Theme 1 - Government intervention

Question 1

How does taxation help correct market failure?

Answer 1

Causes a fall in supply and increases costs to the individual, so MPC curve shifts closer to the MSC curve, price increases and output falls closer to the social optimum level.
The tax internalises the externality and social welfare is now maximised

Question 2

What are the advantages of using taxation to correct market failure?

Answer 2

• Internalises the externality; market now produces at the social equilibrium and social welfare is maximised
• Raises government revenue; can then solve the externality in other ways, such as education, which may help goods become price elastic in the long run

Question 3

What are the disadvantages of using taxation to correct market failure?

Answer 3

• Difficult to know the size of the externality and thus difficult to target the tax
• Could be conflict between government goal of raising revenue and solving the externality which makes setting the tax difficult
• Could lead to the creation of a black market
• If demand inelastic then the tax will be ineffective
• Politically unpopular so governments may be reluctant to implement them
• Regressive, meaning the poor spend a larger proportion of their income on indirect taxes than the rich do

Question 4

How can subsidies be used to solve market failure?

Answer 4

They can be used to solve positive externalities and information gaps
They shift the supply curve right as it lowers costs of production
The free market level of production will then move closer to the socially optimum level. This means that social welfare is maximised since the market produces closer to the output that best allocates resources

Question 5

What are the advantages of using subsidies to correct market failure?

Answer 5

• Society reaches the social optimum output and welfare is maximised
• They can have other positive impacts, such as encouraging small businesses, bringing about equality and encouraging sports

Question 6

What are the disadvantages of using subsidies to correct market failure?

Answer 6

• The government has to spend a large amount of money, which will have a high opportunity cost
• They are difficult to target as the size of the externality is unknown
• Subsidies can cause producers to become inefficient, especially if they are in place for a long time
• Once introduced they are difficult to remove

Question 7

How can maximum prices be used to correct market failure?

Answer 7

For a maximum price to have an effect, it must be set below the current market equilibrium
A maximum price is a legally imposed price for a good that suppliers cannot charge above. They are set on goods with positive externalities
They can prevent monopolies from exploiting customers

Question 8

How can minimum prices be used to correct market failure?

Answer 8

Minimum prices must be set above the market equilibrium to have an impact
A minimum price is a legally imposed price at which the price of a good cannot go below
They can be set on goods with negative externalities, so that the price is raised to the social optimum position and consumption is discouraged.
They also encourage producers to produce goods, so can be set on goods with social benefits that are underprovided by the market

Question 9

What are the advantages of using maximum and minimum prices to correct market failure?

Answer 9

• They can be set where MSB=MSC, so allow for some consideration of externalities and so help to increase social welfare
• A maximum price will ensure that goods are affordable, whilst a minimum price will ensure that producers will get a fair price. Both of these are able to reduce poverty and can increase equity/equality

Question 10

What are the disadvantages of using maximum and minimum prices to correct market failure?

Answer 10

• Distortion of price signals and this causes an excess of supply/demand. Excess demand will lead to questions about how to allocate goods and excess supply will lead to questions about what to do with the surplus goods
• It is difficult for the government to know where to set the price, because of the difficulty of knowing the size of the externality and because it will have implications on the size of excess demand/supply
• Both can lead to the creation of black markets. Maximum prices may also lead to illegal bribes or discriminatory policies in allocating goods

Question 11

How can tradable pollution permits be used to correct market failure?

Answer 11

A pollution permit allowed the owner to pollute up to a specific amount of pollution and the government controls how many permits there are so limits the maximum amount of pollution.
Companies have to buy permits to pollute so, in an attempt to cut costs and increase profits, companies may use greener technology
Unused permits can be sold to other companies
Companies exceeding their limit of pollution will face legal action.
As a fixed supply of permits is allocated, an increase in demand will lead to an increase in price for the permits, so companies will have more incentive to cut emissions by using green technology

Question 12

What are the advantages of using tradable pollution permits to correct market failure?

Answer 12

• As the government caps the number of permits its guaranteed that pollution will fall to the targets set by the government. This will maximise social welfare
• The government can raise revenue by selling permits and by fining firms who exceed their pollution limit
• This encourage companies to use and invest in green technology
• Firms are able to make their own decisions about whether to cut pollution or buy more permits. This helps encourage efficiency

Question 13

What are the disadvantages of using tradable pollutions permits to correct market failure?

Answer 13

• Expensive to monitor and police, but it will only work if it is monitored well. The government needs to impose fines that are large enough to ensure firms follow the regulation
• It will raise cots for businesses, and it is likely that these higher costs will be passed onto consumers
• It may be difficult to know how many permits the government should allow

Question 14

How can state provision of public goods be used to correct market failure?

Answer 14

Public goods are non-excludable and non-rivalrous and so the free-rider problem says they will be under-provided by the free market, leading to market failure.
As a result, the government provides these public goods directly through taxation

Question 15

What are the advantages of using state provision of public goods to correct market failure?

Answer 15

• Corrects market failure by providing important goods which would otherwise not be provided. It will lead to improved social welfare
• It can help to bring about equality, by ensuring that everyone has access to basic goods
• There will be benefits of the goods themselves, for example by providing healthcare, the government ensure that the workforce is healthy and so this can improve economic growth
• By using competitive tenders the government can ensure efficiency

Question 16

What are the disadvantages of using state provision of public goods to correct market failure?

Answer 16

• This is expensive and represents a high opportunity cost for the government. Administration costs are a problem
• Since the market isn’t involved, the government may produce the wrong combination of goods as consumers cannot indicate their preferences. Democracy aims to reduce this problem since consumers can vote for political parties whose aims are similar to their own
• The government may be inefficient at production since they have no incentive to cut costs
• Government officials may suffer from corruption and conflicting objectives

Question 17

How can information provision be used to correct market failure?

Answer 17

When there is asymmetric information, the government provides information to allow people to make informed decisions. They may also force companies to provide information

Question 18

What are the advantages of using information provision to correct market failure?

Answer 18

• Helps consumers to act rationally which allows the market to work properly
• It is best if the government uses this alongside other policies e.g. it can make demand more elastic in the long run and so help indirect taxes to become more effective at reducing output

Question 19

What are the disadvantages of using information provision to correct market failure?

Answer 19

• Can be expensive for the government to do, incurring an opportunity cost
• The government themselves may not always have all the information so it may be difficult to inform consumers
• Consumers may not listen to the information provided due to irrational behaviour

Question 20

How can regulation be used to correct market failure?

Answer 20

Governments are able to impose laws and caps to ensure that levels are set where MSB=MSC to to ensure that companies provide full information on products. The government can also introduce regulatory bodies which ensure firms follow regulation and do not exploit their customers or take advantage of the market position

Question 21

What are the advantages of using regulation to correct market failure?

Answer 21

Ensures consideration of externalities, prevent exploitation of consumers and keep consumers fully informed. This will help to overcome market failure and maximise social welfare

Question 22

What are the disadvantages of using regulation to correct market failure?

Answer 22

• Laws may be expensive for the government to monitor, incurring an opportunity cost
• They don’t take into account the different costs of following the laws for different companies. Compared with tradable pollution permits, regulation is less efficient in reducing pollution
• The government can suffer from regulatory capture
• Firms may pass on costs to the consumer in the form of higher prices
• Excessive regulation may reduce competition in a market, and efficiency, by increasing bureaucracy and reducing innovation

Question 23

What is government failure?

Answer 23

When government intervention in the market leads to net welfare loss and a misallocation of resources. The total social costs arising from the intervention are greater than the social benefits

Question 24

What are the causes of government failure?

Answer 24

• Distortion of price signals
• Unintended consequences
• Excessive administration costs
• Information gaps

Question 25

How does distortion of price signals cause government failure?

Answer 25

- Some types of government intervention change price signals in the market and distort the free market mechanism. As a result they keep some companies in business when they are inefficient so the resources should be switched to somewhere else or make consumers pay too much for a good - Maximum and minimum prices lead to excess demand/supply and make it difficult to allocate resources - The price mechanism aims to allocate resources to their best use and where consumer want and value them most highly. By intervening the government distorts the mechanism and so resources may be allocated inefficiently

Question 26

How do unintended consequences cause government failure?

Answer 26

Some interventions cause effects which the government did not intend to happen. Consumers and producers may react to new policies in unexpected ways and so the policy doesn't have the effect it should

Question 27

How do information gaps cause government failure?

Answer 27

- Any decisions that the government makes must be based on some data but the information that have is always going to be limited - Cost and benefit forecasts of investment are often wrong and so the government invests in a system where the costs are higher than the benefits, so there is welfare loss. It is impractical and usually impossible for the government to get every piece of information they need

Question 27

How do excessive administration costs cause government failure?

Answer 27

- In many cases a lot of money that is allocated by the government is actually used up on basic administration costs. The social costs may be higher than the social benefits, once admin costs are taken into account