1.4.1: Government Intervention in Markets

• Governments intervene in markets in order to prevent market failure
• Indirect taxes are taxes on expenditure. They increase costs of production, which reduces supply
• Types of indirect taxes:

  Ad Valorem tax: Tax in percentages e.g 20% VAT tax

  Specific tax: Set tax per unit, e.g 58p per litre fuel duty
• Indirect taxes reduce quantity of demerit goods consumed by increasing the price of the good. If the tax is equal to the external cost of each unit, supply curve becomes marginal social cost rather than marginal private cost, making the curve socially optimal
• Subsidy: Payment from the government to a producer to lower their costs of production and encourage more production
• Subsidies encourage consumption of merit goods, including the full social benefit, which internalises external benefits and makes the curve more socially optimum
• Consumers gain more from subsidies when demand is price inelastic, and producers supply more when it is price elastic
• Disadvantages of subsidies:

  Opportunity cost to government

  Firms may become inefficient due to reliance on the subsidy

  Governments may fail is they subsidise less efficient industries
• Maximum price: Where a good cannot be sold for more than a given price. Governments to this to encourage consumption/production, so a good doesn't become too expensive to produce or consume
• Maximum prices could increase welfare gains for consumers and efficiency in firms
• Maximum prices could reduce a firm's profits, reducing investment in the long run. Firms might also raise prices on other goods to counteract the maximum price, so consumers have no net gain
• Minimum price: Where a good cannot be sold for less than a given price. Governments use it to discourage consumption/production of a good e.g minimum price on alcohol so less people can buy it
• Maximum prices must be set below the equilibrium/free market price and minimum prices must be set above it
• Tradeable pollution permits: Permits that allows the owner to pollute up to a certain amount. Firms can buy and sell them to each other
• Advantages of tradeable pollution permits:

  Encourages firms to use green production methods

  Government gains revenue from selling these to firms
• Disadvantages of tradeable pollution permits

  Firms may relocate to places where they can pollute without limit

  Expensive for the government to monitor all emissions

  Firms might pass on the extra costs to consumers
• State provision of public goods: Government provides public goods which are underprovided in the free market. This makes merit goods accessible but might be expensive for governments
• Provision of information: Governments provide information to ensure there is no information failure, helping consumers and firms be more rational. However this is expensive to regulate
• Regulation: Government usage of laws to ban consumers from doing or not doing something. These laws may create positive externalities, but may also increase costs of firms and/or consumers. There would also be high administrative costs