Micro 13 - Government intervention in markets 3: Maximum and minimum prices and tradable permits

Question 1

What are tradable pollution permits used for?

Answer 1

Tradable pollution permits are used to try to control pollution levels

Question 2

How do tradable pollution permits work?

Answer 2

-The government will set an optimal level of pollution and allocate permits that allow firms to emit a certain amount of pollution over a period of time
- Firms may trade their permits with other firms, so if a firm can keep its emissions low, it can sell its permits to other firms who want to buy permits to allow them to pollute more

Question 3

What is the relationship between tradable pollution permits and the market mechanism?

Answer 3

Tradable pollution permits use the market mechanism - pollution is given a value and firms can buy and sell permits

Question 4

What will happen if firms exceed their allowances for pollution?

Answer 4

Firms will be fined if they exceed their allowances but they can trade allowances between themselves, so firms can buy extra allowances to cover any extra emissions

Question 5

What are the advantages of tradable pollution permits?

Answer 5

• These schemes are a good way of trying to reduce pollution to an acceptable level as they encourage firms to become more efficient and pollute less
• Firms causing low levels of pollution will benefit from these schemes as they will be able to sell permits allowing them to invest more and expand
• Governments can use any revenue to invest in other pollution reducing schemes
• These schemes internalise the externality of pollution
• Pollution permits provide continuous incentive to reduce emissions so permits may be sold

Question 6

What are the disadvantages of tradable pollution permits?

Answer 6

• The optimal pollution level can be difficult to set. If the level is set too high firms have no incentive to lower their emissions. If the level is set too low, new firms might not be able to start up at all or existing firms might choose to relocate to somewhere they are less restricted. So setting the optimal pollution level at the wrong level can lead to government failure
• The pollution permit scheme creates a new market, there might be market failure within this new market
• High levels of pollution in specific areas may still exist and this would still be harmful to the environment
• There are administrative costs involved in such schemes to both governments and firms

Question 7

What are tradable pollution permits?

Answer 7

Tradable pollution permits act as a limit placed on a firm’s carbon emissions as firms are not legally allowed to exceed their pollution limit unless they have a permit

Question 8

What will the effectiveness of tradable pollution permits in reducing external costs depend on?

Answer 8

• Whether the scheme is applied just to one country or internationally. Applying to one country may just lead to firms moving production to a nation without the permits system
• The number of permits issued. If too many permits are issued there will be no real incentive for firms to change behaviour
• How well the scheme is monitored. If the government do not enforce the scheme there will be little incentive to follow the rules

Question 9

What is a maximum price?

Answer 9

A maximum price is a ceiling price set by the government on a good or service, above which it cannot rise. It may be enforced through government legislation

Question 10

Why may a maximum price be set for a good?

Answer 10

A maximum price may be set to increase consumption of a good or to make a necessity more affordable

Question 11

What effect will a maximum price have if it set above the market equilibrium price?

Answer 11

If a maximum price is set above the market equilibrium price it will have no impact

Question 12

What effect will a maximum price have if it is set below the market equilibrium?

Answer 12

If a maximum price is set below the market equilibrium it will lead to excess demand and a shortage in supply. The excess demand cannot be cleared by market forces so to prevent shortages the product needs to be rationed out

Question 13

After the introduction of a maximum price scheme what will the amount of excess demand for a good depend on?

Answer 13

The goods price elasticity of demand and price elasticity of supply

Question 14

Draw a diagram showing a maximum price scheme

Answer 14

See page 89 in the revision guide

Question 15

What is a minimum price scheme?

Answer 15

A minimum price scheme is a floor price set by the government on a good or service below which it cannot fall often set above equilibrium. It may be enforced through government legislation

Question 16

Why may a minimum price be set for a good?

Answer 16

Minimum prices are often set to make sure that suppliers get a fair price

Question 17

What effect will a minimum price have if it set below the market equilibrium price?

Answer 17

If a minimum price is set below the market equilibrium price it will have no impact

Question 18

What effect will a minimum price have if it set above the market equilibrium price?

Answer 18

If the minimum price is set above the market equilibrium price it will reduce demand and increase supply leading to an excess supply

Question 19

What is a guaranteed minimum price scheme?

Answer 19

A guaranteed minimum price scheme is where the surplus output created is purchased by a government agency at the minimum price. The main aim of the scheme is to protect producer incomes

Question 20

What is needed to make a guaranteed minimum price work?

Answer 20

To make a minimum price for a good work the government must purchase the excess supply at the guaranteed minimum price. The goods bought by the government will either be stockpiled or destroyed

Question 21

After the introduction of a minimum price scheme, what will the amount of excess supply depend on?

Answer 21

The price elasticity of supply and the price elasticity of demand

Question 22

What are the advantages of a maximum price scheme?

Answer 22

• Maximum prices can help to increase fairness by allowing more people the ability to purchase certain goods and services
• They can also be used to prevent monopolies from exploiting consumers
• They can reduce inequality

Question 23

What are the disadvantages of a maximum price scheme?

Answer 23

• Since demand will be higher than supply, some people who want to buy the product aren’t able to
• Governments may need to introduce a rationing scheme to allocate the good
• Excess demand can lead to the creation of a black market for a good
• Reducing incomes for businesses may reduce the quality of a good or service that can be provided

Question 24

What is the effectiveness of a maximum price scheme likely to depend on?

Answer 24

• How much below the equilibrium price the maximum price is set
• Price elasticity of supply
• How price elastic demand is
• How carefully it is enforced by the government

Question 25

What are the advantages of a minimum price scheme?

Answer 25

• They can reduce the consumption of goods which are harmful to consumers and have high external costs
• Taxes can be paid for by the producer meaning prices do not rise overly. A minimum price ensures the price of the product rises and so demand is likely to fall
• Producer surplus is likely to rise
• A national minimum wage can reduce exploitation of labour while increasing incentives to work

Question 26

What are the disadvantages of a minimum price scheme?

Answer 26

• Excess supply may occur as the price mechanisms can no longer restore the market to equilibrium
• Consumers will need to pay higher prices
• Consumer surplus will fall
• If demand is price inelastic, consumption will not fall greatly when the price rises meaning it may not be effective in reducing demand for products
• Government spending on a minimum price scheme has a high opportunity cost