1.4 Government Intervention

Question 1

What is the role of the govt in a free market ?

Answer 1

• role is mainly to protect property rights, uphold the rule of law and maintain the value of currency
• believe markets are best suited to allocating scarce resources and allow the market forces of S&D to set prices

Question 2

What is government intervention ?

Answer 2

• when the state gets involved in markets + takes action to try and correct market failure, improve economic efficiency, impact upon the macroeconomic performance of the economy and/or change the distribution of income & wealth
• can use regulations taxes, subsidies, max & min prices to change price signals, better info or direct provision to change resource allocation

Question 3

Examples of fiscal policy intervention by govt’s to alter the level of demand for different products ?

Answer 3

• indirect taxes: raise the price of products with negative externalities ➡️ shift market equilibrium towards a SOP level
• subsides: lower prices of goods with positive externalities ➡️ boots consumption + output of products leading to a lower equilibrium price
• tax relief: govt can offer financial assistance eg. tax credits for business investment in R&D or a reduction in corporation tax ➡️ promote new capital investment & extra employment
• changes to taxation & welfare payments: used to influence overall distribution of income & wealth eg. higher direct tax on rich or increase in the value of welfare benefits ➡️ tax and benefit system more progressive

Question 4

🔔 Government intervention and stakeholders ?

Answer 4

🔔 when discussing the costs and benefits of govt intervention REMEMBER to ask “who are the major stakeholders in this issue”

• a stakeholder = any person or organisation that has an interest in a specific project or policy decision
• the decisions of govt, businesses and other organisations inevitably affect groups within society ➡️ many businesses are increasingly taking into account the effects of their actions not just on the value that such decisions create for shareholders but also to a broader range of stakeholder groups
• typically stakeholder issues come into play on major infrastructural projects where a cost benefit analysis might be undertaken to. asses the likely social costs and benefits (must bring as many stakeholders into the picture as possible ➡️ many people may be affected)

❗️ eg. employees, communities, suppliers, creditors, investors, govt, trade unions ect

Question 5

🔔 Evaluation on govt intervention ?

Answer 5

• value judgements
• changing prices to change incentives and behaviour
• social science ➡️ hard to forecast effects with great accuracy as peoples behaviours are subject to change
• combinations of policies ➡️ one single intervention is unlikely to produce a solution to deep rooted economic and social problems
• power of markets ➡️ intervention may not always be necessary as market forces can be powerful in finding profitable solutions to problems
• costs and benefits
• ‘law of unintended consequences’ ➡️ govt intervention does not always work in the way which it was intended or the way in which economic theory predicts it should
• case by case basis ➡️ need to consider each scenario/market failure/example on its own (different things will work in different markets)

Question 6

🔔 Judging the effects of intervention ?

Answer 6

1. efficiency of a policy: does intervention lead to a better use of scarce resources? eg. improve allocation or efficiency
2. effectiveness of a policy: which policy is likely to meet a specific economic or social objective ?
3. equity effects of intervention: is a policy thought as fair or does one group in society gain more than another ?
4. sustainability of a policy: does it reduce the ability of future generations to engage in economic activity ?
5. does the policy need to be used alongside something else ?

Question 7

What are indirect taxes and how can they fix market failure ?

Answer 7

• taxes collected by the customs and excise eg. VAT, fuel duties, tobacco duties, wine/spirit and beer duties
• used to raise the price of products with negative externalities, designed to increase the opportunity cost of consumption and thereby shift the market equilibrium towards a socially optimum level ➡️ imposition of an indirect tax will cause market supply to decrease

Question 8

How do you calculate the tax incidence/burden ?

Answer 8

• tax incidence (consumer burden of tax increase) reflects the amount by which the market price rises
• producer burden is the decline in revenue they get after paying the tax

eg. consumer:
£19 - £15 = £4
£4 x 250 = £1000

producer:
£15-£12 = £3
£3 x 250 = £750

total tax:
£19 - £12 = £7
£7 x 250 = £1750

Question 9

What are the pros of indirect taxation ?

Answer 9

1. Can be used as an incentive to reduce externality eg. shift production away from product ‘A’ or look for more efficient ways of doing something
2. Can target particular industries (externalities) and therefore make the ‘polluter’ pay ➡️ internalises the externality
3. Tax funds raised by the govt can be used to ‘clean up the environment’ or to compensate the victim of pollution
4. The level of pollution/size of externality should fall as output of the good or service is reduced and the price increased ➡️ incentive to become more socially desirable

Question 10

What are the cons of indirect taxation ?

Answer 10

1. tax revenue raised may not be used to compensate victims or clean up the environment
2. they increase the costs of production for firms ➡️ less competitive internationally
3. might encourage the development of illegal markets eg. tobacco & alcohol smuggling to avoid high taxes
4. very difficult for the govt to fix a monetary value on an externality ➡️ hard to decide on optimum tax
5. who is to blame: not all costs/externalities can be split in this way eg. how can global warming be attributed to a specific area
6. depends on the PED: taxes less effective if PED is inelatic ➡️ price may not be enough to deter them from consuming the product eg. cigarettes
7. cost of administration: enforcing the tax costs money ➡️ must be considered eg. people truing to avoid the tax

Question 11

Evaluating indirect taxes ?

Answer 11

aim: internalise a negative externality although it is difficult to implement these taxes

1. setting the right tax rate
2. cost of collection
3. price inelastic demand: eg. higher petrol prices via higher indirect taxes had little effect on demand of fuel
4. redistribution effects: indirect taxes are regressive and affect low-income households most
5. increased costs: higher indirect taxes may cause inflation ➡️ affecting consumers who did not pollute + international competitiveness

Question 12

What are subsidies and how can they fix market failure ?

Answer 12

• a payment made to a producer by a governement to help keep prices low prices & encourage consumption/ production
• for consumers they will lower the price of goods with positive externalities ➡️ boost consumption & output of products (can cause an increase in market supply and leads to a lower equilibrium price)
• subsidies increases supply by lowering the MSC so that the socially optimum quantity is achieved

Question 13

What are benefits of subsidies to fix market failure ?

Answer 13

• reduces price and increases quantity
• leads to an increase in production/consumption of merit goods
• encourages firms to take part in activities that are beneficial eg. subsidising public transport ➡️ encourages people to drive less and reduce their negative externalities
• encourage firms to develop more products with positive externalities ➡️ in the long term they change preference posititvely

Question 14

What are the drawbacks to subsidies ?

Answer 14

• the money to pay for the subsidy will have to be met through taxation
• opportunity cost
• it is difficult to estimate the extent of the positive externality ➡️ hard to work out how much subsidy to give
• the govt may have poor information about the product/service ➡️ don’t know how much to subsidise
• there is danger that govt subsidies encourage firms to be inefficient ➡️ come to reply on the subsidy rather than improve their efficiency
• firm may not pass on the benefits ➡️ may choose to absorb the subsidy itself (HOWEVER less likely if there is a lot of competition)
• 🔔 depends on the size of the subsidy + how long the subsidy is given for + PED (inelastic ➡️ less effective)

Question 15

Evaluating government subsidies ?

Answer 15

• effectiveness in meeting their aims? ➡️ will they achieve the desired stimulus to demand
• will it affect productivity? ➡️ firms may become dependant
• how much does it cost + who benefits? ➡️ more tax ?
• does it help to correct one or more market failures? ➡️ will it lead to unintented consequences ?

Question 16

What are maximum price levels ?

Answer 16

• also known as price ceiling
• set to increase consumption of a merit good or to make a necessity more affordable eg. govt may set max rent to keep it affordable
• to be affective the max price has to be set below the existing market equilibrium price ➡️ can lead to excess demand and a shortage in supply
• the PES and PED of the good has a huge effect on the amount of excess demand

❗️ eg. rent controls, energy price caps, cap on mobile roaming charges in the EU, cap on interest rates, currency pegs

Question 17

What are the pros of maximum prices ?

Answer 17

• leads to lower prices for consumers
• can help to increase fairness by allowing more people to purchase certain goods/services
• can be used to prevent monopolies exploiting customers and suppliers with higher prices
• usually reserved for important goods eg. food and renting

Question 18

What are the cons of maximum prices ?

Answer 18

1. leads to a shortage ➡️ since demand in higher than supply some people who want to buy the good/service are unable to
2. emergence of black markets due to excess demand or because of scarcity of supply ➡️ some customers are willing and able to pay above the regulated price
3. govts may need to introduce a rationing scheme to allocate the resources
4. may create a lack of incentive eg. landlords to properly maintain properties
5. can lead to businesses ect leaving the market ➡️ reduces supply

Question 19

Evaluation of maximum prices ?

Answer 19

• govts should use them for necessary goods as a temporary solution as it leads to an immediate drop in prices for consumers which may be needed (or people may suffer?)
• however it is not a long term solution as it is likely that a subsidy will need to be granted

Question 20

What are minimum price levels ?

Answer 20

• also known as price floor
• imposed to make sure suppliers get a fair price eg. EU’s cap guarantees a min price for many agricultural products
• to be effective must be set above the normal equilibrium price
• commonly associated with minimum wages in the labour market or guarantee price support schemes for farmers or other producers

Question 21

What are the pros of minimum prices ?

Answer 21

• designed to give producers more income
• protects businesses and industry (in theory)
• protects consumers from over buying harmful/demerit goods
• reduces some of the externalities from harmful goods

Question 22

What are the cons of minimum prices ?

Answer 22

1. higher prices for consumers
2. higher tariff necessary on imports to keep prices high
3. imbalance/disequilibrium in the market ➡️ what would you do with over supply of products - destroy ?
4. emergence of black markets ➡️ costly for society (increase in criminal activity) - police needed?
5. depends on elasticity
6. won’t affect the ruch so much ➡️ unlikely to deter the richer in society from consuming the product
7. what is the socially optimum level ➡️ can be errors in calculating the socially optimum level

Question 23

What are tradable pollution permits ?

Answer 23

• the govt permit a certain amount of something with the aim of reducing it overall eg. sulphur, in which they issue permits to pollute (the max amount they want to see emitted)
• the govt allocates these permits to individual firms in which these permits are then tradable for money between the different polluters ➡️ firms which are successful in reducing their pollution can sell their spare permits onto other producers exceeding their limits

Question 24

What are the benefits of tradable pollution permits ?

Answer 24

• internalises the externality + makes the polluter pay
• good way to reduce pollution ➡️ encourages firms to be more efficient and pollute less
• using permits tends to cost industry less than if you were to use regulation
• a market is created for buying and selling the permits
• creates a strong incentive to reduce the pollution (externality)
• the no. of permits can be reduced overtime to ensure that pollution targets are met
• the govt can sell additional permits ➡️ use this money to compensate victims and reduce the effects of the externality
• production costs will increase for firms that exceed their pollution allowances ➡️ have to purchase additional permits, providing a source of revenue to cleaner firms that can sell their excess pollution permits
• govt can use any money gained from any fines to invest in pollution reducing schemes ➡️ these schemes internalises the externality of pollution since the polluter is the one trying to fix the problem

Question 25

What are the drawbacks of tradable pollution permits ?

Answer 25

1. deciding on the right no. of permits to allocate can be difficult
2. the govt might allocate too few permits ➡️ firms production costs rapidly rise due to the additional permits and face fines ➡️ reduces international competitiveness
3. disputes over the allocation of permits (who gets them ect) ➡️ some firms may take legal action against the govt and the EU if they feel they should have received a bigger allowance
4. firms might pass on the cost of buying the pollution permits on to the customer ➡️ higher prices
5. not worldwide solution ➡️ China & USA still polluting
6. administration costs ➡️ monitoring
7. less pressure on major polluting firms to actually clean up their act if its easy to but more permits
8. pollution permits may create an entry barrier for new firms to enter the industry ➡️ restricting competition
9. firms may relocate ➡️ firms take their business outside of the EU ?

Question 26

What is government provision of public goods and the ‘free-rider’ problem ?

Answer 26

• govt needs to provide public goods to help overcome the free-rider problem
• difficult to charge people for benefitting once a good is available as public goods are non-excludable
• free rider problem can lead to non-provision of a good ➡️ causing market failure as private sector unwilling to provide them
• free riders have no incentive to reveal what they are willing and able to pay for a public good because they are enjoying a benefit w/o paying

Question 27

What grounds are public goods usually provided on by the state ?

Answer 27

1. fairness ➡️ view that everyone should have equitable access to good quality public goods eg. sanitation systems, flood defence systems, the rule of law and open access to justice
2. efficiency ➡️ collective provision funded through taxation can lead to economies of scale and a more efficient use of scarce resources
3. social welfare ➡️ positive externalities from good quality public services not all of which can be measured by a market price

Question 28

What are the drawback of the state providing public goods

Answer 28

• those who favour a smaller role for the govt believe that the private sector is more efficient and innovative
• in the LR leads to a rising tax burden ➡️ might crowd-out or hinder the growth of private sector businesses (some believe)
• opportunity cost ➡️ what else could the money be spent on ?
• reduces idenpendence of the consumer eg. overuse of the NHS
• technological change is also changing the degree to which public goods are non-excludable
• not all public goods need providing ➡️ eg. fire works display
• some public goods can be provided on a local small scale by local organisations able to collect fees instead of the govt

Question 29

What is meant by provision of information ?

Answer 29

• often there is a mis-allocation of resources due to a lack of information with customers paying too much or too little and firms producing too much or little
• information is given to try and help consumers make rational decisions and prevent market failure caused by consumers and producers having asymmetric information

❗️ eg. advertising campaigns to encourage healthy eating/compulsory food labelling/health warnings on cigarette packets/campaigns to raise awareness of risks of drink driving

Question 30

What is meant by regulation/legislation to correct market failure ?

Answer 30

• regulations are rules enforced by an authority (government) which are backed up by laws ➡️ ‘command and control’ approach to intervention in a market backed up by inspections & penalties for non compliance
• legislations (laws) mean legal action can be taken against those who break the rules
• used to reduce the negative effects of externalities ?

Question 31

What are the benefits of regulations ?

Answer 31

1. legally binding ➡️ business must adjust their behaviour or will risk prosecution
2. can reduce demerit goods/services ➡️ ban/limit sale of such products
3. can reduce the power of monopolies ➡️ eg. setting up a regulatory body to set rules
4. can provide protection for consumers and producers from problems arising from asymmetric information
5. can have a relatively quick impact
6. easy to understand
7. cheap to implement
8. revenue from fines can be used to correct the cause of market failure or compensate those affected by the externalities
9. most effective when the costs of the cost of the fine is greater than the benefits of ignoring the regulations

Question 32

What are the drawbacks to regulations ?

Answer 32

1. difficult to fix the right level of regulation eg. what is the correct age to be allowed to buy alcohol
2. regulations might be too tight or too lax eg. firms had to spend £30mil fitting anti-pollution devices to machinery ➡️ too harsh = hurt economy OR too lax = not a deterrent
3. new regulations need monitoring and enforcing ➡️ costly
4. likely to push up the cost of production ➡️ reduce business profits
5. businesses may simply increase prices to cover the cost of new regulations ➡️ higher prices for consumers
6. govt only have power in their own country eg. efforts to reduce pollution

Question 33

What is government failure ?

Answer 33

• when govt intervention in a market leads to a less efficient allocation of resources and therefore makes a situation worse (net welfare loss)
• government failure can happen if a policy decision fails to create enough of an incentive to change people’s actual behaviour

Question 34

What are the causes of government failure ?

Answer 34

• political self interest ➡️ govt influence by influential political lobbying eg. farm support policies
• information faliure ➡️ govt lack data to make effective decisions
• poor value for money ➡️ low productivity/ high waste makes govt spending less effective eg. investment on IT projects in the NHS
• policy short-termism ➡️ govts are often looking for a ‘quick fix’ solution for political purposes eg. road widening to reduce congestion
• regulatory capture ➡️ when a govt agency operates in favour of producers not consumers
• conflicting objectives ➡️ one policy objective might conflict with another eg. minimum carbon prices could damage UK competitiveness
• bureaucracy and red tape ➡️ cost of enforcement may hurt enterprise & incentives eg. costs of meeting health and safety laws
• unintended consequences ➡️ policies have unanticipated/unintended side-effects eg. smoking ban leading to an increased use of outdoor patio heaters

Question 35

What is the law of unintended consequences ?

Answer 35

• actions of consumers, producers and govts always have at least one and often many effects that are unanticipated or unintended
• well intentioned legislations often acts against the interest of those it is intended to serve
• people and businesses find imaginative ways to circumvent new laws
• shadow markets then develop to undermine official policy eg. maximum price cap

eg. bio-fuel subsidy ➡️ many divert production away from food causing food price inflation, hitting the poorest in society
eg. import tariffs on steel ➡️ hits domestic car and construction firms
eg. targets for treating patients ➡️ contribute to a reduction in the quality of care

Question 36

What is regulatory faliure ?

Answer 36

actions of regulators may also bring about government failure

• regulators may limit innovation in fast growing markets
• capping prices might prevent new firms entering a market
• regulation becomes bureaucractic and costly
• many lack the powers to be truly effective in protecting consumers
• regulators might be “behind the curve” with new technologies
• frequent rules changes can stifle business investment

Question 37

key points about govt failure ?

Answer 37

1. free market economists are distrustful of intervention ➡️ they believe that the price mechanism should be given freedom to operate
2. often we can accuse the govt of policy failure only with the benefit of hindsight
3. limited information ➡️ no govt has the resources and info available to it to make fully informed, objective judgements
4. govt failure is most likely to occur when decisions are made in the vested interest of special interest groups, at the expense of other groups ➡️ loss of equity

Question 38

Specific vs AD valorem tax ?

Answer 38

• ad valorem: % based tax on the price eg. VAT
• specific tax: taxing quantity/per unit ie. a fixed amount