Government Intervention

Question 1

Tax

Answer 1

A charge, placed on an individual or firm, that is payable to the government under punishment of law.

Question 2

Indirect Tax

Answer 2

Tax placed on goods and services.
* Government collects revenues from the supplier, after the supplier collects it from the purchaser.
* Government collects money from the consumers indirectly.
* Either a specific tax or an ad valorem tax.

Question 3

Specific Tax

Answer 3

Charge a specific amount to be paid for every unit of a good sold.
* Supply curve shifts upward or left by that amount.
* Parallel shift, as the amount of per-unit tax is constant (regardless of price or quantity).

Question 4

Ad Valorem Tax

Answer 4

Base the tax on a percentage of the purchase price.
* Higher the price of the good, the overall amount of the tax will increase.
* Supply curve shifts upward or left by that amount, but the distance between S and S1 grows as the price increases.

Question 5

Pigouvian Tax

Answer 5

Indirect tax that is imposed on any market that creates negative externalities, in order to eliminate the externality.

Question 6

List Consequences of Taxing The Sales of a Good.

Answer 6

• Taxes raise prices
• Taxes reduce output
• Market size shrinks
• Consumers suffer
• Producers suffer
• Government benefit

Question 7

Deadweight Loss

Answer 7

The loss of welfare, utility or benefit to market participants, typically as a result of taxes, protectionist policies or externalities.

Question 8

Excise Tax

Answer 8

Tax applied to a
type of good.

Question 9

Market Failure

Answer 9

Situation in which the allocation of resources by a free market is not efficient. It is real-world conditions that cause markets to function inefficiently.

Question 10

To produce output above PE and QE, it would cause:

Answer 10

Costs to Exceed Benefits

Question 11

To produce output below PE and QE, it would:

Answer 11

Leave Some Portion of Consumer/Producer Surplus Unenjoyed.

Question 12

Pareto Optimal

Answer 12

A market situation where no one can be made better off without making someone else worse off. At a normally functioning competitive market equilibrium, there exists a state of pareto optimality.

Question 13

Pareto Optimality Conditions:

Answer 13

• If the P > PE, consumers would be worse off.
• If the P < PE, producers would be worse off.
• If the Q > QE, society’s cost (MSC) would be greater than its benefits (MSB). Therefore, everyone would be worse off.
• If the Q < QE, some amount of community surplus would be lost.

Question 14

Social Efficiency

Answer 14

Maximization of community surplus achieved at PE and QE, where MSB = MSC (which is synonymous with Pareto optimality).

Question 15

List Types of Market Failure

Answer 15

• Negative externalities (of production and consumption)
• Positive externalities (of production and consumption)
• Lack of public goods
• Common access to resources and threat to sustainability
• Asymmetric information
• Abuse of monopoly power

Question 16

Externality

Answer 16

A transaction in which someone other than the buyer or seller (third party) experiences a benefit or loss, as a result of the transaction.

Question 17

What is the Effect of Externalities?

Answer 17

If an externality occurs, there is a difference between society’s experience and that of the individual firm or consumer. No longer is the private benefit equal to society’s benefit. Therefore it is possible to say that marginal social benefits of the good are equal to the private benefit plus the additional amount of beneficial externality

Question 18

Marginal Social Benefit

Answer 18

All the utility or benefit derived from the use of a good, including benefits to the consumer and the rest of society.

Question 19

Marginal Private Benefit

Answer 19

The benefit derived solely by the consumer of a good.

Question 20

Marginal Social Cost

Answer 20

All the cost incurred from the production or use of a good, including costs to the producers and the rest of society.

Question 21

Marginal Private Cost

Answer 21

The costs of a good suffered solely by the producer.

Question 22

Mathematically, when there are externalities:

Answer 22

• social benefits = private benefit + external benefit
• social costs = private cost + external costs

Question 23

Mathematically, when there are no externalities:

Answer 23

social benefits = private benefits
social costs = private costs

Question 24

Negative Production Externalities

Answer 24

Loss due to production; Suffer from transaction. Beyond private costs, the external costs suffered by others increase the overall social costs.

Question 25

# Negative Production Externalities: Effect on Graph

Answer 25

The cost to society, marginal social cost (MSC), is higher than the private cost (MPC). Not a shift to the left of the supply curve. Just more accurate diagram of the full costs of production. You could refer to the MSC curve as the ‘true’ supply curve because it shows all the costs to society.

Question 26

# Negative Production Externalities: New Equilibrium

Answer 26

This implies that goods whose production creates a negative externality are: * Overproduced * Sold at prices that are too low (below what the market would show if all costs were added in) * Resources are misallocated (MC =/ MB) * The distance between a and b represents the marginal negative externality at that point. ## Footnote Q* significantly less than QE; P* is higher than PE

Question 27

# Negative Production Externalities: Solutions

Answer 27

1. Legislation/Regulation 2. Taxation 3. Advertising/Persuasion

Question 28

Negative Consumption Externalities

Answer 28

Person’s use of a product affects others adversely. The marginal social benefits are less than the benefits enjoyed by the private consumer.

Question 29

# Negative Consumption Externalities: Effect on Graph

Answer 29

Marginal social benefit falls below or “behind” the marginal private benefit.

Question 30

# Negative Consumption Externalities: New Equilibrium

Answer 30

This implies that goods whose consumption creates a negative externality are: * Demand less of product * Value them at less * “Too many produced, too many consumed” ## Footnote Q* significantly less than QE; P* is lower than PE

Question 31

# Negative Consumption Externalities: Solutions

Answer 31

1. (Pigouvian) Taxes 2. Legislation/Regulation ("Command and Control" Approach) 3. Education/Raising Awareness

Question 32

Positive Production Externalities

Answer 32

Benefit due to production; Benefit from transaction. Marginal social cost, the true cost to society, is lower at every point than the private cost experienced by firms.

Question 33

# Positive Production Externalities: New Equilibrium

Answer 33

This implies that goods whose production creates a positive externality are: * Too little being produced * Costs should be lower * This suggests that more could be produced, and society would enjoy the extra benefits of that production, shown by the blue triangle as ‘potential welfare gain.’ ## Footnote Q* more than QE; P* is less than PE

Question 34

# Positive Production Externalities Solutions

Answer 34

1. Subsidies 2. Direct Provision

Question 35

Positive Consumption Externalities

Answer 35

Benefit due to consumption; Benefit from transaction. Social benefits exceed the private benefits. In other words, MSB will be greater than MPB.

Question 36

# Positive Consumption Externalities: New Equilibrium

Answer 36

This implies that goods whose consumption creates a positive externality are: * Not enough being produced. * Price should be higher (to reflect society’s true value for good/service). * The amount of the potential gain in welfare is shown by the shaded triangle. ## Footnote Q* more than QE; P* is more than PE

Question 37

# Positive Consumption Externalities Solutions

Answer 37

1. Subsidies 2. Improving Information Regarding Benefits/Advertising or Campaigns 3. Legal Requirements

Question 38

Price Ceiling

Answer 38

A maximum legally allowable price for a good, set by the government. ## Footnote * Great potential for high prices. * Makes a goal of keeping prices low. * Make basic goods and services more affordable. * Prevents price from reaching PE. This is called binding or effective price ceiling

Question 39

Effects of Price Ceiling

Answer 39

* Shortages * Rationing * Decreased Market Size * Elimination of Allocative Efficiency * Informal (Black) Market

Question 40

Examples of Price Ceilings

Answer 40

* Rice, Bread, and Other Staple Foods * Rent Control * Housing Subsidies

Question 41

Price Floor

Answer 41

A minimum legally allowable price for a good, set by the government. ## Footnote * Good may be important or necessary. * May be supporting employment in a particular industry. * Usually it depends on the good itself. * Prevents price from dropping to PE. * Excess at PMIN is surplus.

Question 42

Effects of Price Floor

Answer 42

* Surplus * Reduced Market Size * Cost Inefficiency * Elimination of Allocative Efficiency * Informal Markets

Question 43

Examples of Price Floor

Answer 43

* Argricultural Price Supports * Minimum Wage

Question 44

Merit Good

Answer 44

One for which the marginal social benefits exceed the marginal social costs when sold on the open market (MSB > MSC) | Education, healthcare services, public transportation, renewable energy. ## Footnote * Create positive spillover benefits. * Underproduced by the free market. * Governments (and economists) encourage the consumption of these goods to capture potential welfare gain that would not be enjoyed without intervention.

Question 45

How do governments encourage the consumption of lesser merit goods?

Answer 45

* Advertising and public opinion campaigns * Subsidize merit goods, either by direct payment or reduced taxation * Degree of government provision or encouragement is directly related to the amount of spillover benefits provided by the good. ## Footnote Religious schools, for example, may be actively subsidized, as they are in many countries, or implicitly subsidized by reducing or eliminating taxes for religious organizations themselves.

Question 46

Public Good

Answer 46

Good that is non-rivalrous and non-excludable, and is typically provided by the government. | Streetlights, national defense, prisons, roads. ## Footnote * Extreme examples of merit goods. * Typically provided by the government. * They are non-rivalrous: One person’s consumption of it does not prevent others from enjoying it. * They are non-excludable: The producer cannot prevent particular individuals from enjoying its benefits.

Question 47

Demerit Good

Answer 47

One for which the marginal social costs exceed the marginal social benefits when sold on the open market (MSC > MSB). | Cigarettes, drugs, alcohol, gambling. ## Footnote * Create negative spillover costs to third parties. * Negative externality goods are typically demerit goods. * Overproduced and over consumed. * As an optimal allocation of society’s resources would reduce their use.

Question 48

How do governments discourage the consumption of demerit goods?

Answer 48

* Public persuasion * Taxation * Regulation * Banning of the good can all be employed * Bans against the consumption of demerit goods rarely destroy the market. Instead, bans drive the market underground to the black market. * Depends on the perceived severity of the problems associated with the good. ## Footnote Cigarettes are heavily taxed and are often labelled with large warnings and photographs to discourage consumption.