Theme 1 - 1.4 Government Intervention

What is market failure?

Market failure arises when the price mechanism fails to allocate resources efficiently and a good is over or under produced / consumed

What are the advantages of indirect taxation

• Reduces overproduction / overconsumption and internalises negative externality

• Government gets tax revenue which can be used on correcting market failure

What are the disadvantages of indirect taxation

• Only effective if the government can accurately calculate the size of the external cost - too small of a tax will not correct market failed, too large will cause government failure

• If PED is inelastic tax will have to be high and most of the tax will be borne by the consumer

What are the advantages of subsidies

• Increase production and consumption of goods that are merit goods or create positive externalities

• May reduce inequalities by making some goods cheaper

• May increase producer and consumer surplus

What are the disadvantages of subsidies

• Has long term effect on market by distorting market signals (may lead to overproduction of goods that are not in high demand)

• Difficult to determine correct level of subsidy

• If PED is elastic most of the subsidy will be absorbed by producer - supporting inefficient firms

• If PED is high so is the cost of the subsidy

• If PED is inelastic subsidy will be ineffective

• Next best alternative may be better - for example funding healthcare

What are the advantages of regulation

• Overrides the workings of the market mechanism and therefor removes the problem of market failure

• Legally binding

• Enables a specific level of the externality making it more direct

What are the disadvantages of regulation

• Government must have sufficient knowledge to determine the optimum level of regulation

• Enforcement is expensive and hard

What is government failure?

When government intervention actually leads to a worsening of the overall allocation of resources, increasing allocative inefficiency and net welfare loss

What are the advantages of tradable pollution permits

• Enables a specific level of pollution to be achieved

• Polluter pays principle holds - the firms causing the most harm pay the highest price

• Could bring revenue to the government

• Provides incentives for firms to go green

What are the disadvantages of tradable pollution permits?

• Optimal level of pollution is unknown and difficult to estimate

• Difficult to fairly allocate these permits - if they are given to the largest firms barriers to entry are increased

• Difficult to enforce

What are the advantages of information provision

• Reduces over / under production and consumption arising from lack of information

• Consumers can make choices based on more complete information and uncertainty for firms is reduced

What are the disadvantages of information provision

• May be expensive and imposes opportunity costs

• May not be effective as it assumes homo economicus - consumers are not always rational and provision of information doesn’t really do much in that instance