1.4 Government intervention Flashcards
Define market-based policy
An approach to tackling market failure using the market mechanism
Examples of market-based policies
Indirect taxation (stick) - ad valorem & specifc
Subsidies (carrot)
Max & min pricing
Trade pollution permits
Define non-market-based policies
Direct action to command and control behaviour.
Examples of non-market-based policies
Regulation
Provision of information
Public goods provided by state
Define regulation
Intervention to tackle market failure by direct action to command & control behaviour. Rules and laws enacted by government.
How to tackle:
- Externalities
- Under provision of public goods
- Imperfect market information
- Interalise externality; tax or impose regulation to ensure appropriate level of output of a good is produced. May limit emissions of toxic gases & impose fines on firms that do not comply.
- Arises from free-rider problem; when goods are non-exclusive & non-rivalrous, individuals have no incentive to pay
- Provide info e.g. gov campaign to spread info or regulation to force firms to reveal info about their products e.g. specify ingredients in processed food products.
What is a negative production externality?
A negative externality that affects the production side of the market.
How can taxes help internalise externalities?
If the tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, so the free market equilibrium becomes the socially optimum equilibrium.
The polluter pays for the damage and the full costs are reflected in the firms costs.
Define 1. Indirect tax 2. Direct tax 3 Specific tax 4. Ad valorem tax
- Indirect tax
A tax levied on expenditure of goods or services. - Direct tax
Tax charged directly to an individual based on a component of income
e.g. income tax
3 Specific tax
A sales tax that is set at a constant amount per unit of sales.
- Ad valorem tax
A sales tax that is set at a percentage of the price e.g. VAT adds 20% to unit price
Define incidence of tax?
What does it depend on?
When is gov revenue from ad valorem tax larger?
The way in which the burden of paying a sales tax is divided between buyers and sellers.
Depends on the price elasticity of demand of the good.
Gov revenue from ad valorem tax is larger if demand is price inelastic - demand would only fall slightly with tax.
Advantages of indirect taxation
Provides incentives to reduce neg externality e.g. pollution.
Social efficiency (MSB = MSC) Intention of tax is not to fully eliminate problem but reduce it to the point where the marginal benefit of reducing pollution is matched by the marginal cost of doing so.
Taxes raise revenue for government.
Can be spent on alternatives e.g. public transport or tax rev can be used to tackle problems relating to the externality (sugar tax -> money goes to healthcare)
Disadvantages of indirect taxation
Regressive - increase inequality. Tax on cigarettes taxes higher percentage of income from low-income. Worse when good is price inelastic demand.
Difficult to measure level of neg externality so cannot accurately identity how much tax should be.
Unintended consequences/gov failure from a tax that is too high. Firms may exist market creating unemployment.
Black markets may emerge; unregulaed & lead to harm of consumer/police time.
Consumers may go overseas to buy/smuggle.
Costs of policy would then outweigh benefits.
Inelastic demand; higher taxes will not reduce demand due to necessity/addictive quality.
External costs are not fully internalised; consumption fails to reduce.
Cost of administration is high.
Possibility of evasion e.g. new tax on disposing of rubbish leading to increased fly tipping (illegal dumping of rubbish)
Define subsidy
A grant given by the government to producers to encourage the production of a good/service.
e.g. electric cars, museums, public transport & vaccinations
Advantages of subsidies
Enables greater social efficiency; consumers end u paying the socially efficient price which includes the external benefits.
In long term - helps change preferences.
Encourages firms to develop more products with positive externalities.
e.g. public transport encourage people to drive less & reduce negative externalities.
Disadvantages of subsidies
All firms must be eligible to ensure level playing field; expensive.
Gov to consider opp cost of using subsidies
e.g. education/healthcare budgets may reduce or indirect taxes may increase (increasing inequality) or gov borrowing may increase.
If costs outweigh benefits -> misallocation of resources. -> gov failure
Encourage firm inefficency/x-inefficiencies as they become reliant on subsidy rather tan improve efficiency.
If price decrease is not enough, quantity may not increase to socially optimum level. Hard to determine how much subsidy.
Effects depend on elasticity of demand. If good is inelastic, consumer will benefit most of the subsidy due to lower price but with lower increase in quantity. Doesn’t solve market failure.
May be other factors rather than price e.g. safety of own car.
Under consumption & market failure continues to exist.
Define minimum price controls - other name?
Why are they set?
A minimum price where goods cannot be sold at a price below this.
Set above the market price.
Set by gov to discourage consumption of a particular good e.g. demerit good
How can minimum prices reduce the use of demerit good?
As price increases, demand falls proportionately less. External costs are not fully internalised so there is still misallocation of resources. Consumer absorbs most of the price but does not reduce consumption greatly.
Min prices are regressive & will inc inequality.
Price floor on alcohol takes a higher percentage of income from those on a low-income.
Evaluation of minimum pricing to reduce use of a demerit good
Black market could be created at lower price/consumers may find a legal substitute; this is worse for their health but cheaper.
Difficult to determine the right price to set.
If set too low, externality is not internalised & price increase is not enough to reduce the quantity to the socially optimum level of output.
If price is too high, unintended consequences & gov failure.
Unintended consequences where costs of policy outweigh benefits; gov failure.
Inc unemployment/firms close or move overseas.
Minimum pricing and commodities
What is minimum wage?
Commodity prices are volatile & their price inelasticity means when S or D shifts, the income of agricultural producers is destabilised.
Minimum price gives them stability.
The minimum wage is a statutory pay flor that cannot be undercut.
Define maximum price controls - other name?
Why are they set?
a.k.a price ceiling
Maximum price where goods cannot be sold at a price above this.
Set below the market price, P.
Set by gov to encourage consumption of a particular good.
How can maximum prices be used?
To improve affordability of essential goods & services e.g. housing/food
Implementing rent control allows those who need accommodation but cannot afford it in the free market to access housing; improve living standards & reduce under consumption issues; improve allocation of resources.
