1.4 Government Intervention

• Indirect taxation can be introduced by the government when a good has a negative externality to prevent market failure
• Introduction of indirect taxation causes a fall in supply and increases costs to the individual, shifting the supply curve/MPC curve from S1 to S2
• In the free market, the equilibrium position is at P1Q1 where MPC=MPB, but the social optimum position is at P2Q2 where MSB=MSC
• After the tax, the equilibrium position is at S2=MPB=MSB, at P2Q2, internalizing the externality and maximizing social welfare
• Advantages of indirect taxation:

  • Internalizes the externality, producing at the social equilibrium position
  • Raises government revenue, which can be used to solve externalities in other ways such as through education
• Disadvantages of indirect taxation:

  • Difficult to know the size of the externality and target the tax
  • Conflict between raising revenue and solving the externality
  • Could lead to the creation of a black market
  • Ineffective if demand is inelastic
  • Politically unpopular and regressive
• Subsidies can be introduced by the government to solve positive externalities
• Introduction of subsidies shifts the supply curve to the right, lowering the cost of production
• In the free market, equilibrium is at Q1P1 where MPC=MPB, but the social optimum position is at P2Q2 where MSC=MSB
• After the subsidy, the equilibrium point is at Q2P3, maximizing social welfare
• Advantages of subsidies:

  • Reaches social optimum output and maximizes welfare
  • Can have other positive impacts such as encouraging small businesses and bringing about equality
• Disadvantages of subsidies:

  • Government spending has a high opportunity cost
  • Difficult to target and can cause producers to become inefficient
  • Difficult to remove once introduced
• Maximum and minimum prices can be set by the government to address externalities
• Maximum price is set below the current equilibrium price to prevent exploitation and excess demand

  • Can be set on goods with positive externalities
• Minimum price is set above the current equilibrium price to raise it to the social optimum point and discourage consumption

  • Can be set on goods with negative externalities or underprovided social benefits
• Advantages of maximum and minimum prices:

  • Can help increase social welfare by considering externalities and reducing poverty
• Disadvantages of maximum and minimum prices:

  • Distortion of price signals leading to excess supply/demand
  • Difficult for the government to set prices accurately
  • Can lead to the creation of black markets
• Pollution permits allow companies to pollute up to a specific amount, controlled by the government
• Advantages of pollution permits:

  • Guaranteed reduction in pollution to government targets
  • Raises revenue for the government and encourages green technology
• Disadvantages of pollution permits:

  • Expensive to monitor and police
  • Raises costs for businesses and may be passed onto consumers
  • Difficulty in determining the number of permits allowed
• Sulphur trading scheme reduced sulphur dioxide by 40%
• EU Emissions Trading Scheme (ETS) launched in 2005, representing a 21% reduction in greenhouse gases
• Other greenhouse gases like nitrous oxide have been included in the scheme
• The scheme has been extended to the airline industry
• Permit scheme introduced in China
• Public goods are non-excludable and non-rivalry, leading to under-provision by the free market and market failure
• Government provides public goods directly through taxation to correct market failure and improve social welfare
• Government can provide merit goods to ensure everyone has access to basic goods and services
• Advantages of government provision of public goods:

  • Corrects market failure
  • Helps bring about equality
  • Benefits of the goods themselves, such as improving economic growth through healthcare
  • Ensures efficiency through competitive tenders
• Disadvantages of government provision of public goods:

  • Expensive with high opportunity cost
  • Market not involved, leading to potential wrong combination of goods
  • Government may be inefficient at production
  • Risk of corruption and conflicting objectives
• Government provides information to allow informed decisions in the presence of asymmetric information
• Advantages of government provision of information:

  • Helps consumers act rationally
  • Can make demand more elastic in the long run
  • Helps indirect taxes become more effective
• Disadvantages of government provision of information:

  • Expensive for the government
  • Government may not always have all the information
  • Consumers may not listen due to irrational behavior
• Regulation allows governments to impose laws and caps to ensure levels are set where MSB=MSC or to provide full information on products
• Advantages of regulation:

  • Ensures consideration of externalities
  • Prevents exploitation of consumers
  • Maximizes social welfare
• Disadvantages of regulation:

  • Laws may be expensive to monitor
  • Less efficient compared to tradable pollution permits
  • Risk of regulatory capture
  • Firms may pass on costs to consumers
  • Excessive regulation may reduce competition and efficiency
• Causes of government failure:

  • Distortion of price signals
  • Unintended consequences
  • Excessive administration costs
  • Information gaps
• Examples of government failure:

  • Subsidies keeping inefficient companies in business
  • Maximum and minimum prices leading to resource allocation issues
  • Buffer stock scheme in the EU causing overproduction
  • Targets for treating patients on the NHS leading to reduced quality of care
• Excessive administration costs can lead to a misallocation of resources and higher social costs than benefits
• Information gaps can result in wrong cost and benefit forecasts, leading to welfare loss