Government intervention to correct market failure

Question 1

One way of correcting market failure is tax, explain the diagram.

Answer 1

• Tax shifts the supply curve to the left and makes the good more expensive. This will reduce demand.
• The government can use tax for demerit goods and goods with negative externalities.

TAX, AD VALOREM TAX DIAGRAM

Question 2

Tax pros and cons

Answer 2

Pros:

•Raises revenue for the government to spend on alternatives.
•Internalises the externality (tax makes people pay the full social cost).
•Creates incentives in the long-term to encourage firms to reduce pollution or provide alternatives.
•Tax can also alter consumer behaviour in the long-
term. For example, higher petrol tax may encourage consumers to buy a bicycle.

Cons:

•If demand is
inelastic, tax will only have a minimal effect in reducing
demand. This may occur if there are no alternatives to the good e.g. oil.
•High taxes may encourage tax evasion, e.g. cigarette tax encourages cigarettes to be smuggled on the black market.
•High specific taxes will be regressive. They take a higher percentage of income from the poor than high-income earners.
•There may be administration costs in implementing new taxes, e.g. it would be difficult to implement a congestion charge for small cities.
•It can be difficult to measure the external cost and how much tax should be increased.

Question 3

What is a subsidy?

Answer 3

The aim of subsidies is to encourage consumption of goods which are underprovided / under-consumed in a free market.

SUBSIDY DIAGRAM

Costs:

-Cost to the government. Subsidies will be expensive and will require higher taxes on other goods.
•If demand is inelastic, a subsidy will be ineffective in
increasing demand. For example, a subsidy on train travel may be ineffective if it is a poor substitute to driving a car.
•A firm that receives a subsidy is more likely to be inefficient, as they become reliant on the government subsidy. Subsidies may keep inefficient firms in business.
•There may be government failure, e.g. the government has poor information about who to subsidise.
•Subsidies may be most effective if combined with other policies, e.g. tax on driving and subsidies to reduce cost of buses.

Question 4

State Provision pros

Answer 4

For some merit goods and public goods, the most efficient solution for market failure is for the government to provide services directly.

• It ensures everyone has access to this important merit good and provides greater equality in society.
• A national health service may be able to benefit from economies of scale, leading to lower average costs than small independent hospitals.
• For services like health and education, workers do not need the same profit motive of a private manufacturing firm. Therefore, there is less likely to be government failure due to a lack of incentives.
• Public goods like law and order may not be provided at all in a free market.

Question 5

Private sector pros and cons

Answer 5

1. Increased demands are being placed on the public sector due to demographic changes. If more people went private, this would enable the NHS to ave shorter waiting lists.
2. Provides consumers with more choice.
3. If less people use the NHS,it would enable the government to lower taxes and reduce borrowing.
4. The private sector has a profit incentive to cut costs and provide a more efficient service, e.g. public bodies may have over-staffing because of political fears about job cuts.
5. Possible diseconomies of scale in the NHS.

Cons:

1. It is difficult to introduce a profit motive into public services such as health care;for example, it is not practical to give performance related pay to nurses/ doctors. Also, the private sector may cut costs by reducing the quality of service, e.g. cutting back on cleaning.
2. May increase inequality. People on low incomes cannot afford private health care.
3. Health is a merit good and will be underprovided in a free market. Therefore, there is a justification for government subsidy.