20 Markers

• reasons for government intervention:

  • support firms
  • correct market failure
  • collect government revenue
  • support low income households
  • promote equity (equality between poor and rich)
• market failure is caused when the price mechanism fails to allocate resources efficiently, leading to an over/under provision of resources
• To maximise profit, firms will not correct the misallocation of resources caused by market failure. Therefore the government needs to step in.
• Government intervention is often used to correct market failure by influencing the level of production or consumption
• Governments need revemue to provide essential goods, public goods and merit goods
• Government revenue is raised through taxation and the sale of goods/services
• Promote equity - reduce the opportunity gap between the rich and poor
• governments can intervene by supporting key firms to help them remain competitive
• intervention is used to redistribute income (tax the rich and give to the poor) to reduce the impact of poverty as a way to support low income households
• common methods to intervene:

  • indirect tax
  • subsidies
  • min price
  • max price
• indirect taxes are taxes paid on the consumption of goods and services
• Type of indirect taxes: specific and ad valorem tax
• specific tax: FIXED amount of tax
• ad valorem tax: set based on the VALUE of the good/service
• Specific tax

  Specific tax

  
• Ad valorem tax

  Ad valorem tax

  
• Ad valorem tax diagram analysis:

  • initial equilibrium at P1Q1
  • supply shifts left from S to S+tax
  • the two supply curves diverge because more tax per unit is paid at higher prices
• taxes don’t completely remove the welfare loss but it does bring the market closer to the optimum level of output
• taxes reduce the welfare loss
• governments intervene by taxing the production of demerit goods with negative externalities
• Merit goods - goods with external benefits that are under consumed
• Governments use subsidies to encourage the production of merit goods
• subsidies don’t fully reduce the welfare loss but it brings market closer to social optimum level of output
• Governments use max prices to help consumers
• maximum prices are prices set below the market equilibrium price
• max prices reduced the incentive to supply (Q1 to Q2) and increases the incentive to consume (Q2 to Q3)
• max prices create excess demand which then creates a shortage
• max prices allow consumers to benefit from lower prices but also excludes some from purchasing as a shortage is created
• max prices creating excess demand can cause black markets to arise
• governments set minimum prices to incentivise production of a certain good
• min prices are prices set above the market equilibrium price
• min prices make prices higher which increases incentive to supply and decreases incentive to consume
• min prices creates excess supply (glut)
• min price is set in agricultural markets to guarantee farmers income as their crop is sold at a higher price. However, the government will need to buy the excess supply and potentially export it
• if the cost of buying more permits is greater than the cost of investing in new technology, firms will want to switch to greener technology
• firms can sell their spare permits to gain additional revenue
• the price of buying another permit accounts as an additional cost of production
• Public goods are not provided by private firms due to the free rider problem
• government intervention methods:

  • regulation
  • state provision of public goods
  • provision of information
  • TPP’s
• government failure is when government intervention causes in an even greater net welfare loss