1.4.1 Government intervention in markets

INDIRECT TAX

INDIRECT TAX

• When the good has a negative externality, the gov can introduce indirect taxation to prevent market failure

• increases cost of production so supply will decrease-shifts from S1 to S2

• The free market would produce at P1Q1, where MPC=MPB, but the social optimum position is P2Q2, where MSB=MSC

• Following the introduction of the tax, the equilibrium position is S2=MPB=MSB, at P2Q2

• The tax internalises the externality and social welfare is now maximised

• This diagram shows a specific tax but an ad valorem tax would have the same effect, but the shift of the curve would look slightly different

INDIRECT TAX- ADVANTAGES

• It internalises the externality- the market now produces at the social equilibrium position and social welfare is maximised

• It raises gov revenue, which could be used to solve the externality in other ways such as through education- may help goods to become more elastic in the long run

INDIRECT TAX- DISADVANTAGES

• difficult to know the size of the externality and so its difficult to target the tax; the effect depends on where the tax is set- gov suffers from info gap when setting the tax

• There could be conflict between the gov 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 for the good is inelastic, then the tax will be ineffective at reducing output

• Taxes are politically unpopular-so govs may be reluctant to introduce them

• They are regressive-lower income spend a larger proportion of their income on indirect taxes

INDIRECT TAXES- EXAMPLES

• landfill taxes

• fuel duties

• alcohol duties

• tobacco duties

• air passenger duties

• sugar taxes

SUBSIDIES

• Subsidies can be introduced to fix info gaps or solve positive externalities

• will shift the supply curve to the right as it will lower the cost of production

• free market would produce where MPC=MPB at Q1P1 whilst the social optimum is where MSC=MSB at P2Q2

• introduction of subsidy means the equilibrium point is Q2P3 (social optimum output)

• This means that social welfare is maximised since the market produces at the output that best allocates resources

SUBSIDIES- ADVANTAGES

• social optimum output reached and welfare maximised

• they can have other positive impacts (e.g. encouraging small businesses, bringing equality and encouraging exports)

SUBSIDIES- DISADVANTAGES

• give has to spend large amount of money- high opportunity cost

• subsidies can cause producers to become inefficient- especially if they’re in place for a long time

• once introduced- subsidies difficult to remove

MAXIMUM AND MINIMUM PRICES

• for max price to have effect- set below current price equilibrium

• for min price to have effect- set above current price equilibrium

MAXIMUM PRICE

• a legally imposed price for a good that the suppliers cant charge above- set on good with pos externalities

• can be applied to rents for accommodation when prices too high- can prevent monopolies from exploiting consumers

• the equilibrium position is P1Q1 but the imposition of the maximum price means there is excess demand of QD -QS, shown by the shaded area

MINIMUM PRICE

• legally imposed price at which the price of the good cannot go below- set on goods with neg externalities (so that price is raised to the social optimum and consumption is discouraged

• also encourage producers to produce goods- so can be set on goods with social benefits that are underprovided by the market

• market equilibrium price is P1Q1

• but the minimum price is set at P2 and so there is excess supply of QS-QD, shown by the shaded area

MIN AND MAX PRICES- ADVANTAGES

• They can be set where MSB=MSC, so allow for some consideration of externalities and help to increase social welfare

• max price will ensure that goods are affordable and min price will ensure that producers get a fair price- both of these reduce poverty and can increase equity/equality

MIN AND MAX PRICES- DISADVANTAGES

• There’s distortion of price signals which causes excess 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

• difficult for gov to know where to set the prices bc of the difficulty of knowing the size of externalities and bc it will have implications on the size of excess supply/demand

• can lead to the creation of black markets- max prices may also lead to illegal bribes or discriminatory policies in allocating goods

TRADABLE POLLUTION PERMITS

• allows the owner to pollute up to a specific amount of pollution and gov controls how many permits there are so limits the max amount of pollution

• companies have to buy permits in order to pollute- so to cut costs and increase profits, they may use greener tech

• unused permits can be sold to other companies (why they’re tradeable)

• 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 tech

TPP- ADVANTAGES

• since gov caps the number of permits, it is guaranteed that pollution will fall to the targets set by the gov- will maximise social welfare

• gov can raise revenue by selling permits and by fining firms who exceed their pollution limit

• encourages companies to use and invest in green tech

• Firms can make their own decisions about whether to cut pollution or buy more permits- helps encourage efficiency

TPP- DISADVANTAGES

• can be expensive to monitor, but it will only work if it is monitored well- gov needs to impose fines that are large enough to ensure firms follow the regulation

• will raise costs for businesses- likely that these costs will be passed onto consumers

• may be difficult to know how many permits the gov should allow

STATE PROVISION OF PUBLIC GOODS

• Public goods are non-excludable and non-rivalry and so the free rider problem says they will be under-provided by the free market- leading to market failure

• so the gov provides these public goods directly through taxation

• Similarly, the gov can provide merit goods

STATE PROVISION OF PUBLIC GOODS- ADVANTAGES

• corrects market failure by providing important goods which would otherwise not be provided- will lead to improved social welfare

• can help to bring about equality, by ensuring everyone has access to basic goods

• There will be benefits of the goods themselves- e.g. by providing healthcare, the gov ensures that the workforce is healthy and so this can improve economic growth

• By using competition, the gov can ensure efficiency

STATE PROVISION OF PUBLIC GOODS- DISADVANTAGES

• expensive and represents a high opportunity cost for gov- administration costs are a problem

• since the market is not involved, the gov may produce the wrong combination of goods as consumers can not indicate their preferences- e.g. there may be too many soldiers and too few hospital beds: if they were provided by the market, price signals would lead to a shift in resources. Democracy aims to reduce this problem, since consumers can vote for political parties whose aims are similar to their own

• gov may be inefficient at production since they have no incentive to cut costs

• gov may suffer from corruption and conflicting objectives

PROVISION OF INFORMATION

• when there is asymmetric info, the gov provides info to allow people to make informed decisions

• they may also force companies to provide info

PROVISION OF INFO- ADVANTAGES

• helps consumers to act rationally- allows the market to work properly

• best if the gov 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

PROVISION OF INFO- DISADVANTAGES

• can be expensive for gov to do- lead to opportunity cost

• gov themselves may not always have all the info, so it may be difficult to inform consumers

• consumers may not listen to the info provided due to irrational behaviour

REGULATIONS

• govs are able to impose laws and caps to ensure that levels are set where MSB=MSC or to ensure that companies provide full info on products

• gov can also introduce regulatory bodies such as OFCOM for communications and OFGEN for energy

• ensure firms follow regulation and do not exploit their customers or take advantage of market position

REGULATIONS- ADVANTAGES

• can ensure consideration of externalities, prevent exploitation of consumers and keep consumers fully informed

• will help to overcome market failure and maximise social welfare

REGULATIONS- DISADVANTAGES

• laws may be expensive for the gov to monitor, incurring an opportunity cost

• don't take into account the different costs of following the laws for different companies- compared with tradable pollution permits, regulation is a less efficient method of reducing pollution

• gov 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