THEME 1 -Topic 8 - Government Intervention And Government Failure

Question 1

Define internalising an externality

Answer 1

Is an attempt to deal with the externality by bringing an external cost (or benefit) into the price system.

Question 2

State 4 ways in which the government intervened in markets to reduce the effect of negative production externalities

Answer 2

Imposition of taxes
Pollution permits
Regulation
Property rights

Question 3

What is meant by a green tax?

Answer 3

An indirect tax on a good that damages the environment, in an attempt to reduce its production.

Question 4

Name 3 advantages of using an indirect tax to correct market failure caused by negative production externalities

Answer 4

1. Reduce the consumption and production of environmentally damaging goods to the socially optimum output.
2. Generate revenue that can help fund socially beneficial projects (merit goods).
3. Useful when the product is price elastic in demand, consumers are highly sensitive to price, reducing volume more substantially.

Question 5

Name 3 disadvantages of using an indirect tax to correct market failure caused by negative production externalities

Answer 5

1. It is difficult to place a monetary value on external costs, so it is difficult to set the correct level of tax.
2. Higher taxes in one country may encourage producers to move production to another country, and not solve the externality.
3. Ineffective when the product is price in elastic in demand. Consumers are not sensitive to a change in price,so the total volume of pollution reduced will not be substantial.

Question 6

Define regulation

Answer 6

Is a legally enforced requirement or standard made by the government to reduce the quantity that producers supply of a certain good.

Question 7

Name 3 advantages of using regulation to correct market failure caused by negative production externalities

Answer 7

1. Easy to understand so firms are more likely to comply and reduce their externalities.
2. They can be strengthened over time to further improve allocative efficiency.
3. Backed by the law with the threat of sanctions acting as a deterrent to producers.

Question 8

Name 3 disadvantages of using regulation in to correct market failure caused by negative production externalities

Answer 8

1. There is a time lag before the law is passed, and so reducing the externalities will not happen instantly.
2. Firms will not reduce their emissions if the fine for overproducing is more cost-effective than reducing their production overall.
3. Ineffective if only 1 country implements it as producers can reallocate production to other countries with more lenient regulations.

Question 9

Define a pollution permit

Answer 9

Is a cap on the total amount of pollution that can be emitted from 1 single unit. It uses the market mechanism to change prices and incentives producers to reduce their carbon emissions. They are exchangeable.

Question 10

Name 3 advantages of a pollution permit system

Answer 10

1. Encourages innovation of more environmentally friendly equipment.
2. Firms have the flexibility to suit their needs if reducing emissions is cost-beneficial or not in such a system, where they can purchase more permits.
3. The cap can be adjusted over time by issuing fewer permits, allowing continued progress to allocation efficiency and the emissions goal.

Question 11

Name 3 disadvantages of using a pollution permit system

Answer 11

1. If the cap on emissions is too low, firms will choose to buy permits rather than reduce their emissions.
2. It can be costly to monitor progress and output of emissions among all firms.
3. More influential firms may hold permits as they may see it as profitable to sell them in the future if the price increases.

Question 12

Name 4 advantages of using a subsidy to correct market failure caused by positive consumption externalities

Answer 12

1. Increases demand for a socially beneficial good.
2. Increases affordability so it benefits the poorer.
3. Effective if the good is price elastic in demand.
4. Decreases pressure on inflation, allowing firms to be more competitive in global markets.

Question 13

Name 3 disadvantages of using a subsidy to correct market failure caused by positive consumption externalities

Answer 13

1. Opportunity cost of scarce resources for the government.
2. Determining the subsidy value requires a valued judgement, difficult to a monetary value on the full external benefits and made lead to over/underconsumption and government failure.
3. Ineffective if the good is price in elastic in demand.

Question 14

Define a minimum price

Answer 14

(Also known as a price floor) is the lowest legal price a product can be sold at and to be effective must be set above the equilibrium price.

Question 15

Name 3 advantages of using a minimum price to correct market failure caused by a demerit good

Answer 15

1. It increases the price so demand may fall towards the socially optimum output level.
2. It may reduce costs in the other sectors such as healthcare.
3. It makes individuals pay a price that more closely resembles the full social cost.

Question 16

Name 4 disadvantages of using a minimum price to correct market failure caused by a demerit good

Answer 16

1. It’s a regressive measure so it impacts on the poor more than the richer, increasing the inequality gap.
2. It may encourage a black market of alcohol, meaning the government doesn’t gain as much revenue and the external costs are not dealt with.
3. It results in a net welfare loss (deadweight loss triangle on the diagram).
4. Demerit goods are usually habit forming/addictive thus are relatively price in elastic in demand so the fall in demand is less proportional than the price increase.

Question 17

Name 3 reasons why governments set a price floor on certain goods

Answer 17

1. To protect the earnings of producers (guarantees the producer income).
2. To create a surplus (in gluts surpluses can be stored for possible shortages in the future).
3. To guarantee a certain level of earnings (workers can be given a minimum wage so that their earnings don’t fall below an unacceptable level).

Question 18

Define prohibition

Answer 18

Is an attempt to prevent the consumption of a demerit good by declaring it illegal.

Question 19

Define maximum price

Answer 19

(Also known as a price ceiling) is the highest legal price a product can be sold at and to be effective must be set below the equilibrium price.

Question 20

Name 3 advantages of using a maximum price to correct market failure caused by merit goods

Answer 20

1. Increases affordability of goods, benefits poor.
2. Increases demand towards socially optimum output level.
3. Reduces the exploitation of monopolies inflating prices above the marginal cost.

Question 21

Name 4 disadvantages of using maximum prices to solve market failure caused by merit goods

Answer 21

1. May lead to black markets.
2. May lead to a shortage of good.
3. Market will become less profitable for firms.
4. Reduction in the quality of the product.