What is the purpose of indirect taxation (ad valorem and specific) in various contexts in correcting market failure using diagrams?
In the free market, goods and services that produce negative externalities are often produced at quantities above the social optimum. Indirect taxation can be used to correct this market failure, resulting in firms internalising (facing the costs of) the negative externality.
For example, in the diagram above, at the original market equilibrium price of P and the original market equilibrium quantity of Q, the good or service that is being produced may be being produced at a quantity greater than the socially optimum level if the good or service creates large negative externalities. As a result, the government can apply a specific tax on this good or service which results in an inward vertical shift of the supply curve from S to S1. This results in a fall in the equilibrium quantity to Q1, meaning the quantity of the good or service that produces the negative externality is likely to fall closer to the socially optimal quantity, correcting the market failure of this good or service being produced at quantities far above the socially optimal quantity.
In the diagram above, the good or service which was being produced at the market equilibrium price of P and the market equilibrium quantity of Q may have been produced at a quantity greater than the socially optimal level, resulting in the imposition of an ad valorem tax on the good or service. As a result, there has been an inward pivotal shift of the supply curve from S to S1. This has resulted in a fall in the quantity of the good or service produced from Q to Q1, likely meaning that the quantity of the good or service produced is now closer to the socially optimal quantity, correcting the market failure that occurred within the free market, where the quantity of the good or service being produced was far greater than the socially optimal quantity.
Indirect taxes (ad valorem and specific) are imposed on a wide variety of goods and services with negative externalities, with common examples being cigarettes and alcohol.
What is the purpose of subsidies in various contexts in correcting market failure using diagrams?
In the free market, goods and services that produce positive externalities are often produced at quantities below the social optimum. Subsidies can be used to correct this market failure.
As shown in the above diagram, a subsidy has resulted in an outward shift of supply from S to S1. This subsidy is likely given to firms that produce goods and services which produce positive externalities. As a result of the outward shift of supply, there has been an increase in the quantity from Q to Q1, likely resulting in the quantity of the good or service that produces positive externalities now being closer to the socially optimal level. This is because, in the free market, the quantity of goods and services that produce positive externalities is often below the socially optimal level, and thus subsidies are helpful in correcting this market failure as the quantity of these goods and services that produce positive externalities is likely to rise.
Subsidies may be given to firms that produce goods or services with positive externalities, for example, firms in the healthcare industry or firms involved in research and development.
What is the purpose of maximum and minimum prices in various contexts in correcting market failure using diagrams?
A maximum price is often introduced on goods and services when the government is trying to improve equality of access to these goods and services, correcting the market failure of poor equality of access to certain goods and services. For example, the government may introduce maximum prices on rent on houses, or maximum prices on energy.
The diagram above shows a maximum price being introduced at P1. A maximum price is likely to result in excess demand as the quantity demanded (Qd) is greater than the quantity supplied (Qs) at the maximum price of P1.
A minimum price is often introduced to protect incomes. For example, a minimum price of coffee may help to ensure a basic income for a farmer who produces coffee. Moreover, a minimum wage rate (which is the minimum price of labour) helps to ensure that workers have a basic income.
The diagram above shows a minimum price of P1 being introduced. This creates excess supply as the quantity supplied (Qs) is greater than the quantity demanded (Qd) at the price of P1.
What is meant by the trade of pollution permits (as another method of government intervention)?
Governments may introduce tradable pollution permits in order to correct the market failure of high levels of pollution which may occur without government intervention taking place. When governments introduce tradable pollution permits, the government gives out a fixed amount of permits. Firms can then buy and sell these permits according to how much they need to pollute. Firms that need to pollute more will thus need to purchase more tradable pollution permits, resulting in these firms internalising the negative externality of greater pollution. These tradable pollution permits incentivise producers to reduce the amount they pollute, as producers can make a profit when they sell permits, thus helping to reduce pollution. Moreover, producers may be incentivised to invest in green energy to reduce the number of tradable pollution permits they require in the future so that they can sell their spare tradable pollution permits for a profit. This increase in investment in green energy is likely to reduce pollution in the future.
What is meant by the state provision of public goods (as another method of government intervention)?
Without government intervention, there may be very few public goods as a result of the free rider problem. Public goods suffer from the free rider problem, as those who use public goods may not always pay for this use, meaning that firms aren't incentivised to produce these public goods. As a result, the government may intervene to increase the amount of public goods available to correct the market failure of public goods not being sufficiently provided by the markets.
What is meant by the provision of information (as another method of government intervention)?
Without government intervention, economic agents may not have sufficient information or knowledge about the costs and benefits of certain goods and services. The government may intervene to correct this market failure and provide information, for example through public information advertisements, to ensure economic agents have sufficient knowledge and information.
What is meant by regulation (as another method of government intervention)?
Regulation is where the government enforces rules which aim to reduce the level of market failure in the economy. For example, firms that produce food may be required to be assessed on hygiene and display their hygiene ratings. This helps to provide consumers with knowledge of the standard of the food, reducing market failure.
What is government failure (regarding intervention that results in a net welfare loss)?
Government failure occurs when the government intervenes in the economy, but the benefits gained from this intervention are smaller than the costs of this intervention, resulting in a net welfare loss.
How is the distortion of price signals a cause of government failure?
Governments may introduce minimum prices in order to improve the equality of access to a good or service. However, minimum prices may result in excess supply. Moreover, governments may introduce maximum prices, for example by setting a maximum price on sugar to protect farmers that produce sugar. However, maximum prices are likely to result in excess demand. These examples of intervention are likely to distort price signals, meaning that the costs incurred by the intervention may outweigh the benefits, resulting in government failure.
How are unintended consequences a cause of government failure?
When a government intervenes within an economy, some effects may occur that the government didn't mean to happen. For example, if a government bans a good or service, a black market may be created for this good or service, and the government may have to divert a lot of resources towards eradicating the black market. Unintended consequences of government intervention may mean that the costs incurred by the intervention may outweigh the benefits, resulting in government failure.
How are excessive administrative costs a cause of government failure?
Governments may incur high levels of administrative costs. Due to potential inefficiencies, large amounts of money may be spent on administration and organisation rather than directly on the economy. For example, when the government spends money on infrastructure, more money may be spent on the organisation and administration of the infrastructure project, rather than being directly spent on the infrastructure project itself such as on purchasing equipment to construct a new bridge. Whereas, without intervention, spending by economic agents such as firms is likely to be much more efficient As a result, money may be inefficiently spent, meaning that the costs incurred by the intervention may potentially outweigh the benefits, resulting in government failure.
How are information gaps a cause of government failure?
Governments are unlikely to have all the information available to them before they intervene in the economy. This is because collecting large amounts of information and data may be expensive, and some of the information they collect may be inaccurate. As a result, the costs incurred by the government intervening within the economy, as a result of not having perfect information, may potentially outweigh the benefits of the intervention, resulting in government failure.
How does government failure occur in various markets?
Government failure is likely to occur in various markets. For example, in the labour market, a higher national minimum wage may result in there being an excess supply of labour, potentially meaning that some workers who earn a wage rate close to the national minimum wage rate may become unemployed as producers may not be able to hire as many workers at this higher wage rate as a result of a higher national minimum wage. Another example could be within the market for agricultural goods. If the government purchases large amounts of agricultural goods to try and guarantee a basic income for producers that produce agricultural goods, the price of the agricultural may rise significantly, which decreases the affordability of agricultural goods for lots of consumers. As a result, the potential costs of this intervention in terms of loss of affordability of agricultural goods may be greater than the benefits of a higher income for producers if the rise in price is significant, resulting in government failure.
How are mergers controlled by the government?
In the UK, the CMA oversees any merger that takes place. The CMA ensures that mergers don't lead to a substantial reduction in competition within the market. The CMA assesses the potential effects on price, quality and choice of goods and services from the merger, and has the ability to block the merger if they believe that it will lead to a significant reduction in competition.
What is price regulation and how does it help to control monopolies?
Price regulation is where the government prevents monopolies from charging very high prices for their goods and services and exploiting their market position.
A common approach is the RPI-X formula which is used within the UK. The RPI stands for Retail Price Index, which acts as a benchmark in measuring inflation. X is the adjustment permitted to the RPI and is known as the efficiency factor.
For example, say the RPI was 5% and regulators determined that X was 2%, the monopoly can only increase their prices by a maximum of 3% (5% - 2%).
What is profit regulation and how does it help to control monopolies?
Profit regulation is where the amount of profit a firm makes is limited so that the firm doesn't exploit its market position.
The most common form of profit regulation is the 'rate of return' regulation which was developed in the US. It works by calculating the operating costs of a firm and then allowing the firm to earn a 'fair' rate of return which would be a typical rate of return earned in a competitive market. Any profit earned above the 'fair' rate is taxed at 100%. However, there may be information asymmetries on where to set the 'fair' rate and if additional profit is always taxed away, there is likely to be no incentive for the firm to improve its efficiency.
Regulators can also impose a windfall tax. This is a tax on excessive profits, which is meant to encourage firms to reinvest their profits rather than simply give them out in the form of dividends to shareholders.
What are quality standards and performance targets and how do they help to control monopolies?
Quality and performance standards are where regulators set standards for the quality of goods and services and the achievement of specific outcomes such as high levels of efficiency.
Monopolies often produce lower-quality goods and services in order to save money, so regulators may set quality targets to prevent this. For example, the UK regulator in the gas and electric market, OFGEM, ensures that elderly people are treated with concern by not allowing a firm to cut off gas supplies to them in the winter.
Punctuality targets can also be set such as on train operating companies where there is an expectation that trains arrive and depart on time to ensure reliability.
What are some forms of government intervention that promote competition and contestability?
What are some forms of government intervention to protect suppliers and employees?
What is the impact of government intervention on prices, quality, choice, efficiency and profit?
How does regulatory capture limit government intervention?
Regulatory capture is where a regulator is influenced or controlled by the industry it is meant to regulate, often leading to decisions that favour the interests of the regulated firms over those of the public. It can lead to policies that worsen competition and consumer welfare. Hence it limits government intervention by skewing regulatory decisions.
How does asymmetric information limit government intervention?
Regulators often rely on firms to provide them with information based on their costs and profitability. However, firms may lie and provide inaccurate information, leading to less effective interventions.
