2.11 Government Intervention

Question 1

What is an indirect tax, and what is it purpose ?

Answer 1

• An indirect tax is a charge paid to the government based on the spending on a good and service
• its usual intended purpose is to reduce over-production/consumption (reduce market failure associated with de-merit goods and G/S which exhibit negative externalities)

Question 2

What is the effect of an indirect tax ?

Answer 2

• A tax usually increases costs of production for firms, an indirect tax is collected and payed to the government, hence increasing firms costs of production. This leads to a decrease in supply, increasing the market price and decreasing quantity traded
• if the tax corrects the market failure, resources will be allocated efficiently, social welfare will be maximised Q* = Q2

Question 3

What are the 2 types of indirect tax and how are they different ?

Answer 3

1) Specific tax - a certain fixed sum is payed to the government per unit of the G/S sold e.g Fuel duty is a specific tax
2) ad valorem tax - a tax applied as a percentage of the selling price of the G/S e.g VAT is charged as +20% of the selling price

Question 4

How can indirect tax’s correct market failure due to negative production externalities ?

Answer 4

• if the government’s objective is to fully correct the market failure, they need to set a level of tax = MEC, this makes the producer internalise the external costs by adding to private costs (polluter pays principle)
• if the level of tax is set at a level where the producer fully internalises the MEC, then quantity traded will equal Q*, no over-production/consumption, allocative efficiency is achieved and social welfare is maximised

Question 5

How can indirect taxes be used to correct market failure associated with demerit goods ?

Answer 5

Demerit goods are over consumed and over produced due to an information failure, the perceived private benefit is greater than the social benefit MPB > MSB. An indirect tax (t) would decrease the supply of the demerit good, since a tax would increase the cost of production of the demerit good as firms pay the tax to the government, this leads to an increase in the price of the demerit good and a contraction in demand from Q1 to Q, eliminating the over consumption and production. If the tax is equal to the external costs then the new market determined output will be Q and social welfare is maximised

Question 6

What is the burden of tax ?

Answer 6

The burden/incidence of tax indicates the portion of tax that is endured by a particular group

Question 7

What does the burden of tax look like ?

Answer 7

Question 8

What happens when PED > PES (when an indirect tax is applied) ?

Answer 8

• When PED > PES the burden of the tax on producers is greater than the burden of the tax on consumers

Question 9

What happens when PES > PED (when an indirect tax is applied) ?

Answer 9

When PES > PED the burden of the tax on consumers is greater than the burden of the tax on producers

Question 10

What are the advantages of using an indirect tax to correct market failure ?

Answer 10

• an indirect tax can be used to reduce production and consumption of demerit goods and goods which result in negative externalities, this means a tax may lead to a more efficient allocation of resources, increasing social welfare
• An indirect tax is a market-based measure, the price mechanism is still allocating resources so costly alternative methods of rationing are not required, the price mechanism still provides incentives for firms and consumers to change behaviour, this is means it may be more efficient intervention than alternatives, such as regulation
• the use of tax raises revenue for the government which can then be used to increase spending on other economic activities to correct market failure

Question 11

What are the disadvantages of using an indirect tax to correct market failure ?

Answer 11

• indirect taxes are regressive in nature, because the tax increases the price of the G/S by a fixed amount meaning it takes a higher proportion of income for those on low incomes this may increase inequality.
• it is very difficult to determine the correct level of tax, it is difficult to quantify and put a value on the marginal external cost, it is also difficult to quantify the information failure associated with demerit goods
• some demerit goods have price inelastic demand which will require tax to be very high to discourage consumption, they may be less effective in reducing consumption and production, but much better at increasing government revenue

Question 12

Why do governments use taxes ?

Answer 12

• to reduce consumption and production of demerit goods
• to discourage the purchase of imports (tariffs)
• to provide the government with tax revenue needed to finance government expenditure
• tax’s can be used to redistribute income

Question 13

How to evaluate indirect taxes ?

Answer 13

Depends on:
- the size of the tax imposed
- the price of elasticity of demand of the G/S
- Other factors affecting the market
- How the tax revenue raised is used
- effectiveness of tax in correcting market failure
- costs associated with the intervention

Question 14

What is subsidy ?

Answer 14

A subsidy is a payment by government to producers to encourage an increase in the production and consumption of a G/S

Question 15

What is the effect of a subsidy ?

Answer 15

• A subsidy may be based on a fixed sum paid by the government to producers per unit of G/S
• this means that when the subsidy is paid, there is a parallel shift to the right of the supply curve

Question 16

How do subsidies correct market failure associated with merit goods ?

Answer 16

merit goods are under-consumed and under-produced at the MDO due to an associated information failure. MPB < MSB. Subsidies (subs) would increase the supply since subs reduce costs of production for firms, this leads to a fall in price, an extension in demand leading to an increase in quantity traded, this eliminated the underproduction and underconsumption. If the subsidy is set at the level of MEB then the market failure is fully corrected and social welfare is maximised as well as an elimination in deadweight welfare loss.

Question 17

What are advantages of using subsidies to correct market failure ?

Answer 17

• Subsidy can be effective at increasing production and consumption of merit goods, may lead to a more efficient allocation of resources increasing social welfare
• a subsidy is a market based measure, this means the price mechanism is allocating resources with the subsidy intervention, the price mechanism still provides incentives for firms and consumers to change behaviour, this means subsidies may be more efficient than other interventions
• subsidies are progressive in nature, meaning subsidies reduce the proportion of income spend on G/S for those on low incomes by more than those on higher incomes

Question 18

What are disadvantages of using subsidies to correct market failure ?

Answer 18

• it is very difficult to determine the correct level of subsidy, it is hard to put a value on MEB and to quantify the information failure
• there is an opportunity cost associated with government spending on subsidies, the money may be better used in a different market where social welfare is increased more
• if the PED is inelastic the level of subsidy needs to be very high to encourage an increase in consumption

Question 19

Why do government grant subsidies ?

Answer 19

• increase the production and consumption of merit goods
• to provide firms with revenue to support specific industries e.g agriculture
• to redistribute income and wealth, by lowering prices of particular goods and services for low-income buyers

Question 20

What are the evaluation points of subsidies ?

Answer 20

• the size of the subsidies paid
• the price elasticity demand (PED) of the G/S
• how the subsidy payments are funded, what are the opportunity costs associated ?
• effectiveness of the intervention in improving efficiency in the allocation of resources

Question 21

what are price controls ?

Answer 21

price controls are a form of price regulation - price controls may be set in the form of:
1. legally enforced minimum price (price floor)
2. legally enforced maximum price (price ceiling)
3. fixed price

Question 22

what is the purpose of minimum price ?

Answer 22

the purpose of mimimum price is to ensure the price of a G/S is not unnacceptably low, by setting a legally enforced price floor that the selling price is not allowed to fall below

Question 23

what does a minimum price diagram look like ?

Answer 23

the minimum price may create excess supply Qs>Qd at Pmin, this means the quantity traded is restricted by demand unless there is further government intervention.

Question 24

what is the effect of a minimum price ?

analysis

Answer 24

• if the price_min is set above the equilibrium price level P_e, the price of the G/S will increase from P_e to P_min, since firms will not be able to charge less than P_min
• this means that the market is now in disequilibrium becuase Q_s > Q_D at P_min: there is excess supply.
• if buyers are forced to pay higher prices at P_min, there will be a contraction of demand from Q_e to Q_d since consumer are less willing and able to buy the product.
• if producers produce the product at a level greater than Q_d there may be a suplus or glut a P_min

Question 25

what is the **effect of a minimum price on social welfare** | analysis

Answer 25

* if the new market quantity traded is at Q_d then consumer surplus reduced from the area **P_eAE to P_minAB** * producer surplus increases from **P_eGE to P_minGFB** * Due to the minimum price at Q_d the total Deadweight loss to society is shown by **BEF, this is assuming no market failures**

Question 26

what are the **advantages of minimum price** ?

Answer 26

* a price floor can **discourage consumption** of potentially harmful low quality products by increasing the price **and decreasing consumption, espcially of demerit goods** e.g alcahol * minimum price can also be used in markets where the product is **scarce** e.g non-renewable energy, this is because a higher price needs to be paid and **Qd is limited** * National minimum wage (a form of minimum price) increases wages of **lowest paid workers** and possibly increase standards of living and **reduce income inequality**

Question 27

what are the **disadvantages of minimum price** ?

Answer 27

* minimum price can lead to **an inefficient allocation of resources**, since interferring with the price mecahnism **results in a deadweight loss of social welfare** (if the market is not failing) * a price floor can provide incentives for **illegal markets to form**, since the prices in illegal markets are below the legal minimum, since high profits can be made by those willing to break the law by **selling to those consumers who are willing and able to buy below P_min.** * the market may become **more profitable** for firms in less competitive product markets, as firms will only produce enough to meet demand, and may become more **profitable by doing this**, this may lead to less innovation and lower productivity in the market. * Higher prices for consumers converts **consumer surplus into producer surplus**, lower income households pay higher prices leading to lower SoL, there may be increased income inequality.

Question 28

what are **some evaluation points for minimum price** ?

Answer 28

* the size of the **excess supply will depend on PED and PES**, if PED and PES are relativley price inelastic the surplus will be smaller * the assoicated **social welfare loss** may be more acceptable if there is an increase in prices of products that are **deemed less socially acceptable e.g alcohol** this may offset the effects of a failing market. * An **indirect tax may be more effective**, by ensuring harmful products are less affordable and by reducing the incentive for producers to supply, there wouuld be no surplus and **no associated waste in production** * minimum prices may be more effective **in markets which exhibit monopsony power (a single buyer)** as this can increase prices without a fall in Qs. e.g in aggriculture where there a many small scale farmers and few large scale buyers. this may lead to **an increase in allocative efficency if the minimum price offsets the power of monopsony buyers**

Question 29

what is **government failure** ?

Answer 29

government failure occurs when government intervention leads to **a less efficent allocation of resources** than if the government hadn't intervened, there will be a greater **loss of economic welfare due to the intervention.**

Question 30

what is the **purpose of maximum price** ? | price ceiling

Answer 30

the purpose of maximum price is to **ensuure the price of a G/S is not too high**, by setting a legally enforced price ceiling the price is not allowed to go above

Question 31

what does **maximum price look like on a diagram** ?

Answer 31

## Footnote for the intervention to have an effect P_max needs to be less than P_e

Question 32

what are **some examples where Max price has been used** ? ## Footnote AO2

Answer 32

* rented housing in **New York** * food products in **Venezuela** * the cap on the unit energy price of energy **in the UK**

Question 33

what is the **effect of a maximum price** ?

Answer 33

1. a price ceiling is a legally enforced maximum price **P_max**, if set below P_e, a maximum price will lead to the market price falling to the maximum allowed, since firms will not be able to charge above P_max 2. the causes the market to be in disequilibrium, since **Q_d > Q_s at P_max**, there is excess demand at P_max 3. if sellers receive P_max, there wiill be less incentive to supply the good; producers will only be **willing and able to supply Q_s at P_max**, meaning there will be a **contraction in supply (Q_e to Q_s)**, since fewer firms will be willing and able to supply the good at P_max. which will likely limit the quantity traded to Q_s

Question 34

what is the **effect of a maximum price on social welfare** ?

Answer 34

* P_max limits quantity traded to Q_s * consumer surplus increases **from P_eAE to P_maxABF** * while producer surplus decreases from **P_eEG to P_maxFG** * the loss of **producer surplus is greater than the gain in consumer surpluus**, meaning the total deadweight loss due to the max price is **BEF** (assuming no market failure)

Question 35

what are the **advantages of a Max price** ?

Answer 35

* prices are not allowed to rise **above P_max**, meaning the product is sold at an affordable price for buyers, this is especially important if buyers with **lower incomes are no able to purchase the product**, may be more **equitable access** * Maximum price may **offset significant price setting power by monopoly sellers**. since producers are forced to charge a lower price. * Max price can provide a **more equal distribiution of merit goods**, if the selected system of rationing allows access of the product to **those most in need of the product** e.g the use of maximum pescription/medicine charges rationed to those in most **medical need**. However this is likely to be offset with **lower overall supply of the product** (unless another economic agent guarentess to sell at P_max to statisfy excess demand) .

Question 36

what are the **disadvantages of Max price** ?

Answer 36

* **possible inefficient allocation of resources**, because excess demand is created by interfering with the free-market price mechanism, leading to under-allocation of resources and a deadweight loss of social welfare * An **additional form of rationing may be needed to deal with excess demand**, such as queuing, limits on quanity, waiting lists. these rationing systems may involve additional resources **which may come at a cost to the government** possible opportunity cost involved. * the market supply may become **less profitable for firms**, in the long run this may lead to **reduced investment** further decreasing inovation and competitveness.

Question 37

what are **some eval points for Max price** ?

Answer 37

* the size of the shortage and **welfare loss** will depend on **PED and PES** if PED and PES are relatively price inelastic the shortage will be smaller than if demand and supply are relatively elastic * the associated **loss of welfare** may be socially more acceptable if there is a more **equitable set of prices without a signicant fall in consumption** * **subsidies may be more effective market based intervention**, by ensuring basic **products are more affordable** and increasing the **quantity supplied**; those on low incomes can consume the necessities in greater quantities, reducing inequality * Max price may be more **effective when suppliers are exerting monopoly power**, excessive producer surplus will be converted to consumer surplus

Question 38

what is an **example of government failure in terms of max price** ?

Answer 38

* max price controls used in **venezuela** - there was a signifcant fall in standard of living and a fall in availability of basic items (lower food supplies) , possibly due to the elastic supply and a large shortage.

Question 39

What is a **buffer stock scheme** and what is its main purpose ?

Answer 39

- A buffer stock scheme is a **price stabilisation scheme**, where the government intervenes as a **seller of the good and as the buyer of the good**, to help **stabilise price** - the main purpose is to reduce **price volatility** to provide greater certainty for producers and consumers (especially in commodity markets with inelastic PED and PES)

Question 40

What are the **2 possible options for how buffer stock prices can be set** ?

Answer 40

1) buffer stock scheme set based on a combination of an **upper boundary (price ceiling) and a lower boundary (price floor), this creates a band where market price can moves freely 2) buffer stock scheme set around **one fixed price**, maximum and minimum price are the same To do this effectively the government needs to have ‘buffer’ stocks in reserve and also need a facility to be able to store the stock

Question 42

What does a **buffer stock diagram look like with upwards sloping supply curves** ? And what is it showing ?

Answer 42

- in this type of buffer stock scheme, the government sells buffer stocks when there is **excess demand Qd2 > Qs2** at the maximum price - the government buys buffer stocks when there is **excess supply Qs3 > Qd3** at the minimum price - a 2 price scheme is shown in the diagram, in a 1 price scheme the government provides greater certainty for prices however buying and selling of buffer stocks is much more frequent which requires more resources

Question 43

What does a **buffer stock diagram look like with perfectly inelastic supply curves** ? And what is it showing ?

Answer 43

Here the quantity supplied is fixed showing the supply for 1 specific growing season - the government sells buffer stocks when there is excess demand **Qd2 > Qs2** - the government buys buffer stocks when there is excess supply **Qs3 > Qd3**

Question 44

How are **buffer stocks self financing** ?

Answer 44

B