1.4 Government intervention

1.4.1 Government Intervention

What is gov intervention used to do?

Correct market failure

What two areas of market failure does it correct?

• Inefficient resource allocation

• Lack of equity

What are the different forms of government intervention using T - STRIPES?

• T - Tradable Pollution Permits

• S - Subsidies

• T - Taxation

• R - Regulation

• I - Information provision

• P - Price controls (max and min prices)

• E - Extension of property rights

• S - State Provision of Public goods

What is a Pigouvian tax?

A type of tax designed to correct negative externalities

What two things are equal on a diagram when a Pigouvian tax internalises the externality?

Private costs = social costs

What are 3 examples of a Pigouvian Tax?

• Carbon tax - encourages greener energy

• Sin tax - unhealthy products

• Congestion tax - encourages public transport

How does an indirect tax effect supply?

It shifts inward

How does an ad valorem tax effect supply?

Causes a pivotal inward shift

What type of externality does a Pigouvian tax like Carbon tax correct?

Negative externality in production

What is the key feature of a negative externality in production diagram?

MPC is lower than MSC (MPC is more to the right)

Is the free market equilibrium quantity higher or lower than the socially optimal quantity?

Higher

What curve does the introduction of the tax effect and how?

• MPC - Shifts inwards (more costly) to MPC 1 (+ tax)

At what quantity does MPC 1 meet MSB?

Socially optimal quantity

What curve also meets MSB at this point?

MSC

Diagram : Effect of tax on negative externality

What are 2 advantages of taxes?

• Social welfare is maximises as externality is internalised

• Raises gov revenue which can be used to solve the externality in other ways

Why does the government make mistakes with taxes often?

Hard to know size of the externality and therefore the tax to set

What could heavy taxes lead to the creation of?

Black market

Why might a government be afraid to set taxes?

They are politically unpopular

What level of PED would make the tax ineffective?

• PED < 1

• Inelastic PED means people buy good anyway despite price rise

Who receives most of the burden of the tax if the PED of the good is inelastic?

Consumers

What type of externality does this not reduce then?

Negative externality in production

What about taxes means that the poor spend a larger proportion of their income on them?

They are regressive - increasing inequality

What are subsidies?

Payments made to producers to reduce costs and increase output

What type of externality are subsidies used to correct?

Positive

How does a subsidy effect supply?

It shifts supply outwards

What type of good is a subsidy used for?

Merit goods

What do these goods have positive externalities in?

Consumption

What is the key feature of the positive externality in consumption diagram?

MSB is higher than MPB

What two curves are equal?

MPC = MSC

Is the free market equilibrium lower or higher than the socially optimal equilibrium?

Lower

What does a subsidy reduce?

MPC

What does this look like on a diagram?

MPC shifts outwards to MPC + Subsidy

What increases as a result?

Free market equilibrium

What does this now become equal to?

Socially optimal equilibrium

Diagram : Effect of subsidies on positive externalities

Why does the government often fail to fully correct the externality with subsidies?

Hard to know size of externality and therefore size of subsidy

What is another disadvantage of subsidies for the government?

Large amounts of money

How may subsidies actually lower productivity?

Firms don’t need to cut costs as much so are less efficient

What elasticity would limit the effectiveness of a subsidy?

Inelastic

Why is this the case?

Little response to reduction in price - underconsumption not fixed alot