1.3.6 government intervention

Question 1

why does the government intervene?

Answer 1

to correct market failure
- when the benefits gained from intervention are greater than the cost of intervention, the total welfare will be increased
- the market equilibrium moves closer to the optimum level
- there will be allocative efficiency

Question 2

what are the methods of government intervention?

Answer 2

1. indirect taxation
2. subsidies
3. maximum prices
4. minimum prices
5. traceable pollution permits
6. extension of property rights
7. state provision
8. regulation
9. provision of information

Question 3

indirect taxation

Answer 3

to internalise the externality, & getting the firm to pay for the external costs they created
taxes discourages consumption/ production by increasing the firm’s private costs and corrects the negative production externalities
(MPC curve shifts upwards to equal MSC curve)

Question 4

what is the ideal amount of tax imposed?

Answer 4

it should be the same as the external cost per unit, so the firm to produce at the social optimum quantity, eliminating the negative externality by removing the source of allocative inefficiency
=> the market failure would be fully corrected

Question 5

how to decide what kind of tax to impose?

Answer 5

constant marginal external cost per unit -> specific tax
rising marginal cost per unit -> ad valorem tax

Question 6

what are some examples of indirect taxes used to correct the negative externalities?

Answer 6

cigarettes, alcohol, tobacco, sugar

Question 7

benefits of indirect taxes (4)

Answer 7

1. internalise the externality by making suppliers (and indirectly, consumers) pay taxes, which is the external cost, reducing production and consumption
2. government has higher tax revenue and can provide better public services
3. more flexible than regulation since the tax rate can be changed as conditions change
4. can influence people to switch to substitutes with external benefitsby incentivising good behaviour (eg taxing petrol to encourage consumers to switch to electric cars)

Question 8

disadvantages of indirect taxes (7)

Answer 8

1. difficult to measure the external cost, so it is hard to determine the best amount to tax. the government may tax too much or too little
2. unpopular among consumers since they will have to pay more. they may get angry at the government and protest, causing political unrest and problems
3. *big impact on profit and employment. since the cost or production increases and profit decreases, the quantity demand would decrease. firms may try to cut costs, so workers will get less pay/ unemployment increases
4. regressive as it causes inequality. since everybody pays the same amount of tax, it hurts poor people more as the tax is a higher % of their income than it is to rich people
5. does not fix the problem it the demand is inelastic. there will be little change in behaviour and the problem will not be fixed
6. encourages black market, people would smuggle and sell products illegally so they don’t need to pay tax
7. administrative costs may be high, and may outweigh the benefits

Question 9

subsidy

Answer 9

encourages production and corrects positive production externalities by reducing the firm’s private costs (MPC curve shifts to the MSC curve). If the subsidy is the same as the external benefit, the firm would produce at the social optimal quantity

Question 10

what is the purpose of providing subsidies to producers?

Answer 10

• encourages production and corrects positive production externalities
• reduces the firm’s private costs (shifts MPC rightwards to MSC)
• if the subsidy is the same as the external benefit, the firm would produce at the social optimum quantity
• the source of allocative inefficiency is removed, resource allocation is improved
  —> can fully correct market failure

Question 11

what is the purpose of providing subsidies to consumers?

Answer 11

• encourages consumption and corrects the positive consumption externalities
• reduces the private rice to consumers (shifts MPB upwards to MSB)

Question 12

benefits of subsidies (4)

Answer 12

1. increase quantity of product since the production cost is decreased, the firm is incentivised to produce more and pass on cost savings to consumers. if the price is decreased, it is more affordable, the consumers would buy more and there would be an extension in demand
2. there would be financial injection into the economy because money is directly given to producers, they can produce more and there would also be higher profits
3. encourages consumption by reducing the private price to customers since the costs are lower, more producers are attracted and consumers have more options, increasing the consumer surplus
4. internalises the externality by correcting the positive production externalities. it internalises the external benefits since more private consumers directly receive the benefits, resource allocation is improved

Question 13

disadvantages of subsidies (4)

Answer 13

1. hard to measure the external benefit since the subsidy should be equal to the external benefit. the government may subsidise too much/ too little because of imperfect market information
2. there is an opportunity cost. the gov has a limited budget and it could have spent the money on something else
3. it causes political concerns because the gov may subsidise big donors of political parties, so this may be made for political and not economic reasons
4. the administrative costs, eg distributing cost, background checks, monitoring costs may outweigh the benefits

Question 14

minimum price

Answer 14

an effective minimum price is set higher than the equilibrium price

Question 15

what happens with the excess products? why do they occur?

Answer 15

they are produced as a result of the higher price available in the market
the excess could be thrown away, sold in the black market at lower prices, or exported to other countries at lower prices (local farmers cannot compete), stored or donated

Question 16

advantages of minimum prices (4)

Answer 16

1. decrease the consumption of harmful products as higher prices discourage consumption
2. there will be greater producer surplus because the qty supplied would increase as the price increases. the extension of supply increases and more profits are gained because the price is above the market price
3. income support for low-wage workers as they can get above market wages
4. if the good has inelastic demand, it would benefit suppliers. the higher prices would have a proportionally smaller impact on consumers, so the total revenue of producers would increase

Question 17

disadvantages of minimum prices (5)

Answer 17

1. people would go to black markets to sell the excess supply at a price that is lower than the minimum price so government loses potential tax revenue
2. it is difficult to set the appropriate minimum price, it may be too high or low as it is hard to quantify external cost
3. may encourage inefficient production & misallocation of resources. if the minimum price is higher than the cost, the producers would make a profit and stay in business despite being inefficient.
4. there would be lower consumer surplus as there would be a higher price but a smaller quantity demanded
5. elastic demand hurts producers as the higher prices would have a proportionally bigger impact on consumers, the total revenue of producers would decrease

Question 18

price support

Answer 18

minimum prices for farm produce
agricultural products have low income elasticities of demand, and prices are unstable
there is a surplus and the government buys the excess supply at the price floor and stores, exports, donates or throws it away

Question 19

disadvantages of government buying excess supply (3)

Answer 19

1. there is an opportunity cost, they could’ve spent the money on education and healthcare. buying the excess supply is a burden on the government’s budget
2. some farmers may become inefficient since they know they’re going to get really high prices anyways so there is no incentive for them to be effective (supports inefficient production)
3. administrative costs are expensive, eg transport and storage costs

Question 20

maximum prices

Answer 20

an effective maximum price is set lower than the equilibrium price (there is a price ceiling)

Question 21

benefits of maximum price (3)

Answer 21

1. there is greater consumer surplus because the good has become more affordable, there will be an extension in demand
2. government popularity would increase which may lead to a stable political climate that encourages spending and investment. however, the government may lose support from businesses as well.
3. inelastic demand of the god would lead to a smaller shortage since lower price has little impact on demand, the problems of shortages are reduced

Question 22

disadvantages of maximum prices (7)

Answer 22

1. elastic demand leads to a greater shortage because when lower prices has a big impact on demand, there will be a big problem of shortage and lots of people may not get the goods
2. there might not be enough supply because of shortages (lower price high demand). consumers won’t be able to get the products and this might lead to black market issues
3. producer surplus would be reduced because of lower prices leading to lower quantity supplied so their total revenue decrease
4. unemployment may rise because as profit for firms decrease, they may try to cut costs
5. suppliers/ people may sell/ resell the goods in the black market at a price that is higher than the market price
6. it is difficult to determine the appropriate maximum price, it may be to high/ low
7. investment from suppliers may fall because their total revenue has decreased and they have to cut costs, cannot afford to spend money on other investments

Question 23

regulations

Answer 23

rules or laws put in place to influence behaviour

Question 24

how does maximum prices work?

Answer 24

encourages more consumption so society can benefit from the positive externalities in consumption
as the price falls, the quantity demanded increases (there is an extension in demand), bringing the private equilibrium quantity demanded closer to the social optimum quantity
since the price is lower, the product will become more affordable and the market failure would be corrected
however, there would be persisting market disequilibrium because the market doesn’t reach a market-clearing price
there is an excess demand and too few resources lead to allocative inefficiency

Question 25

how does minimum prices work?

Answer 25

the price floor discourages the consumption of a particular good.
the price rises as the qty demanded falls, thus lowering the external costs created by the consumption of the good/ service
- qty consumed is less
- eliminates the negative externalities -> market failure is corrected
however there would still be a market disequilibrium and the market does not reach the market- clearing price because there is excess supply. the overallocation of resources leads to allocative inefficiency

Question 26

advantages of regulations (3)

Answer 26

1. the government can reduce/ ban certain undesirable behaviour to reduce/ eliminate negative externalities and reduce the overallocation of resources
   - the economic cost of imposing the regulation should equal the economic benefit arising from a reduction in the externality (MPC -> MSC)
2. the gov may regulate to make it compulsory for people to consume certain goods/ services to attain positive externalities
3. fines/ criminal offences/ prison sentences can be issued to those who do not comply with the regulations to correct the market failure

Question 27

disadvantages of regulations (5)

Answer 27

1. it is hard to measure the level of regulation
2. it may be costly to comply with the regulation because producers have to meet the production requirement and have to spend resources. consumers have to spend money on things that the government regulates
3. regulations are sometimes influenced by political interests and don’t reflect economic interests
4. causes inequality because it doesn’t discriminate between individual cases and may be unfair
5. administrative/ enforcement costs may be high, eg to monitor/ enforce laws, legal costs when someone offends the law. these are all opportunity costs where it could be spent on something else

Question 28

tradeable pollution permits

Answer 28

a market based solution that internalises the externality (producers have to pay for the costs, therefore they are incentivised to try to reduce the external costs), is used to tackle negative externalities
1. the government first caps the total amount of pollution it is prepared to accept. then, pollution permits are assigned to different firms, allowing each firm to pollute up to the specified level stated in the permit in a given period of time.
2. these pollution permits may be traded in the market at the market price
- heavy polluters who want to exceed their allocated pollution level may buy extra permits from the market —> increases production cost
- firms that pollute less can sell their unused permits on the market and gain a profit
- this gives firms an incentive to reduce pollution to become more efficient so they can sell their permits. this helps correct the market failure & reduce the negative externality
3. the supply of permits is perfectly inelastic because it is fixed at a particular level by the government. it may be lowered over time to encourage further reductions in pollution (fewer permits = higher price, more incentive to cut pollution)
4. as the economy grows, the demand for permits is likely to increase
5. if the price of the permits is falling, it means the supply of the permits is too high. it gives the market signal to the government to reduce available permits

Question 29

benefits of tradeable pollution permits (4)

Answer 29

1. internalises the externality by getting firms to pay for the external cost (they are incentivised to reduce costs and pollution)
2. acts as signals to the government to decrease/ increase the number of permits, little intervention is needed
3. it is a source of revenue for efficient firms because they can sell the permits that they don’t need
4. it offers certainty for reaching end target of correcting market failure as the number of permits equals to the amount of acceptable level of pollution

Question 30

disadvantages of tradeable pollution permits

Answer 30

1. it is hard to determine the external cost (harm of emissions), so government cannot determine the exactly right number of permits/ the acceptable level of pollution
2. the costs of setting up and monitoring the market may be higher than the benefits (eg administrative costs, research)
3. it may be unfair when distributing the permits because some firms may be more popular than others, and because of political reasons instead of economic reasons, the government may give them more permits
4. **some producers may not remain viable*8 since they may not have enough permits/ resources to buy permits to cover the pollution costs, they may be forced to shut down/ cut costs
5. there might be **government failure when too many permits are issued*8 because if the price decreases, the companies can buy permits easily and keep on polluting. they would have less incentive to invest and become more efficient

Question 31

extension of property rights

Answer 31

helps markets to efficiently allocate resources. as long as property rights are clearly defined and transaction costs are low, owners of that property could seek redress if their property was damaged.

Question 32

how does the extension of property rights correct market failure?

Answer 32

1. owners will have bargaining power to make the other part consider the negative externality (they can sue the offending party)
2. owners are encouraged to protect and invest in that property/ resources and prevent over-exploitation
3. internalises the externality for the producer and would adjust to the socially optimal position

Question 33

benefits of extension of property rights (3)

Answer 33

1. transfer of resources from polluters to owners (now polluters pay for the external costs)
2. protect/ invest in the resource/ property so that its value increases, and owners become wealthier if someone damages it (incentive)
3. easy to do/ less resources needed for government to intervene, they only need to say the property is theirs

Question 34

limitations of the extension of property rights (4)

Answer 34

1. may not be able to prove linkage —> no compensation
2. don’t have property rights on air/ atmosphere/ forests
3. legal costs are very high
4. hard to determine the size of the external cost (area of the property)

Question 35

state provision

Answer 35

goods/ services that the government directly provides at a minimal cost/ free of charge. it increases the quantity provided. consumer and lowers the price.
public goods are provided by the government because it will not be provided by the market mechanism
government funds these through taxation or by borrowing

Question 36

do government employees have the incentives to run the government owned companies as efficient as possible?

Answer 36

no
in the public sector organisations, all benefits and profits goes to the taxpayers. the employees lack profit incentive to work hard and improve.
however, in the private sector, they get more salary if they’re successful, so they have a profit incentive to work hard

Question 37

disadvantages of state provision

Answer 37

1. no/ limited profit incentive
2. political influences/ inappropriate government choices affecting the provision
3. there is an opportunity cost, the resources could be spent on something else
4. there is no competitive pressure so there is no incentive to cut costs and provide better service, causing the quality to remain poor and less than optimal
5. it is hard to determine the external benefits, so the government doesn’t know how much to provide
6. it depends upon capital and technical expertise available, if the government doesn’t have the capital and expertise, it cannot provide these services/ goods

Question 38

provision of information

Answer 38

the government can provide information directly or force firms to provide information in case of imperfect information to correct market failure and help consumers to make more informed decisions

Question 39

government failure

Answer 39

occurs when government intervention results in a net welfare loss, the total social cots of government intervention exceeds the total social benefits arising from it
it is caused by an inefficient allocation of resources

Question 40

causes of government failure (5)

Answer 40

1. information gaps causes gov failure because the governments may not process the necessary info to make informed decisions, they might overestimate benefits and underestimate costs
2. distortion of price signals causes gov failure as it results in a misallocation of resources. minimum prices or subsidies may keep inefficient high-cost producers in the market. minimum wages may distort the price of labour, leading to unemployment. provision of unemployment benefits may reduce workers’ incentives of looking for a job.
3. there may be unintended consequencescaused by gov intervention. a policy to correct a problem in one area may lead to a creation of a problem in another
4. excess administrative costs may outweigh the welfare benefits to be gained, eg. cost of collecting tax, enforcing regulations
5. moral hazard causes gov failure because they don’t face the consequences of their actions so they may take greater risks than what is desirable