Government Intervention

Question 1

Why are price fluctuations bad? (3)

Answer 1

1. Causes revenue/profits of producers to fluctuate
   - Reduces their living standards in the and years
   - May force them into bankruptcy/cash flow problems if price falls below costs of production
2. Discourages investment, due to uncertainty, producers save extra profit rather than investing it
3. Impact on customers. If they are other firms, their profits also fluctuate, as they don’t know their costs of production

Question 2

What’s a way to reduce the uncertainty caused by fluctuating prices?

Answer 2

Diversification - producing of a range of products

Question 3

Explain a Buffer Stock Scheme

Answer 3

1. Government estimates LR market price
2. Government sets a max & min price, either side of the LR market price
3. In a good year, P goes below minP so government buys to keep P=minP
4. In a bad year, P goes above maxP so government sells to keep P=maxP

Question 4

Will a buffer stock scheme work? (7)

Answer 4

1. It involves a cost to the government. There is an initial cost and a cost of storage
2. Is the product perishable?
3. What if a bad year occurs first? The government might be temped to set the price range quite high to buy more often and sell less often. But this makes issues worse and means consumers pay more
4. Asymmetric information - producers know more about the LR than the government so they may push the government to set a higher target price range
5. The model assumes D does not change, if it does the price range is wrong
6. Requires all producers to be part of the scheme
7. How often the government has to intervene depends on the PED

Question 5

Define Market Failure

Answer 5

Market Failure is when the price mechanism does not allocate resources efficiently. In theory the market should produce the ‘correct amount’ of each good, but this does not always happen - sometimes the market will ‘under-produce’ and sometimes it will ‘over-produce’

Question 6

What are the main causes of market failure: (4)

Answer 6

• Nature of the good/ “public good”
• External costs & benefits
• Asymmetric information
• Factor immobility

Question 7

What is a Public Good?

Answer 7

A Public Good is one where there is:

• non-rivalry: one person consuming the food does not mean there is less available for other customers
• non-excludability: once a good is provided then it is impossible to prevent non-payers from using the good
• the free rider problem: a person can receive the benefits of a good without paying for it, so the ‘logical’ thing to do is not to pay, but if everyone thinks like this then no one pays and so no firm would be prepared to make the good, so no one would get it. This is called a missing market

All public goods are provided by the government and we all pay via taxation. However not all government provided goods (public sector) are public goods

Question 8

Explain the concept of Externalities

Answer 8

In theory markets are efficient because the market equilibrium (S=D) is where the marginal (extra) cost = marginal (extra) benefit. However these are the costs/benefits to those people involved in the trade (buyer/seller) but there may be costs to 3rd parties (people not involved in the trade). The efficient Q (or allocation of resources) ought to take these 3rd party costs/benefits into account, but the price mechanism does not.

The Costs/Benefits to those involved in the trade = Marginal Private Costs/Benefits
The Costs/Benefits to 3rd parties = External Costs/Benefits
All Costs/Benefits = MPC/B + External C/B = Marginal Social Costs/Benefits

When Qm does not equal Qse there is market failure
Qm > Qse - the market overproduces
Qm

Question 9

Describe issues with externalities: (4)

Answer 9

1. Measuring externalities - even if we can agree that an external cost/benefit exists, it is almost impossible to put a monetary value on an externality
2. SR vs LR - many products cause an external cost in SR but an external benefit in LR
3. May be both external costs & benefits - these may counter act each other, ie. polluting factory creating jobs
4. Size of Qse-Qm (market failure) depends on elasticity of curves (more inelastic = less difference)

Question 10

Explain Asymmetric Information

Answer 10

For a market to work efficiently both buyer and seller should have access to the same information (about the quality, benefits, alternatives…). Where this does not occur we have market failure caused by asymmetric information

Examples:

• Seller knows more: cars, housing, foods, drugs, education
• Buyer knows more: health insurance

Question 11

Explain mobility of labour

Answer 11

Mobility of labour refers to how willing/able workers are to move jobs. There are 2 types of immobility:

• Occupational immobility: where the workers don’t have the skills/qualifications to change profession. Often this includes an unwillingness/mobility to retrain
• Geographical immobility: where workers can’t travel to/don’t live in areas where jobs are. One reason why they are unwilling to move is house prices, another - family/friends

Question 12

What are the possible solutions to immobility of labour: (4)

Answer 12

1. Subsidising training schemes/paying people on training
2. Rent control (maximum price for rent)
3. Building of new, affordable housing
4. Improving transport links (easier/cheaper to travel to work)

Question 13

What are the 2 categories of government intervention?

Answer 13

• Replacing the market

- Internalising the externality: polluter pays, the firm is responsible

Question 14

Explain and evaluate State Provision

Answer 14

State provision - state producing the product at Qse. However how does the state know how much to provide? Also it is an opportunity cost as the state produces many other things.

Question 15

Explain and evaluate Regulation

Answer 15

Regulation - introducing laws: asymmetric information - calories on packaging, banning children from buying certain products, introducing limits or quotas on the amount of pollution a firm can produce.

Advantages:
- Easy to understand and easy to enforce

Disadvantages:

• Can be expensive to monitor firms
• May increase costs for firms
• Ignores price mechanism (government regulation does not account for changes of Qse)

Question 16

Explain and evaluate Taxation of external costs

Answer 16

Taxation of external costs - setting a tax at a level equal to the external cost. So the firm has an extra private cost that is equal to the external cost and so will produce at Qse.

Advantages:

• Uses the polluter pays principle, both producers and consumers pay the external costs
• Uses the price mechanism, if demand or costs change the system adjusts
• The level of output should fall to socially optimal level
• Tax funds are raised to deal with the effects of pollution/external costs

Disadvantages:

• No guarantee taxes will be used to deal with effects
• It is difficult to measure an externality, so difficult to set tax
• Indirect taxes increase costs and make firms less competitive with foreign firms
• If the PED is low, quantity won’t change much, so no less pollution
• May encourage a black market

Question 17

Explain and evaluate Subsidising goods with external benefits

Answer 17

Subsidising goods with external benefits - providing a subsidy at a level equal to the external benefit. So the firm has an extra private benefit that is equal to the external benefit and so will produce at Qse.

Advantages:

• Uses the polluter pays principle, the rest of society, who gain the external benefits pay part of the costs via taxation
• Uses the price mechanism, if demand or costs change the system adjusts
• The level of output should rise to socially optimal level
• In the LR the subsidy may change people’s habits and cease to exist

Disadvantages:

• It is difficult to measure an externality, so difficult to set subsidy
• Opportunity cost to the government
• Subsidies may encourage firms to be inefficient so price may be higher than with no subsidy
• There is no guarantee the people who pay the tax are the ones receiving the external benefit

Question 18

Explain and evaluate Extending property rights

Answer 18

Extending property rights - some external costs occur because no one owns the scarce resource being destroyed. So the solution would be to give the ownership it the government or an agency. Then a firm would have would have to pay them, it’s a cost so it will produce at Qse

Advantages:

• Uses the polluter pays principle, both producers and consumers pay the external costs
• Uses the price mechanism, if demand or costs change the system adjusts
• The level of output should fall to socially optimal level
• Funds are raised to deal with the effects of pollution/external costs

Disadvantages:

• Funds are required for administration
• It is difficult to measure an externality
• Increases costs and make firms less competitive with foreign firms
• If the PED is low, quantity won’t change much, so no less pollution
• May encourage a black market
• May not be practical (can Scandinavians charge UK firms for acid rain?)

Question 19

Explain and evaluate Tradable permits (cap and trade system)

Answer 19

Tradable permits (cap and trade system) - when the government allocates a set amount of permits, which allow a set amount of externality. The permits are allocated to firms but those who need to crate more pollution can buy them from those who create less. Government keeps some amount.

Advantages:

• By capping the total amount of permits the government can force firms to reduce emissions. Over time the Q of permits can be reduced
• It internalises the cost of polluting by forcing firms to buy permits
• It provides an incentive for firms to invest in green technology
• The sale of permits raises finance to government, to deal with the effects

Disadvantages:

• If too many permits are issued and their price falls there is no incentive to reduce emissions
• If not enough are issued, it increases costs, making firms less competitive
• Firms may pass on extra cost to consumers
• The price of permits varies making it difficult for firms to plan for the LR
• Firms may relocate outside of the scheme
• There is a monitoring cost to the government

Question 20

Define government failure

Answer 20

Government failure occurs when the government allocates resources inefficiently. This means the government may provide too much/too little of education etc

Question 21

Why do governments intervene in an economy?

Answer 21

1. To correct market failure

2. Political motivation (redistribution of income)

Question 22

Why does government failure occur? (4)

Answer 22

1. Conflicting objectives - there always is an opportunity cost, the government may not be able to produce as much of all the product it would like. It has to make choices.
2. Lack of knowledge - the market has S&D to tell us what is the correct Q. If the government produces, there is no market, so how do they decide the Q?
3. Market distortion - when government intervenes in a market but doing so it stops the market working properly and so makes things worse
4. Illegal markets - government intervention can encourage ‘hidden’ markets to avoid the regulations

Question 23

What are the 3 basic economic decisions?

Answer 23

1. What to produce (items and how many)
2. How to produce (combinations of labour/capital)
3. For whom to produce

Question 24

Define Free Market Economy and Mixed Economy?

Answer 24

Free market economy - when all decisions are made by the price mechanism
Mixed economy - when resources are allocated by a mixture of the price mechanism and governments

Question 25

Is a free market a good thing (evaluate)?

Answer 25

YES:

• Efficient use of resources: firms produce what people want and the market reacts quickly to changes in tastes/costs of production
• Benefits of competition: competition encourages firms to produce better quality products, reduce costs/prices, weeds out inefficient firms, encourages innovation

NO:

• Efficient? The free market sometimes ‘fails’ (externalities, public goods etc) and so doesn’t provide the ‘correct’ amounts of each good
• Risk: ‘competition’ implies firms/individuals need to take risks. This is fine for those who succeed, but what happens to those who don’t
• Unequal distribution of wealth & income: so no income means you die! This may be seen as a positive (incentive), but many people through no full of their own may struggle to get a sufficient income. This creates a vicious circle