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
What is a pollution permit system and how does it work?
A system for controlling pollution based on a market for permits that allows firms to pollute up to a limit.
The government issues or sells permits to firms, allowing them to pollute up to a certain limit. These permits are then tradable, so that firms that are relatively ‘clean’ in their production methods and do not need to use their full allocation of permits can sell their polluting rights to other firms, whose production methods produce greater levels of pollution.
What are the advantages of a pollution permit system?
One important advantage of such a scheme lies in the incentives for firms. Firms that pollute because of their relatively inefficient production methods will find they are at a disadvantage because they face higher costs. Rather than continuing to purchase permits, they will find that they have an incentive to produce less pollution - which, of course, is what the policy is intended to achieve. In this way, the permit system uses the market to address the externality problem in contrast to direct regulation of environmental standards, which tries to solve pollution by overriding the market.
A second advantage is that the overall level of pollution can be controlled by this system, as the authorities control the total amount of permits that are issued. After all, the objective of the policy is to control the overall level of pollution, and a mixture of ‘clean’ and ‘dirty’ firms may produce the same amount of total emissions as uniformly ‘slightly unclean’ firms.
What are the disadvantages of a pollution permit system?
In particular, there is the question of enforcement. For the system to be effective, sanctions must be in place for firms that pollute beyond the permitted level, and there must be an operational and cost-effective method for the authorities to check the level of emissions.
Furthermore, it may not be a straightforward exercise for the authorities to decide upon the appropriate number of permits to issue. in order to produce the desired reduction in emission levels. Some alternative regulatory systems share this problem, as it is not easy to measure the extent to which marginal private and social costs diverge.
One possible criticism that is unique to a permit form of regulation is that the very different levels of pollution produced by different firms may seem inequitable — as if those firms that can afford to buy permits can pollute as much as they like. On the other hand, it might be argued that those most likely to suffer from this are the polluting firms, whose public image is likely to be tarnished if they acquire a reputation as heavy polluters. This possibility might strengthen the incentives of such firms to clean up their production. Taking the strengths and weaknesses of this approach together, it seems that on balance such a system could be effective in regulating pollution.
An example is the EU Emissions Trading System (EU ETS), which has been in operation since 2005. It now operates in 31 countries, and limits carbon emissions from more than 11,000 energy-using installations. The system works on a ‘cap and trade’ system. A cap is set on the total amount of greenhouse gases that can be emitted by installations that are part of the scheme, with the cap being reduced over time. Companies in the scheme receive or buy emission allowances that can then be traded with other firms. The scheme is seen as having had success in reducing emissions - by 2020 they are expected to be 21% lower compared with 2015.
Why are property rights important in an economy?
Nobel prize winner Ronald Coase argued that the existence of property rights and transaction costs is key to understanding how markets work. In other words, the existence of a system of secure property rights is essential as an underpinning for the economy. The legal system exists in part to enforce property rights, and to provide the set of rules under which markets operate. When property rights fail, there is a failure of markets.
In this view of the world, one of the reasons underlying the existence of some externalities is that there is a failing in the system of property rights. For example, think about the situation in which a factory is emitting toxic fumes into a residential district. One way of viewing this is that the firm is interfering with local residents’ clean air. If those residents could be given property rights over clean air, they could require the firm to compensate them for the costs it was inflicting.
However, the problem is that, with such a wide range of people being affected to varying degrees (according to prevailing winds and how close they live to the factory), it is impossible in practical terms to use the assignment of property rights to internalise the pollution externality. This is because the problem of coordination requires high transaction costs in order for property rights to be individually enforced. Therefore, the government effectively takes over the property rights on behalf of the residents, and acts as a collective enforcer.
Ronald Coase therefore argued that externality effects could be internalised in conditions where property rights could be enforced, and where the transaction costs of doing so were not too large.
How does information provision work?
Market failure can arise from information failure, especially where there is asymmetric information or where economic agents lack information or the capacity to process the information available. In such circumstances, the solution would seem to be to find a way of providing the information to remedy the situation.
One example discussed in Chapter 9 was that of second-hand cars, where car dealers may find that they cannot find buyers for good-quality cars at a fair price if potential buyers cannot distinguish quality. The solution here may be to tackle the problem at its root, by finding a way to provide information about quality. In the case of second-hand cars, AA inspection schemes or the offering of warranties may be a way of improving the flow of information about the quality of cars for sale. Buyers may then have confidence that they are not buying a lemon.
Similarly, in the case of the insurance market, the asymmetric information problem helps to explain why insurance companies try to cover themselves by insisting on comprehensive health histories of those who take out health insurance, and include exclusion clauses that entitle them to refuse to pay out if past illnesses have not been disclosed. It also helps to explain why banks may insist on collateral to back up loans.
Information problems may also be present in respect of some demerit goods. Think back to the tobacco example discussed earlier. Tobacco is seen by government as a demerit good on the grounds that smokers underestimate the damaging effects of smoking. There may also be negative externalities caused by passive smoking. At first, taxes were used to try to discourage smoking, but given the inelastic demand for tobacco, this proved ineffective. The taxes were reinforced by extensive campaigns to spread information about the damaging effects of smoking. When even this did not solve the problem, the government had to introduce regulation by prohibiting smoking in public buildings.
Evaluate government intervention and government failure
Some roles are critical for a government to perform if a mixed economy is to function effectively. A vital role is the provision by the government of an environment in which markets can operate effectively. There must be stability in the political system if firms and consumers are to take decisions with confidence about the future. And there must be a secure system of property rights, without which markets could not be expected to work.
There may be areas of the economy where government intervention is needed for markets to work. For example, if firms are to operate effectively and to compete in international markets, they need access to public goods such as a good transport and communications infrastructure. If the government does not put sufficient resources into road maintenance, or the development of the rail network, then firms may face higher costs, and be disadvantaged relative to their international competitors. On the other hand, if the government over-invests, then there is an opportunity cost, because more resources used for infrastructure implies that fewer resources are available for private sector investment.
An example is the HS2 project, which is designed to provide a high- speed rail link between London and Birmingham, extended to Manchester and Yorkshire (Sheffield and Leeds). The first passengers to use HS2 are expected in 2026. Estimates of the cost have varied — the budget for the project in late 2017 was £55.7 billion, but some critics have claimed that it could cost £200 billion. The project has been highly contentious, raising questions about value for money as well as specifics about the route, and whether or not this is the best way of using the funds. The debate provides an example of the tension that can arise when the government seeks to invest heavily in specific projects.
In addition, there are other sources of market failure that require intervention. This does not necessarily mean that governments need to substitute markets with direct action. However, it does mean that they need to be more active in markets that cannot operate effectively, while at the same time performing an enabling role to encourage markets to work well whenever this is feasible.
Such intervention entails costs. There are costs of administering, and costs of monitoring the policy to ensure that it is working as intended. Some policies have unintended effects that may not culminate in successful elimination of market failure. Indeed, in some cases government intervention may introduce new market distortions, leading to a phenomenon known as government failure.
It is therefore important to look out for the unintended distortionary effects that some policies can have on resource allocation in a society. In other words, there is a need to check that the marginal costs of implementing and monitoring policies do not exceed their marginal benefits.
Government intervention can only be as effective as the information on which it is based. The government faces risk and uncertainty about market conditions, and does not always have full information about the market failures that it is attempting to tackle. There is a possibility of government failure that may leave matters worse than without the interventions introduced.
What is government failure?
A misallocation of resources arising from government intervention that causes a less efficient allocation of resources and imposes a welfare loss on society
