(1.4) Government Intervention

• Indirect taxation


  1. When the good has a negative externality, the government can introduce indirect taxation to prevent market failure

  2. This will cause a fall in supply and increase the costs to the individual, so the supply curve/MPC curve will shift from S1 to S2

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

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

  5. The tax internalises the externality and social welfare is now maximised
• This diagram shows a specific tax but an ad valorem tax could also be introduced, which would have the same effect, but the shift of the curve would look slightly different
• Advantages of indirect taxation

  • It internalises the externality- the market now produces at the social equilibrium position and social welfare is maximised
  • It raises government revenue, which could be used to solve the externality in other ways such as through education. This may help goods to become more elastic in the long run. The effect will depend on what the government does with the revenue they raise
• Disadvantages of indirect taxation


  • It is difficult to know the size of the externality and so it is difficult to target the tax; the effect depends on where the tax is set. The government suffers from imperfect information when setting the tax
  • There could be conflict between the government goal of raising revenue and solving the externality, which makes setting the tax difficult
  • It 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 and so governments may be reluctant to introduce them
  • They are regressive, meaning they the poor spend a larger proportion of their income on indirect taxes than the rich do
• Some examples of indirect taxes used for externalities in the UK are: landfill taxes, fuel duties, alcohol duties, tobacco duties, air passenger duties and sugar taxes
• Subsidies


  1. In order to solve positive externalities, the government can introduce subsidies

  2. Subsidies can also be introduced in order to fix information gaps

  3. This will shift the supply curve to the right as it will lower the cost of production

  4. The free market would produce where MPC=MPB at Q1P1 whilst the social optimum position is where MSC=MSB at P2Q2

  5. The introduction of the subsidy means that the equilibrium point is Q2P3, at the social optimum output

  6. This means that social welfare is maximised since the market produces at the output that best allocates resources
• Advantages of subsidies


  • Society reaches the social optimum output and welfare is maximised
  • They can have other positive impacts, such as encouraging small businesses, bringing about equality and encouraging exports
• Disadvantages of subsidies


  • The government has to spend a large amount of money, which will have a high opportunity cost
  • As with taxes, they are difficult to target since the exact size of the externality is unknown
  • Subsidies can cause producers to become inefficient, especially if they are in place for a long time
  • Once introduced, subsidies are difficult to remove
• Some examples of subsidies are those on: biofuels, solar panels, apprenticeship schemes, wind farms and rail industries
• Maximum and minimum prices

  1. For a maximum price to have an effect, it must be set below the current price equilibrium

  2. For a minimum price to have an effect, it must be above the current price equilibrium

  3. A maximum price is a legally imposed price for a good that the suppliers cannot charge above

  4. A minimum price is a legally imposed price at which the price of the good cannot go below
• Maximum price


  They are set on goods with positive externalities. For example, they are set on food as a lack of food will have a negative impact on the NHS. This approach has sometimes been applied to rents for accommodation when prices are too high. They can prevent monopolies from exploiting customers.
• The imposition of the maximum price


  There is excess demand of QD-QS, shown by the shaded area
• Minimum price


  They can be set on goods with negative externalities, so that the price is raised to the social optimum point and consumption is discouraged. They also encourage producers to produce goods, so can be set on goods with social benefits that are underprovided by the market.
• The minimum price is set at P2


  QD is demanded but QS is supplied so there is excess supply of QS-QD, shown by the shaded area
• Advantages of maximum and minimum prices

  • They can be set where MSB=MSC, so allow for some consideration of externalities, and so help to increase social welfare
  • A maximum price will ensure that goods are affordable, whilst a minimum price will ensure that producers get a fair price. Both of these are able to reduce poverty and can increase equity/equality
• Disadvantages of maximum and minimum prices

  • There is a distortion of price signals and this 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
  • It is difficult for the government to know where to set the prices, because of the difficulty of knowing the size of externalities and because it will have implications on the size of excess supply/demand
  • Both can lead to the creation of black markets. Maximum prices may also lead to illegal bribes or discriminatory policies in allocating goods
• Maximum prices have been implemented in Manhattan in the from of rent controls on properties. On top of this, there are price caps on milk, toilet paper, medicine, petrol and other key goods in Venezuela: this has led to the creation of a black market and the goods are no longer sold in supermarkets as the firms are unable to make a profit at those prices
• In Scotland, a minimum price has been imposed on alcohol. It targets the cheapest drinks, which aims to cut down on binge drinking, but it will have negative effects on poverty for those who are addicted. Minimum prices on Limousines in Nashville have stifled competition as the most price competitive firms are forced out of business
• Tradable pollution permits


  1. A pollution permit allows the owner to pollute up to a specific amount of pollution and the government controls how many permits there are so limits the maximum amount of pollution

  2. Companies have to buy permits in order to pollute so, in an attempt to cut costs and increase profits, companies may use greener technology

  3. Unused permits can be sold to other companies, hence why they are tradeable

  4. Companies exceeding their limit of pollution will face legal action

  5. 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 technology
• Advantages of tradable pollution permits


  • Since the government caps the number of permits, it is guaranteed that pollution will fall to the targets set by the government. This will maximise social welfare
  • The government can raise revenue by selling permits and by fining firms who exceed their pollution limit
  • This encourages companies to use and invest in green technology
  • Firms are able to make their own decisions about whether to cut pollution or buy more permits. This helps encourage efficiency, as seen by the numerical example
• Disadvantages of tradable pollution permits


  • This can be expensive to monitor and police, but it will only work if it is monitored well. The government needs to impose fines that are large enough to ensure firms follow the regulation
  • It will raise costs for businesses, and it is likely that these higher costs will be passed onto consumers
  • It may be difficult to know how many permits the government should allow
• One successful example is the US Sulphur trading scheme, which reduced sulphur dioxide by 40%. The EU Emissions Trading Scheme (ETS) was launched in 2005 and it represents a 21% reduction in greenhouse gases. Since then, other greenhouse gases like nitrous oxide have been included and the scheme has been extended to the airline industry. The permit scheme has also been introduced in China
• Public goods


  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
• State provision of public goods

  As a result, the government provides these public goods directly through taxation. Similarly, the government can provide merit goods
• Advantages of state provision of public goods


  • This corrects market failure by providing important goods which would otherwise not be provided. It will lead to improved social welfare
  • The government can ensure an equitable distribution of these goods
• The EU Emissions Trading Scheme (ETS) was launched in 2005 and it represents a 21% reduction in greenhouse gases
• Since then, other greenhouse gases like nitrous oxide have been included and the scheme has been extended to the airline industry
• The permit scheme has also been introduced in China
• Public goods


  Non-excludable and non-rivalry, leading to the free rider problem and under-provision by the free market
• Merit goods


  Goods that the government provides directly through taxation
• Advantages of state provision of public goods


  • Corrects market failure by providing important goods which would otherwise not be provided, leading to improved social welfare
  • Can help to bring about equality, by ensuring everyone has access to basic goods
  • Benefits of the goods themselves, for example by providing healthcare, the government ensures that the workforce is healthy and so this can improve economic growth
  • By using competitive tenders, the government can ensure efficiency
• Disadvantages of state provision of public goods

  • Expensive and represents a high opportunity cost for the government, administration costs are a problem
  • The government may produce the wrong combination of goods as consumers can not indicate their preferences
  • The government may be inefficient at production since they have no incentive to cut costs
  • Government officials may suffer from corruption and conflicting objectives
• In the UK, the government provides a number of goods including roads, education and healthcare
• The NHS suffers from severe underfunding and many schools are having their budgets cut
• More money is spent on improving railways than roads, even though 92% of all journeys in the UK are made on roads, suggesting incorrect resource allocation
• Asymmetric information


  When there is a lack of information, the government provides information to allow people to make informed decisions
• Advantages of government provision of information


  • Helps consumers to act rationally, which allows the market to work properly
  • It is best if the government uses this alongside other policies, for example it can make demand more elastic in the long run and so help indirect taxes to become more effective at reducing output
• Disadvantages of government provision of information

  • Expensive for the government to do, incurring an opportunity cost
  • The government themselves may not always have all the information, so it may be difficult to inform consumers
  • Consumers may not listen to the information provided due to irrational behaviour
• Examples of information provision


  • Labels on cigarette packages
  • Information campaigns on speeding, obesity, drinking and smoking
  • Consumer protection laws and industry standards
  • The 'traffic light system' on food
• Despite these information campaigns, many consumers still undertake harmful and dangerous activities