Chapter 10 - Government intervention and government failure Flashcards
What is indirect tax?
A tax levied on expenditure on goods and services
What is direct tax?
A tax charged directly to an individual based on a component of income.
Who pays the tax that is put on goods?
Although the seller may be responsible for the mechanics of paying the tax, part of the tax is effectively passed on to the buyer in the form of the higher price.
The price elasticity of demand determines the incidence of the tax. If demand were perfectly inelastic, then the sellers would be able to pass the whole burden of the tax on to the buyers through an increase in price equal to the value of the tax, knowing that this would not affect demand. However, if demand were perfectly elastic, then the sellers would not be able to raise the price at all, so they would have to bear the entire burden of the tax.
What is the ‘producer pays principle’?
An argument that a firm causing pollution should be charged the full external costs that it inflicts on society
Who receives the subsidy paid by the government?
Because the price falls by less than the amount of the subsidy, the benefits of the subsidy are shared between the buyers and sellers - depending on the elasticity of
demand. If the aim of the subsidy is to increase production, it is only partially successful - the degree of success also depends upon the elasticity of demand.
How can taxes and subsidies be used to change demand for certain goods?
Indirect taxes may be used to correct some forms of market failure
Subsidies can be used to encourage higher demand for merit goods
What does ‘contracting out’ mean?
A situation in which the public sector places activities in the hands of a private firm and pays for the provision
What does ‘competitive tendering’ mean?
A process by which the public sector calls for private firms to bid for a contract for provision of a good or service
What is a ‘public-private partnership’?
An arrangement by which a government service or private business venture is funded and operated through a partnership of government and the private sector
What is the Private Finance Initiative (PFI)?
A funding arrangement under which the private sector designs, builds, finances and operates an asset and associated services for the public sector in return for an annual payment linked to its performance in delivering the service
What are some good and bad things about the PFI?
The PFI established a partnership between the public and private sectors. The public sector specifies the services that it requires, perhaps in broad terms, and then invites tenders from the private sector to design, build, finance and operate the scheme. In some cases, it may be that the project would be entirely free-standing - for example, the government may initiate a project such as a new bridge, which is then taken up by a private firm that will recover its costs entirely through user charges such as tolls.
In some other cases, the project may be a joint venture between the public and private sectors. The public sector could get involved with such a venture in order to secure wider social benefits, perhaps through reductions in traffic congestion that would not be reflected in market prices, and so would not be fully taken into account by the private sector. In other cases, it may be that the private sector undertakes a project and then sells the services to the public sector, often over a period of 25 or 30 years.
The aim of the PFI is to improve the financing of public sector projects. This is partly achieved by introducing a competitive element into the tendering process, but in addition it enables the risk of a project to be shared between the public and private sectors. This was intended to enable efficiency gains to be made.
One effect of the PFI is to reduce the pressures on public finances by enabling greater private sector involvement in funding. However, it might be argued that this may in fact raise the cost of borrowing if the public sector would have been able to borrow on more favourable terms than commercial firms.
The introduction of a competitive element in the tendering process may be beneficial, but on the other hand it could be argued that the private sector may have less incentive than the public sector to give due attention to health and safety issues. In other words, there may be a concern that private firms will be tempted to sacrifice safety or service standards in the quest for profit. Achieving the appropriate balance between efficiency and quality of service is an inevitable problem to be faced in whatever way transport is financed and provided, for example, but it becomes a more critical issue to the extent that use of the PFI switches the focus more towards efficiency and lower costs.
Why does government expenditure take place?
They need to undertake expenditure on administration and in enabling transfer payments to the vulnerable.
Why do governments intervene in public goods?
Public goods cannot be met through the free market (side note: because firms aim to maximise profit) so government ensures provision.
Why may the government use price controls?
In some markets, governments have been seen to intervene to regulate price directly. This could be viewed as a response to market failure - for example, if it were apparent that price was not being set equal to marginal cost, so that allocative efficiency
was not being achieved.
In other circumstances, the government may perceive that the free market was leading to a situation in which high prices were excluding some people from the market, or where low prices were causing harm to some individuals.
What is the effect of a maximum price?
Imagine a market in which the equilibrium price is at P* and quantity demanded is Q*. Suppose that this is a good that the government thinks is beneficial for people, and it wants to encourage them to demand in greater quantity - i.e. this is a merit good. One way it could intervene would be to direct suppliers that the maximum price they could charge was P-max. This being so, the demand for the good would indeed be higher, at Q.
Unfortunately, the policy may fail because suppliers will not be prepared to supply more than Q at this price, so the market ends up in disequilibrium. In other words, there is excess demand that cannot be met.
How is rent control an example of maximum price?
A market in which governments have been tempted to intervene to affect prices is the housing market. House prices have escalated over the years, and a shortage of rented accommodation has arisen. The temptation for the government is to move this market away from its equilibrium by imposing a maximum level of rent that landlords are allowed to charge their tenants.
First, landlords will no longer find it profitable to supply as much rental accommodation, and so will reduce supply to Q. Second, at this lower rent there will be more people looking for accommodation, so that demand for rented accommodation will move to Q. The upshot of the rent controls, therefore, is that there is less accommodation available, and more homeless people. It can be seen that the well-meaning rent control policy, intended to stop landlords from exploiting low income households, merely has the effect of reducing the amount of accommodation available. This is not what was supposed to happen.
How does a minimum price work?
Minimum price can be used for demerit goods because, in a free market, too much of the good is consumed. In equilibrium, the market price would be p
P* and the quantity traded would be Q*. It might be thought that one way of discouraging overconsumption of the good would be to intervene by forcing suppliers to sell at a price above the equilibrium level. This has the desired effect, as the quantity demanded falls to Q. However, again we see that the market is being held in a disequilibrium position, as suppliers would be eager to sell more at the going price. There is excess supply.
What are some examples of minimum price being implemented?
The Scottish government took the view that excessive use of alcohol was a major social concern — in other words, it viewed alcohol as a demerit good. In particular, it was perceived that low-price alcohol was encouraging behaviour that would cause health problems for individuals in the long term. It was possible for people to reach the recommended limit for alcohol consumption for only £2.50. In May 2018, a law came into effect setting a minimum price for alcohol, measured by alcoholic units. In equilibrium, the price would be P* and the quantity traded Q* Setting a minimum price at P-min has the desired effect of reducing demand to Q. On the supply side, producers would have been prepared to supply more at this price, so the market remains in disequilibrium in a situation of excess supply.
A similar situation arose in European agricultural markets when price support systems were in place. Farmers were guaranteed prices for their goods that were above the equilibrium, the main driver being a strategic one — to ensure that the sector did not run down. One result was the build-up of wine lakes and butter mountains, reflecting overproduction.
Another common example of a minimum price is where the government intervenes to impose a minimum wage, below which employers are not permitted to hire labour. This is intended to protect low-paid workers from being exploited in the labour market.
How does price stabilisation work?
In some commodity markets, prices can exhibit volatility over time. This could arise, for example, when the supply of a good varies from period to period because of the varying state of the harvest. In such a market, the supply curve will shift to the right when the harvest is good, but shift to the left in a period when the weather is poor or where crops are affected by some disease or blight. It may also be that the demand curve tends to shift around through time, with demand for some goods reflecting fluctuations in the performance of economies. In other words, demand may shift to the left when recession bites, but to the right in times of boom and prosperity.
There would be a market in which demand is relatively stable between periods, but in which supply varies. This creates a high level of uncertainty for producers, who find it difficult to form accurate expectations about the future prospects for the commodity. This means that they are less likely to invest in ways of improving productivity because of uncertain future returns. If a way could be found of stabilising the price of the good, then this could encourage producers.
What is a buffer stock?
A scheme intended to stabilise the price of a commodity by buying excess supply in periods when supply is high, and selling when supply is low.
How does a buffer stock work?
A scheme is set up whereby excess supply is bought up by the buffer stock in glut years to prevent the price from falling too low. In periods when the harvest is poor, stocks of the commodity are released on to the market in order to maintain the price at the agreed level. Suppose that it is agreed to maintain the price at P*. When there is a glut year, with the supply curve located at S-glut there is excess supply at the agreed price of the amount BC, so this amount is bought up by the buffer stock and stored. If the supply is at poor because of a poor harvest, there is excess demand, so the buffer stock releases the quantity AB on to the market, maintaining the price.
Although this does have the effect of stabilising the price at P, there is
a downside. If the members of the buffer stock scheme agree to maintain the price at too high a level, relative to the actual average equilibrium price over time, then it will run into difficulties. To maintain price at P, the buffer stock buys up more in the glut year
than it has to sell in the poor harvest year. If this pattern is repeated, then the size of stocks to be stored will rise over time. This is costly and will eventually become unsustainable.
How does legislation and regulation work?
In some markets, the government chooses to intervene directly through legislation and regulation, rather than by influencing prices. The aim of these interventions is to influence the quantity supplied of a good or service. Legislation may be used to prevent the supply of a good, whereas regulation seeks to limit the supply without banning it altogether, or in some cases to encourage more of a good to be supplied.
Legislation can operate by declaring some goods illegal. This may also have unintended effects. Consider the situation in which action is taken to prohibit the consumption of a demerit good such as a hard drug. It can be argued that there are substantial social disbenefits arising from the consumption of hard drugs, and that addicts and potential addicts are in no position to make informed decisions about their consumption of them. One response to such a situation is to consider making the drug illegal to prevent it being sold at all.
Regulation is used to influence the demand for or supply of a good.
Demand for alcohol may be affected if its sale is restricted to those aged 18 or over. In some markets, the authorities may think it important to limit the quantity of a good being supplied by imposing quotas on production and sale. For other goods, regulation may be used to limit the market power of large firms that would otherwise exploit consumers by raising price to increase their profits.
The economic effects of legislation and regulation are similar, in the sense that both have the effect of moving a market away from its equilibrium position. By banning a product, the effect may be to establish a black market, so that sales are hidden from the authorities but continue regardless.
What is competition policy?
Competition policy is a form of regulation used to protect consumers (and, in some cases, firms) from being exploited by firms that have market power. Such market power may arise when a firm (or group of firms working together) is able to increase profits at the expense of consumers, or their suppliers. For example, firms may form a cartel (an illegal form of collusion in which firms meet to fix prices).
What are the main functions of the CMA?
- Investigating mergers that could potentially give rise to a substantial lessening of competition (SLC)
- Assessing particular markets in which there are suspected competition problems
- Antitrust enforcement by investigating possible breaches of UK or EU prohibitions against anticompetitive agreements and abuse of a dominant position
- Criminal cartels — the CMA is able to bring criminal proceedings against individuals who commit the cartel offence
consumer protection
