Policies To Address Market Failure

Question 1

Negative consumption and production externality solution

Answer 1

Indirect tax, raises price so discourages firms from producing and people from buying.
Generates government revenue which can be reinvested
Model on Externality diagram

Question 2

Evaluation of indirect tax

Answer 2

Difficult to measure externality and therefore hard to know how much to tax, so likely under - correction.
the incidence of the indirect tax depends on PED, may be ineffective with demerit, addictive goods.
They are regressive (worst for poorest)
Incentivises firms to cut costs elsewhere, potentially through dirtier production methods

Question 3

Positive consumption externality solution

Answer 3

Subsidy. Decreases price, so consumers and producers have more surplus, society welfare increases. Encourages more consumption of the goods
Rewards producers of socially desirable goods and raises affordability for the low income

Question 4

Evaluation of subsidy

Answer 4

Opportunity cost of spending
Cedes control to private firms, you may want state provision
Welfare loss due to government expenditure
Undermines competition, so trade rules penalise them usually,

Question 5

Negative production externality solution

Answer 5

Market based solution eg cap and trade scheme (pollution permit). Clean producers rewarded, as they can sell permits, dirty producers have to spend more. Incentivises switch to clean energy
Sets an arbitrary cap on pollution

Question 6

Problems with cap and trade scheme

Answer 6

Susceptible to lobbying, which makes it ineffective.
Difficult to decide who gets how many permits.
Government failure may occur and producers still get to pollute a lot of.
Complicated and difficult to put in place