Section 6 - Government Intervention

Question 1

Taxation intro

Answer 1

>Indirect taxes can be imposed on the purchase of goods or services.
>There are two types of indirect tax:
1. Specific taxes.
2. Ad valorem taxes.
>There are also direct taxes. These are imposed on individuals or organisations. E.g. income tax.

Question 2

Specific taxes

Answer 2

>These are a fixed amount that’s charged per unit of a particular good, no matter what the price of that good is.
>E.g. a set amount of tax could be put on bottles of wine regardless of their price.

Question 3

Specific Tax Diagram:

Answer 3

Question 4

Ad valorem taxes

Answer 4

>These are charged as a proportion of the price of a good.
>E.g. a 20% tac on the price of a good would mean a £10 good = £12 and a £100 good = £120.

Question 5

Ad Valorem Tax Diagram

Answer 5

Question 6

Indirect taxes - impact

Answer 6

>Indirect taxes increase costs for producers so they cause the supply curve to shift to the left.
>A specific tax causes a a parallel shift of the supply curve whereas an ad valorem tax causes a non-parallel shift of the supply curve, with the biggest impact being on higher price goods.

Question 7

Governments usage of tax

Answer 7

>Governments often put extra indirect taxes on goods that have negative externalities.
>Governments may use multiple indirect taxes on one item, e.g. in the UK cigarettes have a specific tax (called excise duty) and an ad valorem tax on their retail price.
>The aim of taxation is to internalise the externality that the good produces, i.e. make the producer and/or consumer of the product cover the cost of its externalities.
>The taxes make revenue for the government which can be used to offset the effects of externalities - e.g. the revenue generated from a tax on alcohol could be used to pay for additional police time needed to deal with alcohol related crime.
>Another example of a specific tax used in the UK is landfill tax. The tax aims to reduce the impacts of environmental market failure linked to landfill/

Question 8

How does landfill tax reduce impacts of environmental market failure?

Answer 8

>Local authorities/firms that dispose of waste at landfill sites are charged an environmental tax.
>The tax is set at an amount which attempts to reflect the full social costs of using landfill.
>Tax should encourage recycling reducing negative externalities.
>Although could lead to fly-tipping.

Question 9

Amount of tax paid

Answer 9

>The amount of tax passed on to the consumer will depend on the price elasticity of demand.
>If demand for a good is price inelastic, most or all of the extra cost is likely to be passed on to the consumer.
>If the demand for a good is price elastic then the producer is much more likely to take on most of the extra cost.

Question 10

Advantages of tax to reduce market failure

Answer 10

>The cost of the negative externalities is internalised in the price of the good - this may reduce demand for the good and the level of its production, reducing the effects of the negative externalities.
>If demand isn’t reduced there’s still the benefit that the revenue gained from the tax can be used by the government to offset the externalities. Tax hypothecation.

Question 11

Disadvantages of tax to reduce market failure

Answer 11

>It can be difficult to put a monetary value on the ‘cost’ of the negative externalities.
>For goods where demand is price inelastic, the demand isn’t reduced by the extra cost of the tax.
>Indirect taxes usually increase the cost of production, which reduces a product’s international competitiveness.
>Firms may choose to relocate and sell their goods abroad to avoid the indirect taxation. This would remove their contributions to the economy, such as the payment of tax and the provision of employment.
>The money raised by taxes on demerit goods might not be spent on reducing the effect of their externalities.

Question 12

Subsidies

Answer 12

>The government may pay subsidies with the aim of encouraging the production and consumption of goods and services with positive externalities.
>A subsidy increases the supply of a good/service, so the supply curve shifts to the right.
>Subsidies can be used to encourage the purchase and use of goods/services which reduce negative externalities. E.g. public services to reduce pollution, or as support for firms to help them become more internationally competitive.
>Both consumers and producers can gain from a subsidy.
>The proportion of the subsidy producers and consumers benefit from depends on the elasticity of the supply and demand curves.
>Sometimes subsidies might be given directly to consumers instead.

Question 13

Subsidies - advantages

Answer 13

>The benefit of goods with positive externalities is internalised, i.e. the cost of these externalities is covered by the government subsidy, so the price of the goods is reduced from what it would be in the absence of a subsidy.
>Subsidies can change preferences - producers will supply goods with positive externalities and consumers will consume them and receive the benefits from them. Also, making a merit good cheaper by the presence of a subsidy makes it more affordable and increases demand for it.
>The positive externalities are still present.
>Subsidies can support a domestic industry until it grows to the point that it can exploit economies of scale and become internationally competitive (Although this could encourage inefficiency).

Question 14

Subsidies - disadvantages

Answer 14

>It can be difficult to put a monetary value on the ‘benefit’ of positive externalities.
>Any subsidy has an opportunity cost.
>Subsidies may make producers inefficient and reliant on subsidies. The subsidy means that producers have less incentive to reduce costs or innovate.
>The effectiveness of subsidies depends on the elasticity of demand - subsidies wouldn’t significantly increase demand for inelastic goods.
>The subsidised goods and services may not be as good as those they’re aiming to replace. E.g imported goods may be better quality than the domestically produced alternatives a subsidy is promoting.

Question 15

Subsidy Diagram

Answer 15

Question 16

Maximum price

Answer 16

>A maximum price (or price ceiling) may be set to increase consumption of a merit good or to make a necessity more affordable. E.g. max rent to keep cost of renting a property affordable.
>If a maximum price is set above the market equilibrium price, it will have no impact.
>If it’s set below the market equilibrium, it will lead to excess demand and a shortage in supply. The excess demand can’t be cleared by market forces, so to prevent shortages the product needs to be rationed out, e.g. by ballot.
>A good’s price elasticity of supply and price elasticity of demand will have a big effect on the amount of excess demand.

Question 17

Maximum Price Diagram

Answer 17

Question 18

Minimum price

Answer 18

>Minimum prices (or price floors) are often set to make sure that suppliers get a fair price. The EU’s Common Agricultural Policy (CAP) involves the use of a guaranteed minimum price for many agricultural products.
>If a minimum price is set below the market equilibrium, it will have no impact.
>If it’s set above the market equilibrium price, it will reduce demand and increase supply leading to an excess supply.
>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.
>Gov expenditure would then be AQ1Q2B.
>A good’s PES and PED will have a big effect on the amount of excess supply.
>Minimum prices are a good way to restrict monopsony power as they will provide a guaranteed price for suppliers and ensure that a firm that’s a monopsony buyer can’t keep negotiating lower and lower prices.

Question 19

Minimum Price Diagram

Answer 19

Question 20

Maximum price - advantages

Answer 20

>Max 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.

Question 21

Maximum price - disadvantages

Answer 21

>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, e.g. through a ballot.
>Excess demand can lead to the creation of a black market for a good.

Question 22

Minimum price - advantage

Answer 22

>Producers have a guaranteed minimum income which will encourage investment.
>Stockpiles can be used when supply is reduced (e.g. due to bad weather) or as overseas aid.

Question 23

Minimum price - disadvantage

Answer 23

>Consumers will be paying a higher price than the market equilibrium.
>Resources used to produce the excess supply could be used elsewhere - there’s an inefficient allocation of resources.
>Government spending on a minimum price scheme could be used in other areas - schemes may have a high opportunity cost.
>Destroying excess goods is a waste of resources.
>Depends on the magnitude of the minimum price above the free market price.

Question 24

State provision

Answer 24

>Governments directly provide some goods and services.
>Governments use tax revenue to pay for certain goods and services so that they’re free, or largely free, when consumed. In UK = NHS, state education, waste disposal, fire and police services.
>Public goods, such as defence and street lighting, are also provided by the state.
>State provision can come directly from the government, e.g. state schools and the army.
> Also, governments can purchase the good or service from the private sector and provide it to the public for free, e.g. in some areas community health services are purchased from private companies and then provided free to NHS patients.

Question 25

What can state provision do?

Answer 25

>State provision is a way to overcome market failure.
>Governments might provide certain things to increase the consumption of merit goods, such as education and health.
>Free provision of services can help to reduce inequalities in access, e.g. due to differences in wealth.
>It can also redistribute income - most of the money to pay for the services comes from taxing wealthier citizens.
>The level of state provision is a value judgement made by the government - it’s up to the government to decide the amount of a good/service that they provide. This decision is likely to be based on how important for society they think it is that they provide the good/service.

Question 26

State provision - disadvantages

Answer 26

1. State provision may mean there’s less incentive to operate efficiently due to the absence of the price mechanism.
2. State provision may fail to respond to consumer demands, as it lacks the motive of profit to determine what’s supplied.
3. The opportunity cost of state provision of a good or service is that other goods or services can’t be supplied.
4. State provision can reduce individuals’ self-reliance - they know the good or service is there for them if they need it.

Question 27

Health care

Answer 27

>Health care is a merit good that’s sometimes provided by governments.
>The government funds the NHS so that society benefits from the positive externalities of health care. E.g. can contribute to a happier, healthier population and reduce number of sick days.
>However, there are drawbacks to the state provision of health care by the NHS.

Question 28

State provision of health care - drawbacks

Answer 28

>However, there are drawbacks to the state provision of health care by the NHS:

1. Demand for health care in the UK has increased dramatically since the NHS was introduced. Because the NHS is free at the point of delivery, this has led to excess demand and problems like long waiting lists.
2. Hospitals and clinics can be wasteful of resources, such as money wasted on unused prescriptions.
3. The NHS may not always respond to the wants and needs of patients - e.g. local NHS officials might relocate medical services against the wishes of the population in their area for cost-saving reasons.
4. The NHS can reduce patients’ self-reliance. E.g. it can remove the incentive for patients to deal with medical issues themselves (minor things like colds, sore throats.)

Question 29

Privatisation - definition

Answer 29

>Privatisation is the transfer of the ownership of a firm/industry from the public sector to the private sector.

Question 30

Privatisation intro

Answer 30

>A publicly owned firm/industry is owned by the government.
>The firm/industry will usually act in the best interests of consumers - so price tends to be low and output high. This is possible because they don’t have to make profits.
>However, publicly owned firms tend to be inefficient because they lack competition and that can lead to market failure.
>Governments may decide to increase competition through privatisation.
>Privatisation is the transfer of ownership of a firm/industry from the public sector to the private sector.
>Some economists believe this will lead to a more efficient industry because it’ll be open to free market competition.
>Private firms have shareholders, so they’ll usually need to maximise their profits to keep the shareholders happy.

Question 31

Privatisation covers a number of different things, for example…

Answer 31

1. The sale of public (nationalised) firms: e.g. the Royal Mail was privatised through the sale of shares.
2. Contracting out services: a government pays a private firm to carry out work on its behalf, e.g. cleaning government-owned buildings like hospitals and schools.
3. Competitive rendering: private firms bid (or compete) to gain a contract to provide a service for the government. Firms will compete on price and the quality of the service offered.
4. Public Private Partnerships (PPPs) - a private firm works with a government to build something or provide a service.

Question 32

Public Private Partnership examples

Answer 32

>An example of a PPP is a Private Finance Initiative (PFI) - a private firm is contracted by the government to run a project.
>For example, in the UK, some hospitals or schools are built by a private firm, then the government leases the buildings from the firm (usually for a long period of time).
>In 2010, M&S agreed a 5-year partnership with Somerset County Council Waste Partnership for M&S to provide funding (up to £250,000 per year) for the council to collect waste waste from roadsides in the county. This funding has enabled the county council to improve its recycling services, and M&S has benefitted from the collection of recyclable plastic that can be used for its products.

Question 33

Privatisation - advantages

Answer 33

1. Increased competition improves efficiency and reduces x-inefficiency.
2. Improves resource allocation - privatised firms have to react to market signals of supply and demand.
3. PFIs enable the building of important facilities that the government might not be able to afford to build.
4. PFIs means lower taxes in the short run because the government won’t pay for the new facility immediately.
5. The government gains revenue from selling firms.
6. Attracts inward investment.

Question 34

Privatisation - disadvantages

Answer 34

1. A privatised public monopoly is likely to become a private monopoly so extra measures, e.g. deregulation, need to be taken to avoid this.
2. Privatised firms may have less focus on safety and quality because they have more focus on reducing costs and increasing profits.
3. The new private firm might need regulating to prevent it from being a private monopoly - this adds cost for taxpayers.
4. A PFI will often cost more in the long run than it’s worth - so it adds to government debt and may not represent value for money.
5. PFIs mean higher taxes for future generations to pay for the cost of the government leasing the facility.

Question 35

Regulation - definition

Answer 35

>Regulations are rules that are enforced by an authority (e.g. a government) and they’re usually backed up with legislation - which means that legal action can be taken against those that break the rules. >They can be used to control the activities of producers and consumers and try to change their undesirable behaviour.

Question 36

Importance of Regulation

Answer 36

>Regulations are used to try to reduce market failure and its impacts.
>With appropriate legislation, firms or individuals who don’t follow the regulations can be punished, e.g. with fines.
>For example, laws, like the Clean Air Act and the Environmental Protection Act, have been created to limit the damage caused to the environment by economic activity and to enforce minimum environmental standards in major industries.
>Regulations can be difficult to set.

Question 37

How can regulations help reduce market failure and its impacts?

Answer 37

1. Reducing the use of demerit goods and services. E.g. by banning or limiting the sale of such products.
2. Reducing the power of monopolies. E.g. using a regulatory body to set rules such as price caps.
3. Providing some protection for consumers and producers from problems arising from asymmetric information. E.g. the Sale of Goods Act protects consumers against firms supplying substandard goods.

Question 38

The difficulty of setting regulations

Answer 38

>It can be difficult for a government to work out what is ‘correct’. E.g. a government might set the level of acceptable pollution by firms too low or too high.
>There’s a need for regulation in some areas to be worldwide rather than in just one country. E.g. regulations to control greenhouse gas emissions might be more effective if they were enforced worldwide - regulations in one country may reduce its emissions, but this could be offset by an increase in emissions elsewhere in the world.
>Following excessive regulations can be expensive and may force firms to close or to move to a different country.
>Monitoring compliance with regulations can be expensive for a government, and if the punishment for breaking regulations isn’t harsh enough, then they may not be a deterrent and change behaviours.

Question 39

Regulations and renewable energy

Answer 39

>The UK government has introduced Renewables Obligation Certificates (ROCs) to encourage the use of power generated from renewable energy sources.
>Electricity suppliers are given a set minimum percentage of power that must come from renewable sources.
>Companies who generate the renewable energy are issued with ROCs which link to the amount of renewable energy they’ve generated. They then sell these certificated on to suppliers.
>Suppliers that fall short of the target percentage of power from renewable sources have to pay a financial penalty. The money raised from these penalties is distributed between the suppliers who did reach the target.

Question 40

Deregulation - definition

Answer 40

>Deregulation means removing or reducing regulation.

Question 41

Deregulation - info

Answer 41

>Deregulation means removing or reducing regulations.
>It removes some barriers to entry, so it can be used to increase competition in markets, particularly monopolistic markets, and tackle market failure.
>Deregulation is often used alongside/as part of privatisation - privatising an industry effectively removes the legal barriers to entry that prevent other firms entering the market.
>Additional deregulation to reduce barriers to entry further can then be used to help prevent the privatised public monopoly from becoming a private monopoly.
>Examples of deregulation in the UK include the deregulation of directory enquiries. BT, which was a private firm at the time, provided the directory enquiries service - it was deregulated to allow other firms to enter the market.

Question 42

Deregulation - advantages

Answer 42

1. Improves resource allocation: removing regulations means the market becomes more contestable, so new firms are more likely to enter the market. The threat of competition from new firms, or the actual entry of new firms into the market, means prices fall closer to the MC and output increases.
2. It can be used alongside privatisation of a public monopoly to prevent the privatised firm from becoming a private monopoly.
3. Improves efficiency by reducing the amount of ‘red tape’ and bureaucracy.

Question 43

Deregulation - disadvantages

Answer 43

1. It’s difficult to deregulate some natural monopolies, e.g. utilities. These require large infrastructures, e.g. the water industry needs a pipe network. These infrastructures are expensive to build and maintain, and there’s only need for one of them.
2. Deregulation can’t fix other market failures such as negative externalities, consumer inertia or immobile factors of production.
3. Deregulation might mean there’s less safety and protection for consumers.

Question 44

Consumer inertia - definition

Answer 44

>Consumer inertia is resistance to change by customers.
>E.g. it’s seen as too much effort to change energy suppliers.

Question 45

Competition Policy

Answer 45

>Competition policy aims to increase competition in a market.
>Governments often choose to intervene in concentrated markets where monopoly power is causing market failure. E.g. if a monopoly exists and prices are above the market equilibrium price, there’s a misallocation of resources and deadweight welfare loss - i.e. there’s market failure.
>The intention of the government is to protect the interests of consumers by promoting competition and encouraging the market to function more efficiently.
>The government can do this through the use of competition policy.

Question 46

Competition authorities

Answer 46

>The European Commission and the UK’s Competition and Markets Authority (CMA) both monitor competition to look out for unfair monopolistic behaviour. Things they look out for include:
1. Mergers.
2. Agreements between firms (e.g. cartels, collusive oligopolies.)
3. The opening of markets to competition.
4. Financial support from governments (European Commission only).
>The European Commission and the CMA can block mergers and impose fines on firms guilty of anti-competitive behaviour.

Question 47

Role of competition authorities - mergers

Answer 47

>They monitor mergers and takeovers so they can prevent those that aren’t beneficial to the efficiency of the market or to consumers.
>They may choose to stop a merger that would give a firm too high a market share (e.g. over 25%) and make it a monopoly, or that would give a firm too much monopoly power.

Question 48

Role of competition authorities - agreements between firms

Answer 48

>E.g. cartels, collusive oligopolies.
>Often, agreements involving price fixing, splitting markets or limiting production are are anti-competitive, cause market inefficiency and are unfair to consumers.

Question 49

Role of competition authorities - opening of markets to competition

Answer 49

>This is when markets that were controlled by a government are opened up to competition.
>If a government-owned transport service is privatised, the government might want to ensure the existing firm is open to free-market competition and doesn’t dominate the market as a private monopoly.

Question 50

Role of competition authorities - financial support from governments (European Commission only)

Answer 50

>If a government in one EU country gives financial support to firms in a market, this may give the, an unfair advantage over firms in other EU countries in that same market.

Question 51

Regulatory bodies

Answer 51

>Regulatory bodies are particularly common in monopolistic or oligopolistic markets.
>These bodies have varying responsibilities - these might include regulating price, monitoring safety and product standards, and encouraging competition.
>Regulating bodies can be at risk of regulatory capture.
>Come markets have their own regulatory bodies.

Question 52

UK examples of regulatory bodies

Answer 52

>OFWAT regulates the water industry.
>OFCOM regulates the communication industries.
>OFGEM regulates the gas and electricity markets.

Question 53

Communication policy - dependencies

Answer 53

>The effectiveness of competition policy is greatly affected by the information available to the European Commission or the CMA - they’ll need to decide whether behaviour in different markets is anti-competitive or unfair to the consumer based on the information they have.
>If the information available to the government is reliable, then it should be able to intervene in the market in a way that will improve efficiency, allocate resources more effectively and improve fairness to the consumer. If the information is imperfect then this could lead to government failure.
>Competition policy and its implementation (e.g. through regulations) have costs - but in general, these costs are seen to be outweighed by the benefits. If the costs outweigh the benefits, this is an example of government failure.

Question 54

How can governments intervene?

Answer 54

>There are many ways a government can intervene in a market to try and increase competition:
>Privatisation
>Regulation
>Deregulation

Question 55

Government intervention - privatisation

Answer 55

>Privatisation can introduce competition into a market where there’s a public monopoly.
>A publicly owned monopoly can be privatised to open it up to competition and force it to respond to market signals.
>However privatisation alone won’t increase competition, as the public monopoly may just become a private monopoly. There could also be an increase in prices and a reduction in output, as a private monopoly is less likely to act in the best interests of consumers.
>So, other steps need to be taken alongside privatisation, such as deregulation, to increase competition and protect consumers.

Question 56

Government intervention - regulation

Answer 56

>Governments might use regulation to prevent a firm from gaining monopoly power, or to increase competition by reducing the monopoly power a firm already has.
>For example, a government could use:
-Price caps
-Regulator
-Introduce regulations
-Regulate profits
-Set performance targets.

Question 57

Government intervention - regulation - price caps

Answer 57

>A government or regulating body might introduce price caps (price ceilings) to stop firms from charging prices that are considered to be too high.
>Price caps put a maximum on the price increase that firms can charge their customers. Here are 2 types of price cap:
1. RPI-X
2. RPI-X+K.
>Price caps limit price rises, making a market fairer to consumers.
>They also provide an incentive for firms to increase efficiency (the more efficient they are, the more profit they keep), and consumers benefit from improved services.
>Price caps are common in the UK utility markets.

Question 58

Government intervention - regulation - RPI-X price cap

Answer 58

>RPI-X means firms must make real price cuts.
>RPI inflation and X is the efficiency improvements the government or regulating body expects firms to be able to make.
>So for example, if the RPI (inflation) was 3% and X was 1% firms could only increase their prices by up to 2%.

Question 59

Government intervention - regulation - RPI-X+K price cap

Answer 59

>RPI-X+K is commonly used in the water industry.
>K is the amount of investments firms will need to make in order to achieve efficiency improvements.
>In this case, the firm can charge higher prices to offset the cost of efficiency improvements.

Question 60

Government intervention - regulation - regulators

Answer 60

>The government or a regulator could monitor prices to ensure they stay reasonable and fair to consumers.

Question 61

Government intervention - regulation - introduce regulations

Answer 61

>Governments may introduce regulations to ensure quality standards, such as in food production or construction.

Question 62

Government intervention - regulation - regulate profits

Answer 62

>Governments can regulate profits by imposing windfall taxes on what it decides are excessive profits - this means the government will tax those profits at a higher rate.
>Windfall taxes can help to prevent firms from gaining too much monopoly power, but it reduces their incentive to improve efficiency (as the extra profits might be taxed).

Question 63

Government intervention - regulation - performance targets

Answer 63

>Setting performance targets can also help to maintain competition, but they need to be combined with some sort of penalty, e.g. a a fine, if a firm doesn’t reach its target.
>Examples of performance targets include:
-Firms might be given certain standards of customer service they need to achieve.
-NHS departments might be given targets for the number of patients they should treat.
>There are disadvantages to performance targets.
>Health and safety, quality of service and any other areas of a business which aren’t included in targets might be overlooked in order to reach performance targets.

Question 64

Examples of regulation in markets by the UK government and the EU.

Answer 64

1. Payment Protection Insurance (PPI).
2. Mobile Phone Roaming Charges.

Question 65

Examples of regulation in markets by the UK government and the EU - PPI

Answer 65

>PPI is insurance that’s used to repay debt should the borrower be unable to do so, e.g. due to illness. In the UK there was little competition in the PPI market, a high level of rejected claims and a lot of cases of selling unnecessary cover.
>The market was investigated by the Competition Commission (now the CMA) who produced a list of requirements for firms selling PPI, such as providing information about the right to cancel and costs. The aims were to prevent future mis-selling, help consumers make informed decisions, and increase competition in the market.
>These requirements have increased competition, and successful reclaims of mis-sold insurance have risen since the investigation.

Question 66

Examples of regulation in markets by the UK government and the EU - Mobile phone roaming charges

Answer 66

>Roaming charges are charges for data usage, calls or texts, made or received, when abroad. The European Commission has monitored these charges since 2007 and found that a lack of competition led to excessively high charges.
>The European Commission has used price caps to significantly reduce data roaming charges, and charges for calls and text messages.
>All telecommunications providers in member states must comply with these price caps. Firms can offer lower prices than the caps to compete with each other.

Question 67

Government intervention - regulation - deregulation

Answer 67

>Deregulation can make a market more contestable, so it is easier for new firms to enter the market.
>This increases competition, causing the price to fall closer to marginal cost, and output to increase.
>Deregulation is usually used alongside privatisation to make sure that a public monopoly doesn’t become a private one.

Question 68

Other methods of intervention - list

Answer 68

1. Pollution permits
2. Extension of property rights
3. Information provision
4. Nationalisation
5. Promoting small businesses