Government Intervention

Question 1

Is there government intervention in the uk

Answer 1

The UK is a mixed economy, which means both private enterprise and the government allocate resources to solve the economic problem of what, how and for whom to produce. Often the government intervenes where there is market failure and attempts to correct this so that resources are allocated more efficiently.

Question 2

Give me examples of various measures a government could undertake to correct market failure

Answer 2

Indirect taxation, subsidies, maximum prices, minimum prices, trade pollution permits, regulation, provision of public goods and provision of market information.

The relative merits of each form of intervention are now considered in relation to different types of market failure. Note that the disadvantages of these measures point to the possibility of government failure.

Question 3

What are indirect taxes

Answer 3

Indirect taxes are taxes levied on the expenditure of goods or services. The government often imposes taxes on goods which have significant external costs, such as petrol, tobacco, alcohol and electricity generated from burning fossil fuels.

Question 4

What goods do the government often put indirect taxes on

Answer 4

The government often imposes taxes on goods which have significant external costs eg. Tobacco

Question 5

What will an indirect tax do to a diagram /fix market failure

Answer 5

In a free market, the equilibrium is where MPC meets MPB=MSB, but the social optimum price is above where MSC meets MPC + tax, thus correcting market failure. The tax collected is shown by a rectangle enclosed by the y axis, to the new equilibrium and then a line drawn vertically down to the MPC curve and across to the y axis, the free market equilibrium shows how the tax area is split between consumers and producers. The consumer tax is above the producer tax.

Question 6

Tell me the advantages of indirect taxes to correct market failure

Answer 6

In the case of pollution, indirect taxes are based on the principle that the polluters (both consumers and producer) pay, helping to internalise external costs.

They work with market forces so that choice still exists in terms of consumption and production, unlike the effects of some regulation.

The level of pollution should fall as output of the good or service is reduced and the price increased - the social optimum position of MSB = MSC Can be achieved.

Tax funds are raised for the government and these can be used to clean up the environment or to compensate tbf victims of pollution.

Indirect taxes are difficult to evade as they are often included in the market price. The sellers collect the tax revenue and send it to government.

Indirect taxes are convenient, since they tend to be paid in small amounts and regularly rather than in one lump sum.

Question 7

Tell me the disadvantages of indirect taxes to correct market failure

Answer 7

It is difficult to quantify external costs and then place a monetary value on them. Consequently, the social optimum position might not be achieved.

Indirect taxes increase the costs of production for firms, making them less competitive than firms in other counties where such taxes are not applied.

Widespread use of indirect taxes may be inflationary

Firms may relocate to other countries with less stringent taxes on production.

The demand for the good or service may be price inelastic and so the overall reduction in pollution levels may be small

The tax revenue raised may not be used to compensate victims or clean up the environment

In the case of some goods, unintended consequences may occur such as the development of illegal markets: for examples, tobacco and alcohol smuggling to avoid high taxes.

The regressive nature of indirect taxes leads to further unintended consequences: for example, the burden of payment tends to fall on low income rather than high income groups.

Question 8

Tell me an evaluation technique to do with indirect taxes

Answer 8

Consider the impact on different interest groups, eg how producers of an inelastic good, eg petrol can pass down tax to consumers mostly.

Question 9

What is a subsidy

Answer 9

A subsidy is a grant provided by the government to encourage the production and consumption of a particular good or service. Subsidies are often applied on goods or services with significant external benefits, such as education and healthcare. They may also be given to alternative forms of economic activity which create less pollution, such as public transport and renewable energy.

Question 10

Tell me about the subsidy diagram

Answer 10

When a unit subsidy is applied, Part of the subsidy passed on to consumers, part to producers.

The producer subsidy is above the consumer subsidy (unlike indirect taxes)

A subsidy increase the supply and shifts the supply curve to the right, lowers price and increases output. This can reduce demand for substitute goods eg. A reduction in price of wind power electricity may lead to a reduction in demand in electricity from coal and oil.

Question 11

Tell me advantages of subsidies applied to renewable energy markets

Answer 11

Subsidies can reduce air pollution and other forms of external costs.

Subsidies on renewable energy generation promote sustained economic growth.

The rate of consumption of non renewable energy resources is reduced

Subsidies work with market forces. They help to internalise the external benefits from renewable forms of energy so that the social optimum level of output can be reached.

Question 12

Tell me the disadvantages of subsidies applied to renewable energy markets

Answer 12

It is difficult to quantify external benefits and then place a monetary value on them. Consequently, the social optimum position might not be achieved

There is an opportunity cost to government subsidies. They may lead to higher taxes or cuts in government spending elsewhere. They may be a waste of money: for example, many subsidised bus services operate along routes with hardly any passengers.

Unintended consequences may occur: for example, firms may become dependent on the subsidies and inefficient in production

Wind power and solar power may be less reliable sources of energy than traditional fossil fuels.

There are external costs associated with the provision of renewable energy sources: for example, noise and visual pollution from wind farms. They can also reduce property prices nearby.

Question 13

What’s an evaluation point to do with subsidies about magnitude

Answer 13

Consider the magnitude of an event. For example, when assessing the effects of government subsidies in the renewable energy markets, this will depend upon how large the subsidies are as a proportion of total production costs for the firm.

Question 14

What’s a maximum price scheme

Answer 14

In a maximum price scheme, the government may impose a limit on how much prices of certain goods and services can rise. Such schemes have been used in house rental markets to protect tenants from being exploited by their landlords.

Similarly, during the Second World War the government imposed maximum prices on basic food items to ensure fairer distribution.

Question 15

Define a maximum price

Answer 15

A ceiling price set by the government on a good or service, above which it cannot rise. It may be enforced through government legislation.

Question 16

More recently, what goods were price caps / maximum prices put on

Answer 16

More recently, price caps were applied on various utilities such as gas and electricity. Currently there are price caps on selected rail fares and postal services. There have also been calls for the government to impose maximum wages on exceptionally high-paid public sector workers and bankers.

Question 17

Where is a maximum price usually set

Answer 17

Usually a maximum price is set below the free market price, causing shortages or an excess demand. A maximum price set above the free market equilibrium price will have no effect.

Question 18

Tell me about a maximum pricing diagram

Answer 18

There is a horizontal line drawn under the market equilibrium that is the maximum price. Draw vertical lines down from where p max touches supply and demand curves and a line from the free market equilibrium down. The whole area enclosed by the p max line is excess demand.

Question 19

Tell me the advantages of maximum price

Answer 19

They can reduce exploitation of consumers, especially where a lack of competition exists. For example, the EU has capped the price of some mobile phone calls across member states.

They can reduce inequality, as in the case of a salary cap on highly paid public sector workers and bankers.

They can help people on low incomes to afford key products - for example, rental housing.

Question 20

Tell me the disadvantages of maximum pricing

Answer 20

Unintended consequences may occur: for example, government intervention distorts the operation of the price mechanism, leading to an excess demand and inefficient allocation of resources.

In terms of the house rental market, it reduces the supply of rental property and makes the shortage worse in the long run.

Producer surplus falls and so landlords have less income with which to invest in and maintain their property.

Problems arise over how to allocate supply and meet the excess demand in the market, since price cannot increase. This may involve a first come, first served basis or sellers preference - both of which are deemed to be unfair.

It is difficult for the government to monitor and enforce maximum price controls in markets. There is a danger of shadow markets being created. Some people may be prepared to pay more for the good to ensure they obtain it. This is often seen with tickets at popular football matches and theatre shows.

Question 21

What’s a minimum price scheme

Answer 21

In a minimum price scheme, the government may impose a limit on how much prices of certain goods and services can fall. Such schemes have been used in commodity markets to protect the income of farmers and also in labour markets to prevent the exploitation of workers (the national minimum wage),

More recently, there have been calls for a minimum price on goods which create high external costs, such as alcohol and fizzy drinks.

Question 22

Tell me about farmers and getting a guaranteed minimum price

Answer 22

For example, EU farmers are guaranteed a minimum price for many commodities, including sugar, wheat and barley. Usually the minimum price is set above the free market price, causing agricultural surpluses or an excess supply. These are purchased by a government agency at the guaranteed minimum price.

Note that a minimum price set below the free market equilibrium price will have no effect.

Question 23

Define minimum price

Answer 23

A floor price set by the government on a good or service, which below it cannot fall. It may be enforced through government intervention

Question 24

Define guaranteed minimum price

Answer 24

Where the surplus output created is purchased by a government agency at the minimum price. The main aim of such a scheme is to protect producer incomes.

Question 25

Tell me about the diagram for minimum pricing

Answer 25

A horizontal line is drawn about the free market equilibrium as price minimum (p min) then, where the line crosses the demand and supply curves, lines are draw vertically down to the x axis, this area is government expenditure on the surplus. Total revenue for producers increase to where p min is equal to supply due to the guaranteed minimum price. The excess supply is stockpiled by the government.

Question 26

Tell me the advantages of minimum pricing

Answer 26

They can reduce the consumption of goods which are harmful to consumers and have high external costs, such as alcohol and sugar. They encourage producers to switch to making ‘healthier’ drinks and foods containing less alcohol and sugar They can reduce fluctuations in food prices and so make it easier for consumers to budget their income. They also ensure food supplies even in times of poor harvest, due to the availability of surplus stockpiles. A guaranteed minimum price can stabilise and increase producer incomes, leading to greater investment and employment - for example, in agriculture. Food surpluses can be used as a form of international aid to developing countries. A national minimum wage can reduce exploitation of labour while increasing incentives to work.

Question 27

Tell me the disadvantages of minimum prices

Answer 27

Unintended consequences may occur, for example, government intervention distorts the operation of the price mechanism, leading to an excess supply and inefficient allocation of resources The price of some food and drinks will increase, which could lead to hardship for consumers on low incomes. A minimum price also reduces consumer surplus. Minimum prices may be less effective in reducing consumption of alcohol and sugary drinks when demand is price inelastic. A guaranteed minimum price scheme leads to the government buying up (agricultural) surpluses, which involves an opportunity cost. It may have to raise taxes or cut government spending elsewhere. There are increased storage and security costs for the food surpluses. Alternatively, the food surpluses may have to be destroyed due to their perishability. The food surpluses may be sold in overseas markets at very low prices. This could damage farmers in developing countries, who are unable to compete against imports of cheap food. Farmers are guaranteed an income, which might cause them to become less efficient over time. There is less incentive for farmers to improve the quality of the food or to keep production costs down. A national minimum wage may cause unemployment among workers in low skilled labour markets. It is difficult for the government to monitor and enforce a minimum wage policy.

Question 28

What are tradable pollution permits

Answer 28

They are how much firms are allowed to emit in carbon emissions for the year. The pollution permits are tradable, which means that firms can buy and sell the allowances between firms. The emissions trading system (ETS) allocates permits to EU country’s every year for national governments to allocate amongst firms

Question 29

Define tradable pollution permits

Answer 29

Pollution permits that can be bought and sold in a market. They are an attempt to solve the problem of pollution by creating a market for it.

Question 30

Tell me the advantages of trade pollution permits

Answer 30

A market is created for buying and selling carbon permits, just like other goods and services. In effect, the price mechanism is used to internalise the external costs associated with carbon emissions. Pollution permits can be reduced over time as part of a coordinated plan. For example, in 2008 the European Commission cut carbon allocations by 5%. National governments can raise funds by selling their reserve pollution permits to industry. The revenue could then be used to clean up the environment or compensate victims. Firms have an incentive to invest in clean technology Production costs will increase for firms that exceed their pollution allowances, since they have to purchase additional permits, and this provides a source of revenue for cleaner firms that can sell their excess pollution permits. The emissions trading system (ETS) may act as a foundation for global wide scheme. It has attracted interest from developed outside the EU. New schemes can be set up, benefiting the environment. Firms are able to bank their excess pollution permits for use in future years.

Question 31

Tell me the disadvantages of trade pollution permits

Answer 31

An information gap might cause the European Commission to issue too many carbon permits, so there is little incentive for firms to reduce pollution. Or issue too few permits, so that production costs for EU firms increase rapidly, reducing their international competitiveness. Some firms may relocate outside outside the EU to reduce production costs. Disputes have arisen over the allocation of carbon permits for firms. Some companies believe they should receive larger allowances and have taken legal proceedings against the European Commission. Firms may pass the cost of purchasing pollution permits on to their customers, leading to higher prices of goods eg electricity, steel, glass and paper. This is more likely to happen if demand is price inelastic. Unintended consequences may occur: eg there is less pressure on major firms to clean up their act if it is possible to buy extra permits from elsewhere. The price of pollution permits has fluctuated considerably since their inception in 2005. This has created uncertainty among firms about whether to invest heavily in carbon reducing technology. Firms need clear guidance on what carbon prices will be for the next decade in order to determine their investment levels. There is a cost to the government of monitoring pollution emissions from the many companies within the scheme. It won’t make a difference to the world if other countries continue polluting how they want. The valuation of pollution permits is an inexact science. Perhaps it is too important to leave to the market. Much disagreement exists over the costs of greenhouse gas emissions. Some environmental groups believe too little is being done to reduce carbon emissions. Carbon trading is simply leading to false sense of security.

Question 32

Why is there state provision of public goods

Answer 32

Public goods would not be provided/under provided in a free market economy due to the free rider problem. Once the good is provided, people are able to consume it without paying, and so private enterprise has no incentive to supply it, since making a profit would be difficult. Consequently, the government or state tends to provide public goods in order to correct market failure.

Question 33

How does the provision of public goods work

Answer 33

The government raises funds from general taxation to pay for their provision. The free rider problem is a major reason why most economies are mixed economies today. Public goods involve a large element of collective consumption: eg national defence, flood defence systems, the criminal justice system and refuse collection.

Question 34

Tell me about why the state provision of information is needed

Answer 34

It was mentioned earlier that information gaps cause market failure and so require government intervention to reduce this.

Question 35

How does the state provision of information work

Answer 35

Government provision of information comes through various promotions using social media, such as the internet, television, radio, newspapers and text messages

Question 36

What are the reasons for the state provision of information

Answer 36

To encourage the production and consumption of healthy goods and services: for example, fruits and vegetables, or goods that yield long term benefits, such as pensions. Often these are under-provided in the market. To discourage the production and consumption of unhealthy goods and services: for example, tobacco, alcohol and drugs. Often these are over-provided in the market. To notify and remind people of laws for their own protection, such as wearing seatbelts in motor vehicles and not drinking alcohol and driving. Government provision of information, along with other measures, plays an important role in reducing market failure.

Question 37

Tell me about regulation

Answer 37

There are various forms of government regulations to correct market failure. In some cases direct controls are applied: for example, the environmental protection act (1989) set minimum environmental standards for emissions over 3500 factories involved in chemical processes, waste incineration and oil refining. These firms are monitored by government pollution inspectors who have power to impose fines and close down factories.

Question 38

Define regulation

Answer 38

Government rules in markets to influence the behaviour of consumers and producers.

Question 39

What are the advantages of regulations

Answer 39

They are simple to understand: for example, legal restrictions on the age at which people can buy tobacco and alcohol. Limits can be imposed on the operation of firms to protect consumers, eg a limit on the number of night air flights from Heathrow airport. It is possible to fine or close down companies that have abused regulations eg, emitting dangerous levels of toxic waste Fines act as a deterrent for both consumers and producers not to break the law. The revenue collected from fines could also be used to compensate victims Regulations could require firms to restore and clean up the site after production: eg, in mining and quarrying operations Regulations may help reduce the problem of asymmetric information eg. Restrictions on the sale of tobacco make it harder for young people to begin smoking, irrespective of whether they know how serious the consequences of smoking are.

Question 40

Tell me the disadvantages of regulations

Answer 40

Regulations can be expensive to monitor and enforce, as in the case of pollution levels imposed on firms. Administration costs can be high Regulations may be set at the wrong level to correct market failure: for example, it is difficult to quantify and attach a monetary value to pollution emissions and so the social optimum position may not be reached Regulations may increase the production costs of firms and make them less competitive in global markets, especially against firms in countries with few restrictions such as China Regulations may prevent the operation of the price mechanism, overruling it completely rather than working with it. Unintended consequences may occur. For example, in regulatory capture, the regulator acts in the interest of the firms it is meant to regulate rather than the public it is meant to protect

Question 41

When does government failure occur

Answer 41

Government failure occurs when government intervention leads to an inefficient allocation of resources and a net welfare loss.

Question 42

Tell me the different types of government failure

Answer 42

The distortion of price signals, unintended consequences, excessive administration costs and information gaps.

Question 43

Define government failure

Answer 43

When government intervention leads to an inefficient allocation of resources and a net welfare loss

Question 44

What should be note about government failure

Answer 44

Before being too critical of government intervention, one should note that the failure is often less serious that the market failure it tries to solve. Without government intervention, the problems associated with market failure are likely to be far greater for both consumers and producers. For example, high taxes, health campaigns and regulations on tobacco and alcohol have helped reduce demand, leading to improved public health. However, it is useful to outline some types of government failure using relevant examples.

Question 45

What government failure can maximum and minimum price controls lead to

Answer 45

Maximum and minimum price controls provide good examples of the distortion of price signals.

Question 46

What is the distortion of price signals

Answer 46

How government intervention distorts the operation of the price mechanism and misallocates resources.

Question 47

Define distortion of price signals

Answer 47

The actions of government which distort the operation of the price mechanism and so misallocates resources.

Question 48

How can maximum price controls lead to the distortion of price signals

Answer 48

Maximum price controls lead to an excess demand or shortage. Long term implications include a reduction in both the quality and the quantity of goods available, possibly leading to an increase in the number of those without access to a good.

Question 49

How can minimum price controls lead to the distortion of price signals

Answer 49

Could lead to an excess supply or surplus. Long term implication include problems of disposing goods or surpluses, which could be perishable (eg food) and expensive to store. Minimum price schemes may also require government expenditure on the surpluses, which has an opportunity cost.

Question 50

Define the law of unintended consequences

Answer 50

The actions of government, producers or consumers will always have effects that are unintended or unanticipated

Question 51

Tell me an example of unintended consequences to do with indirect taxes

Answer 51

Indirect taxes may lead to the development of illegal markets: for example, tobacco and alcohol smuggling. This leads to a growth in organised crime, counterfeit products and a loss of tax revenue for the government.

Question 52

Tell me an unintended consequence of subsidies

Answer 52

Subsidies may lead to firms becoming dependent on them and inefficient in production. It may also be difficult to withdraw subsidies once they are in place: for example, grants to bus and rail companies.

Question 53

Tell me an unintended consequence of maximum price controls

Answer 53

Maximum price controls may lead to acute shortages of goods and services. An example is a maximum wage for highly skilled workers: it could lead to a shortage of specialised workers in the banking sector that could undermine economic growth.

Question 54

Tell me an unintended consequence of minimum price controls

Answer 54

Minimum price controls may lead to surpluses of goods and services. For example, the minimum wage for low skilled workers: it could lead to unemployment as labour becomes too expensive for firms to employ.

Question 55

Tell me an unintended consequence of trade pollution permits

Answer 55

Trade pollution permits may not reduce carbon emissions so easily. For example, large polluting firms might find it easier and cheaper to buy some spare permits on the market rather than invest in expensive equipment to reduce carbon emissions.

Question 56

Tell me an unintended consequence of regulations

Answer 56

Regulations may lead to regulatory capture. This is where the regulator acts in the interest of the firms, rather than of the consumers whom it is meant to protect.

Question 57

What are administration costs

Answer 57

Government intervention in markets incurs administration costs, whether it concerns taxes, subsidies, price controls, pollution permits or regulations.

Question 58

Why are administration costs a problem

Answer 58

Sometimes the administration costs are so high as to put into question the cost effectiveness and validity of government intervention. These costs could arise in the formulation, monitoring or enforcement of government measures. Most areas of government intervention suffer from this and several examples are offered.

Question 59

Tell me 3 examples of excessive administration costs

Answer 59

Tax administration and collection can prove difficult and expensive for government: for example, tax changes in a budget may take a year to implement. Welfare benefits are difficult to calculate and monitor to make sure the right claimants receive the correct payments, for example: changes to to housing benefit according to the number of spare bedrooms a claimant might have (the bedroom tax) Regulations require constant monitoring to ensure they are adhered to: for example, ensuring fishing boats do not exceed their fish catches or quotas.

Question 60

Define administration costs

Answer 60

The costs which arise in the formulation, monitoring and enforcing of government measures to correct market failure.

Question 61

How can information gaps lead to government failure

Answer 61

Information gaps can lead to government failure when the government lacks sufficient knowledge of the likely effects of its intervention in a particular market. This means the government could make non rational decisions which lead to an inefficient allocation of resources and net welfare loss. We have previously shown how government intervention might fail by distorting market forces, causing unintended consequences and high administration costs. These are all linked to a lack of information in the first place concerning whether and how the government should intervene in a particular market.

Question 62

Define government information gaps

Answer 62

The government has insufficient information to make rational economic decisions

Question 63

Tell me 3 examples of government information gaps

Answer 63

The allocation of fish catches per boat (quotas) by EU governments appears to be set at too high a level, as the depletion of fish stocks continues. There is also the problem of fishing boats throwing back dead fish to keep within their quotas rather than risk large fines. The EU governments failed to understand how the rest of world would react to the inclusion of air travel in the Emissions Trading Scheme. The EU has been forced to postpone the extensions of the ETS due to threats of retaliatory taxes from other governments. A government setting a very high rate of income tax for top income earners might end up reducing the total tax take due to increased tax avoidance or evasion.

Question 64

List what ways the government intervenes

Answer 64

To correct market failure, it intervenes by indirect taxation, subsidies, maximum and minimum prices, tradable pollution permits, provision of public goods, information and regulation.

Question 65

What are indirect taxes and tradable pollution permits used for

Answer 65

Used to limit production and internalise external costs to the market

Question 66

What are government subsidies used for

Answer 66

Government subsidies are used to increase production and internalise external benefits to the market.

Question 67

What are regulations used for

Answer 67

Regulations are used to support the other measures and set limits on activities that lead to market failure.

Question 68

What is government failure

Answer 68

Government failure may occur: this is where government intervention leads to an increase in inefficiency and a net welfare loss.

Question 69

What are the types of government failure

Answer 69

Distortion of price signals, unintended consequences, excessive administration costs, Information gaps.

Question 70

Government failure is often less serious than.....

Answer 70

....the market failure it tries to solve

Question 71

What is the key reason for government intervention in markets

Answer 71

The key reason for government intervention is to correct market failure so that markets work more efficiently and there is less welfare loss.

Question 72

Why are there high indirect taxes on tobacco, alcohol and petrol

Answer 72

High taxes are placed on tobacco, alcohol and petrol in order to internalise external costs. They are a way of making the polluters pay for these costs. In addition, they provide significant tax revenue to the government, since demand is typically price inelastic for these goods.

Question 73

Why might a government subsidise some goods

Answer 73

The government typically subsidises goods which have significant external benefits in production or consumption: for example, renewable energy sources, public transport and healthcare.

Question 74

Why might a government impose a maximum price in the house rental market

Answer 74

A maximum price in the house rental sector will help low income families afford to rent property and reduce the danger of exploitation.

Question 75

What are the disadvantages of imposing a maximum price in the house rental market

Answer 75

Maximum price controls may reduce both the supply and quality of rental housing, leading to a greater shortage in the market.

Question 76

Why might a government impose a minimum price for alcoholic drinks and sugar

Answer 76

A minimum price for alcohol and sugar will reduce the costs associated with these products: for example, crime, alcoholism, obesity, pressure on the healthcare service and absenteeism from work.

Question 77

What are the disadvantages of imposing a minimum price on alcohol and sugar

Answer 77

Disadvantages include the danger of shadow markets being formed as well as increasing the price of goods for low income households.

Question 78

What is meant by a ‘cap and trade’ scheme

Answer 78

A cap and trade scheme is where the government limits the amount of pollution that firms are able to emit but also allows for them to buy and sell pollution permits between themselves.

Question 79

Why has the EU introduced a system of tradable pollution permits

Answer 79

A system of tradable pollution permits was introduced in order to limit pollution emissions from heavy industry. The EU believes that by creating a market for pollution it can help reduce overall carbon emissions.

Question 80

How might the success of the EU emissions trading system be affected by the number of pollution permits issued

Answer 80

If too many pollution permits are issued then the price falls so much that there is little incentive for firms to cut back on emissions; if too few permits are issued then the price of permits rises so much as to make EU industry uncompetitive in global markets.