Government Intervention

Question 1

What is an indirect tax an what are the effects of an indirect tax?
Give examples.

Answer 1

Indirect taxes are taxes on expenditure, they cause an increase in production costs, leading to a leftward shift of the supply curve. Examples include VAT (Value Added Tax), excise duties and taxes on gambling.

Question 2

What are the two types of indirect tax?

Answer 2

1) Ad Valorem taxes

2) Specific taxes

Question 3

How can indirect taxes be used by government?

Answer 3

Indirect taxes are one of the most common ways in which governments intervene in markets. This may be to deal with external costs such as pollution.
The aim of the indirect tax is to internalise the externality, by taxing the product so that output and consumption will be at the socially optimal level where SMB = SMC.

Question 4

Give two advantages of indirect taxes.

Answer 4

Advantages:

1) Incentive to reduce pollution.
2) Source of revenue for the government.

Question 5

What are subsidies and how may they be used by the government?

Answer 5

The government may give money to producers to lower their production costs in order to cause an increase in supply. This method may be used to deal with the issue of external benefits. In turn this should encourage consumption to bring it up to the socially optimal level.

Question 6

Give two advantages of subsidies.

Answer 6

Advantages:

1) Reduction in the costs of production enabling suppliers to reduce the price.
2) Incentive for people to increase consumption.

Question 7

Give an example of where the government may use maximum prices.

Answer 7

Governments may use maximum prices in a variety of contexts, e.g. on rented accommodation, items of food and the wages of sports stars.

Question 8

Give two advantages of maximum prices.

Answer 8

Advantages:

1) They enable consumers on low incomes to be able to afford to buy a product.
2) They help to prevent an increase in the country’s rate of inflation.

Question 9

Give examples of where government may impose minimum prices. (2)

Answer 9

1) Minimum wage

2) Minimum guaranteed price (MGP) for a particular commodity.

Question 10

Give two advantages of minimum prices.

Answer 10

Advantages:

1) Producers know in advance what they will receive for their product.
2) This greater certainty enables producers to plan investment an output.

Question 11

What are tradable pollution permits and how may they be used by governments?

Answer 11

Tradable pollution permits are another way to reduce external costs. Permits are issued by government to firms that allow them to pollute up to a certain level. Any pollution above the allotted limit is fined.
The key to the system is that permits can be traded between firms so that the ‘cleaner firms can sell surplus permits to firms which are more polluting.

Question 12

Give three advantages of tradable pollution permits.

Answer 12

Advantages:

1) These schemes work through the market mechanism.
2) They are an incentive for firms to reduce pollution.
3) The administration costs are low compared to the installation of regulation.

Question 13

How may a government respond to a lack of the provision of public goods?

Answer 13

The usual response to the lack of provision of public goods by the free market is for the government to supply them, financed through taxation. This ensures that the good is provided at a sufficient level.
Alternative methods of providing some public goods is via agencies appointed by the government (contracted out) or by charities and voluntary organisations.

Question 14

How can information gaps be bridged?

Answer 14

The provision of information through a variety of means allows information gaps to be bridged, in order to inform consumers about issues concerning products or services.

Question 15

What is the aim of the imposition of legal regulation?

Answer 15

Legal regulation can be imposed on the activities of producers and consumers. In theory this should restrict activity to the required level, but without enforcement, firms may not meet the legal requirements.

Question 16

Give two advantages of legal regulation.

Answer 16

Advantages:

1) Regulation can limit the extent of the activity.
2) It might act as an incentive to develop new technologies that avoid the activity.

Question 17

What are property rights and how can they be used by the government?

Answer 17

Property rights are a form of regulation which can be used to deal with external costs. This involves assigning ownership rights to those affected by external costs. This means that owners are given the right to claim damages against the producers of external costs.

Question 18

Give three advantages of property rights.

Answer 18

Advantages:

1) Property rights are an incentive for producers to consider both the private and external costs.
2) Opportunity to fine firms caught polluting and use the money to compensate those damaged.
3) The administration costs of these schemes are low compared to other methods.

Question 19

What is government failure?

Answer 19

Government failure occurs when the government intervenes in a market to correct the market failure, but in fact causes consumption and output to move further away from the socially optimal level. The intervention leads to a ore inefficient allocation of resources than had previously existed.

Question 20

Give four causes of government failure.

Answer 20

1) Distortion of price signals - government intervention involving price manipulation undermines the key function of the price mechanism.
2) If a tax is set too high, then there may be unintended consequences such as an increase in smuggling.
3) Excessive administrative costs
4) Information gaps, the government may not have al the information require when it intervenes.

Question 21

Give two examples of government failure.

Answer 21

1) MGPs in agricultural stabilisation schemes may incur massive storage costs and considerable surpluses, suggesting that resources are not allocated efficiently.
2) Housing subsidies mean that there is little incentive for people to move even if their income increases, limiting the geographical mobility of labour.

Question 22

Give three disadvantages of a subsidy.

Answer 22

Disadvantages:

1) Cost to the taxpayer of providing subsidies.
2) Ineffective in increasing consumption if demand is inelastic.
3) Difficulty in setting an appropriate subsidy because of the problem of quantifying the external benefit.

Question 23

Give two disadvantages of indirect taxes.

Answer 23

Disadvantages:

1) Ineffective in reducing pollution if demand is price inelastic.
2) Difficulty in setting appropriate level of tax because of the problem of quantifying the external cost.

Question 24

Give three disadvantages of maximum prices.

Answer 24

Disadvantages:

1) There is a danger that shortages mean that some consumers will be unable to find supplies of the product.
2) Producers may exit the market in order to use their resources to produce products that are more profitable.
3) If the government subsidises producers in order to maintain their output, then there will be significant cost to the taxpayer.

Question 25

Give three disadvantages of minimum prices.

Answer 25

Disadvantages:

1) If the minimum guaranteed price is set too high, then there will be surpluses every year.
2) These schemes involve storage costs which must be borne by taxpayers.
3) These schemes encourage over-production and may therefore cause an inefficient allocation of resources.

Question 26

Give two disadvantages of tradable pollution permits.

Answer 26

Disadvantages:

1) Pollution will continue, albeit at a lower level than previously.
2) Large firms are able to buy up permits and continue to pollute.

Question 27

Give two disadvantages of legal regulation.

Answer 27

Disadvantages:

1) The cost of enforcement of laws/regulations, e.g. enforcement officers wages.
2) Problems of determining the socially efficient levels of the production process or activity.

Question 28

Give three disadvantages of property rights.

Answer 28

Disadvantages:

1) Problem of assigning property rights.
2) Legal procedure to determine quantity of compensation may be lengthy.
3) It may be difficult to agree on the monetary value of the external cost.