Theme 1 Topic 4 Flashcards
Governments intervene to reduce market failure to : (5)
- Eliminate negative externalities
- Maximise positive externalities
- Increase supply of merit goods
- Reduce supply of demerit goods
- Supply public goods that would be under supplied by the market
Reduce inequalities in the distribution of income and wealth : (3)
- Unequal distribution can lead to poverty
- Tensions in society can be created
- A breakdown in society causes further market failure
Governments intervene to support UK industry :
Full employment is a government target.
Certain industries are more important than others as they employ large amounts of labour.
Infrastructure is essential if businesses are to provide quality services.
6 ways in which a government can intervene to correct market failure :
- Indirect tax
- Subsidies
- Maximum and minimum prices
- Trade pollution permits
- State provision of public goods
- Regulation
Taxation ?
Medium through which governments finance their spending and control the economy.
Indirect tax?
Tax on a good or service.
Direct tax ?
levied directly on an individual or an organisation’s income/profits and is paid directly to the government by the taxpayer.
Incidence/burden tax ?
The amount that the consumer (or producer) will pay for the tax.
Specific tax ?
Set amount per unit.
Parallel shift upwards in the supply curve.
Ad valorem tax ?
% of the price of the good/service.
The more expensive tje product, the greater the tax on it.
Shifts supply curve upwards yet also tilts.
As prices increase, so do taxes.
Indirect tax graph :
It increases the cost of supply for a firm, leading to a shift in supply to the left and upwards.
Quantity supplied falls. Prices increase (P-P1)l
Increase im tax causes price to rise by the vertical distance between the supply curve.
The incidence of the tax paid for by the producer is from P to P0.
The incidence of tax paid for by the consumer is from P1 to P.
2 Advantages of indirect taxes :
- It internalizes the externality, leading to production at the social equilibrium and maximizing social welfare.
- It raises government revenue, which can be used to address the externality (e.g. education), potentially making goods more elastic over time. The effect depends on how the government uses the revenue.
3 disadvantages of indirect taxes :
- It’s hard to determine the size of the externality, making it difficult to set the right tax. The government faces imperfect information.
- If demand is inelastic, the tax won’t effectively reduce output.
- Taxes are regressive, meaning lower-income individuals spend a larger percentage of their income on indirect taxes than higher-income individuals.
Examples of indirect taxes for externalities :
Fuel duties, landfill taxes, sugar taxes.
examples of subsidies :
biofuels, solar panels.
subsidies graph :
cause a decrease in costs of supply for a firm.
causes a shift in the supply curve down and to the right.
quantity supplied will increase by Q to Q1.
prices will fall from P to P1.
it causes supply to fall by a vertical distance between the supply curves.
it is shared between consumer and producer.
upper area : gain to consumers
lower area : gain to producers
both areas : government expenditure on subsidy
vertical line : incidence of subsidy in government
2 advantages of subsidies :
- society reaches the social optimum output and welfare is maximised.
- they can have other positive impacts (e.g. encouraging exports)
3 disadvantages of subsidies :
- high opportunity cost for the government as they spend lots of money.
- difficult to target since the exact size of the externality is unknown
- once introduced, they are difficult to remove.
price control ?
when the government sets max or min prices for a good/service
advantage of max + min prices :
max price ensures all goods are affordable yet minimum prices ensure producers get a fair price.
these can reduce poverty and increase equality
disadvantage of max + min prices :
hard for the government to know where to set prices.
hard to know the size of the externalities.
has implications on the size of excess supply/demand.
maximum price graph :
- A maximum price at P1 causes excess demand (Q1Q2) because consumers want more at the lower price.
- The government may set a maximum price to protect consumers from being exploited.
minimum price graph :
- A minimum price at P1 causes excess supply (Q1Q2) because firms want to supply more at the higher price.
- The National Minimum Wage (NMW), introduced in 1999, aimed to redistribute income to low-paid workers.
- Some argued that it could lead to lower demand for workers, causing excess supply of labor (unemployment).
what is a minimum price ?
- A minimum price is the lowest price suppliers can legally charge for a good.
- It’s used for goods with negative externalities to increase price and reduce consumption.
- For it to be effective, the minimum price must be set above the current equilibrium price.
what is a maximum price ?
- A maximum price is the highest price suppliers can legally charge for a good.
- It’s used for goods with positive externalities and to prevent monopolies from exploiting consumers.
- For it to be effective, the maximum price must be set below the current equilibrium price.
what is a buffer stock scheme ?
- Both maximum and minimum prices are set.
- Government buys excess supply when the price is below the minimum.
- Government sells stock to meet excess demand when the price exceeds the maximum.
- Prevents price fluctuations and provides stability.
- Increases government costs.
What is a subsidy ?
Money grant given to firms by the government to reduce costs of production and encourage an incessant in output.
Tradable pollution permits :
- Firms are allowed to produce a legal level of pollution each year.
- Permits are tradable on the market.
- Firms can sell unused permits to those exceeding their allowance.
- Provides a financial incentive for firms to reduce pollution.
- Trading schemes aim to reduce global CO2 emissions.
- Difficult to assess the correct amount and level of permits to provide.
How do tradable pollution permits work
- Owners can pollute up to a specific amount, with the government controlling the total number of permits.
- Companies must buy permits to pollute, encouraging the use of greener technology to cut costs and increase profits.
- Companies exceeding their pollution limits face legal action.
Tradable pollution permits graph:
The government issue a fixed amount of pollution rights in the economy.
Therefore, supply is perfectly inelastic as it can’t change.
If there is an increase in demand for pollution permits demand will shift right and prices increase.
Firms will either pay more for the right to pollute, or they will be incentivised to reduce pollution.
Governments can enforce stricter pollution control by reducing the number of tradable permits to Q1.
causes a shift in supply to the left, leading to higher prices and a higher cost to firms of creating pollution
Advantages of tradable pollution permits :
- The government caps the number of permits, ensuring pollution falls to target levels, maximizing social welfare.
- The government raises revenue by selling permits and fining firms that exceed their pollution limits.
- Encourages companies to use and invest in green technology.
- Firms decide whether to cut pollution or buy more permits, promoting efficiency.
Disadvantages of tradable pollution permits :
- Monitoring and policing can be expensive and must be done well for the system to work; fines must be large enough to ensure firms follow regulation.
- Higher costs for businesses may be passed onto consumers.
- It can be difficult for the government to determine the correct number of permits to allow.
Example of tradable pollution permit
- The US Sulphur trading scheme reduced sulphur dioxide by 40%.
- The EU Emissions Trading Scheme (ETS), launched in 2005, achieved a 21% reduction in greenhouse gases.
- The ETS has expanded to include other greenhouse gases like nitrous oxide and the airline industry.
- A similar permit scheme has been introduced in China.
State provision of public goods
- State provision occurs when the government intervenes in the market to supply a good or service.
Merit Good
- The government supplies goods like education and healthcare (e.g., NHS) because society believes these are underprovided by the market.
Public Good
- The government supplies goods like defense and infrastructure (e.g., roads) because they would be underprovided by the private sector due to the free rider problem.
Advantage of state provision of public goods
- Corrects market failure by providing important goods that would otherwise not be provided, leading to improved social welfare.
- Helps bring about equality by ensuring everyone has access to basic goods.
- Provides benefits, such as improving economic growth by ensuring a healthy workforce through healthcare.
- Competitive tenders can ensure efficiency in the provision of goods.
Disadvantage of state provision of public goods
- Expensive and represents a high opportunity cost for the government; administration costs are a problem.
- Without market involvement, the government may produce the wrong combination of goods, as consumers can’t indicate preferences (e.g., too many soldiers, too few hospital beds). Democracy can reduce this issue, allowing consumers to vote for parties with similar aims.
- The government may be inefficient at production due to a lack of incentives to cut costs.
- Corruption and conflicting objectives may arise among government officials.
Example of state provision of public goods
- In the UK, the government provides goods like roads, education, and healthcare.
- The NHS suffers from severe underfunding, and many schools face budget cuts.
- More money is spent on improving railways than roads, despite 92% of journeys in the UK being made on roads, suggesting incorrect resource allocation.
Provision of information
- Ensures that economic units can maximize decisions when consuming and producing goods and services.
- When there is asymmetric information, the government provides information to help people make informed decisions.
- The government may force companies to provide information.
Examples:
- In the job market
- For dangerous products
- Providing economic data to help firms plan for the future
Advantages of provision of information
- Helps consumers act rationally, allowing the market to function properly.
- Best when used alongside other policies, such as making demand more elastic in the long run, helping indirect taxes become more effective at reducing output.
Disadvantages of provision of information
- Can be expensive for the government, incurring an opportunity cost.
- The government may not always have all the information, making it difficult to inform consumers.
- Consumers may ignore the information provided due to irrational behavior.
Example of provision of information :
- Information provision includes labels on cigarette packages and campaigns on speeding, obesity, drinking, and smoking.
- Consumer protection laws and industry standards help address issues with second-hand products.
- The traffic light system (green, orange, red) on food labels helps consumers easily identify healthier options.
- Despite these efforts, many consumers still engage in harmful and dangerous activities.
Regulation :
- The government seeks to provide effective competition within markets.
- This can lead to greater choice and lower prices.
- It creates conditions for continued investment in key infrastructure areas of the economy.
Examples:
- In the water and energy industries.
How does regulation occur :
- When MSC = MSB, it ensures full information on products.
- The government can introduce regulatory bodies such as OFCOM for communications and OFGEM for energy.
- These bodies ensure that firms follow regulations.
Advantages of regulation :
This can ensure consideration of externalities, prevent exploitation of consumers and keep consumers fully informed. This will help to overcome market failure and maximise social welfare.
Disadvantages of regulation :
- Laws can be expensive for the government to monitor, incurring an opportunity cost.
- They don’t account for the different costs of following laws for different companies. Compared to tradable pollution permits, regulation is less efficient at reducing pollution.
- Firms may pass on costs to consumers through higher prices.
- Excessive regulation can reduce competition and efficiency, increasing bureaucracy and limiting innovation.
Examples of regulation :
A number of regulations are in place to correct market failure in the UK such as: EU fishing quotas, smoking bans, and maximum vehicle CO2 emissions.
Synoptic point :
- Government intervention in individual markets often has macroeconomic consequences.
- It impacts the government budget, either raising revenue or increasing spending through these policies.
- Policies that raise business costs, such as indirect taxes, regulation, and tradable pollution permits, can reduce international competitiveness and LRAS.
What is government failure
Government intervention in the market causes a net welfare loss + a mis allocation of resources
Total social costs exceed social benefits
Law of unintended consequences
- Unintended consequences occur when government intervention leads to unexpected outcomes.
- This can result from inadequate information, conflicting objectives, and administrative costs.
- Consumers and producers may react unexpectedly to new policies, causing them not to have the intended effect.
Example:
The buffer stock scheme under the CAP aimed to smooth price fluctuations but caused overproduction in the EU and price drops globally due to cheap surplus exports.
Distortion of price signals
- The government tries to create incentives and disincentives to influence the behavior of individuals and firms.
- This helps to create markets that wouldn’t survive in their current state without government support.
- However, this distorts the free functioning of the market and leads to distorted prices.
- As a result, the government may inadvertently create inefficiencies rather than correcting them.
Excessive administrative costs :
- Administrative costs are the expenditures the government spends when intervening in markets.
- These costs can mean that the benefits from government intervention are outweighed by the costs.
- Government bureaucracy often leads to higher costs.
- Budgets are constrained, especially during recessions, forcing the government to make tough decisions about where to spend money.
- Sometimes, incorrect decisions are made, where the costs do not achieve the expected benefits.
Example:
- A significant portion of money allocated to the NHS is spent on organizational administration rather than directly on medical care.
Information gaps (government failure)
Government decisions rely on data, but the information is always limited, and they cannot predict the future.
- Cost and benefit forecasts often go wrong, leading to investments where costs exceed benefits, resulting in welfare loss.
- It is impractical and often impossible for the government to obtain all the necessary information.
types of government failure :
- Unintended consequences
- Distortion of price signals
- Excessive administrative costs
- Information gaps
