impacts of a maximum price?

Answer 29

• A shortage of Qd - Qs, leading to rationing
• Welfare gains for consumers by keeping prices low
• Efficiency increases in firms as they have an incentive to keep their costs low and maintain their profit level
• Could reduce a firm’s profits, leading to less investment in the long run
• Firms could raise the prices of other goods, so consumers might have no net gain
• Could lead to government failure if the optimum market price is misjudged

Question 30

What is an example of a maximum price?

Answer 30

New York City rent caps

Question 31

What is another term for a minimum price?

Answer 31

A price floor

Question 32

What is the purpose of a minimum price?

Answer 32

To discourage the consumption or production of a good, ensuring the good never falls below a certain price

Question 33

Where do minimum prices have to be set?

Answer 33

Above the free market price

Question 34

What is an example of a minimum price?

Answer 34

The National Minimum Wage

Question 35

What are the effects of a minimum price?

Answer 35

• A surplus of Qs - Qd, resulting in wasted goods that the government may have to purchase to store or give away
• Can lead to black markets, as the high price encourages development of illegal markets where the good is sold at lower prices, such as alcohol
• Loss of consumer welfare due to higher price, but ensures income to producers in volatile markets, such as agriculture

Question 36

What are pollution permits?

Answer 36

Licenses provided by the government for firms in polluting industries to allow them to pollute up to a certain amount, and can be traded between firms

Question 37

What is an example of a pollution permit in the UK?

Answer 37

ETS, which provides a limit on the quantity of carbon dioxide emissions released by firms

Question 38

How is the supply of pollution permits represented on a diagram?

Answer 38

A perfectly inelastic supply curve

Question 39

Why is the supply of pollution permits perfectly inelastic?

Answer 39

The government provides a fixed number of them

Question 40

What determines the price of a pollution permit?

Answer 40

Demand

Question 41

Why might the demand for pollution permits increase?

Answer 41

As an economy experiences growth, the level of production will increase, meaning firms in polluting industries will need polluting permits to produce a higher quantity of goods

Question 42

Why should the supply of pollution permits decrease over time?

Answer 42

As the economy develops and becomes more sustainable, there will be less need for pollution permits, so the government may decrease the number provided

Question 43

What are the advantages of pollution permits?

Answer 43

• The environment should benefit in the LR, as firms are encouraged to use less polluting production methods to cut down costs from paying for the permit
• The government can raise revenue from permits, as they can sell them to firms, which could be reinvested into green technology
• If firms exceed their permit, they will have to purchase more permits from firms not using their whole permit, raising revenue for greener firms, who might then invest in green production methods

Question 44

What are the disadvantages of pollution permits?

Answer 44

• Firms may relocate to where they can pollute without limits due to the higher production costs, meaning less national production and output
• Firms can pass the higher costs of production onto the consumer to retain profit
• If the permits create a barrier to entry for potential firms, competition is restricted in the market
• The cost for the government to monitor emissions may not justify the revenue received

Question 45

What does the impact of pollution permits depend on?

Answer 45

• The extent of the pollution, which is normative
• Possible inefficiency from intervention, due to government failure
• If the level of pollution can be measured accurately and truthfully