Government intervention in markets

A) Purpose of intervention with reference to market failure and using diagrams in various contexts:


Indirect taxation (ad valorem and specific)

Unlike direct taxes indirect taxes can be passed onto consumers and therefore can be an effective policy when trying to reduce consumption through higher prices. This is ideal for the government as it allows them to deal with negative externalities in either production or consumption.

Ad valorem tax

An ad valorem tax is a percentage tax rather than a specific one. This means that rather than paying a fixed amount on each unit sold, a percentage of the final valuation of the good/service is paid. An example of this is VAT which is currently at 20% in the UK. As it is a percentage rate it means that the more expensive the good/service is, the more tax that is paid. This is represented by the two supply lines moving further and further away from each other as the price of the good/service increases. If the price of the product is £0 then £0 tax will be paid as 20% of £0 is £0. If the price is £100 then £20 will be paid. If the price is £1000 then £200 in VAT will be paid. As you can see, the amount paid in VAT increases as the value of the good/service does.

Indirect tax new

On the other hand specific taxes are fixed amounts of money that are paid on each unit of goods/services. This means that the tax will stay the same regardless of the products price. Therefore, the two supply curves are parallel to each other. The implementation of the tax reduces supply from S1 to S1+Tax. This causes an increase in the price of the good/service, resulting in a reduction in quantity (Q1 to Q2). The area P2-d-e-P1 represents the burden of the tax that falls onto the consumer, whereas the area P1-e-c-b represents the burden to the producer.

An example of a specific indirect tax used to reduce negative externalities is excise duty. This is a tax on a range of demerit goods such as cigarettes and alcohol. These goods are often over consumed meaning that quantity and price are at the private optimum point rather than the socially optimum point, resulting in a welfare loss to society. By implementing an excise duty, consumption of these goods decrease, resulting in the market operating closer to the socially optimum point thus reducing the welfare loss to society.

However, there are disputes about how effective this tax has been due to the items included in the excise duty being relatively price inelastic. Therefore, despite the big increase in price that the excise duty causes, consumption decreases by a less than proportionate amount. This is often one of the negatives of using an indirect tax to decrease the consumption of products that have an addictive nature to them. This is a great evaluation point to use when writing essays on the effectiveness of indirect tax on reducing overconsumption/production (the effectiveness depends on the price elasticity of the good).

Another negative of indirect taxation is the rise in black markets that can take place as a result of the tax. The increase in price that the indirect tax causes can make room for black markets. Resources then have to be spent by the government in order to tackle this problem, negating the benefit of the indirect tax revenue.

One big benefit of the indirect tax is the revenue that the government gain. This can then be invested in other schemes designed to reduce the negative externalities further, such as information campaigns e.g. on the negative health effects of consuming cigarettes. A good example of this is the sugar tax. The revenue gained from the sugar tax is then spent on school programs that encourage physical activity and balanced diets, helping to reduce the problem of obesity further.



Subsidy diagram

Market failure is also caused by through the under consumption and underproduction of merit goods. In order to fix this market failure, government can intervene in the market and implement a subsidy. This increases supply due to the increased profit revenue and lower consumer prices that a subsidy results in.

The main benefit of the subsidy is that it increases the quantity consumed/produced of the good/service thus reducing the welfare loss to society caused by under consumption/production.

Subsidisation can be seen in the UK educational system. Universities get the majority of their funding from government funding bodies, allowing universities to offer a lower price to students. In 2012 around 35% of university funding came from subsidies given out by the government. This helped to reduce the problem of the under consumption of higher education. The lower price this results in increases consumption and therefore increases the positive externalities caused by higher education. The benefit to the consumer is represented by the area P1-d-e-P2. The benefit to producers is represented by the area a-b-f-p1).

One disadvantage of a subsidy is that it is very expensive for the government to implement. This cost is shown by the area a-b-c-P2. The large cost of this also means that there is a large opportunity cost. If the subsidy is relatively ineffective, then the subsidy would have been far better spent on other areas e.g. information campaigns. The money used for the subsidy could have also been taken away from different areas e.g. the police force, which is likely have a negative effect on their performance.

Furthermore, not all of the subsidy is passed onto the consumer, some of the subsidy can be kept by the producer. This is problematic if the purpose of the subsidy is to increase consumption, especially if the demand for the good/service is price elastic. Subsidies also result in producer inefficiency as they become reliant on it in order to survive in the market. Therefore by subsidising the firm it distorts free market outcomes.


Maximum and minimum prices

Maximum price

Maximum prices are set in order to try and increase the consumption of a good/service that is being under consumed. As shown from the diagram, the maximum price set (Pmax) causes an increase in the quantity of the good/service demanded (Q1 to Qd). However, due to the lower price forced onto the market, the supply of the good/service falls. This is due to the lower price which disincentives producers to continue producing the same level of good/service as they currently do and may even force more inefficient firms out of the market. As the supply of the good/service is now less than the demand, there is an excess in demand. A real life example of this was in Cyprus when they implemented a price cap of €1.32 per litre on wholesale milk in 2013 in order to control excessive prices and increase consumption.

Minimum price

On the other hand, minimum prices can be set to reduce the consumption of a good/service which causes negative externalities. The minimum price reduces the demand for the good/service as consumers now have to pay a higher price than before (P1 to Pmin). However, this higher price encourages firms to increase the quantity of the good/service that they produce due to the profit motive. This results in quantity supplied being greater than quantity demanded thus resulting in an excess of supply. A good example of a minimum price is in Scotland where they have recently implemented a minimum price on alcohol which will take effect on the 1st May 2018. This will be set at 50p a unit and aims to reduce the consumption of alcohol which has a range of negative health effects.  


B) Other methods of government intervention:


Trade pollution permits

Governments will often implement a trade pollution permit scheme in order to tackle market failure as a result of excessive pollution. The government decides the limit for pollution and distributes pollution permits according to this limit. Permits given will represent the size of the business rather than distributing them equally in order to give them pollution requirements which are realistic. Firms can either reduce their pollution levels to match their number permits, or they can buy pollution permits off other firms. If firms continue to emit levels of pollution over the limit then they will face a fine. Although firms are able to buy permits, they are incentivised to reduce their pollution levels as they are able to sell any remaining permits to other firms. In order for the scheme to work, fines must be more than the cost of investing in greener technologies and the cost of buying other permits. Overall, the firm will face increased costs in the short term regardless of their decision. As a result of this, supply will decrease, reducing supply and therefore pollution also. Governments can set the pollution limit to match the socially optimum point thus getting rid of the overproduction problem. Although governments are intervening, the permit scheme is still a market based solution which reduces the negative impacts that intervention can result in.

Tradable pollution permits

The permit scheme can be represented in the diagram above. S1 represents the pollution permits available to firms. This is a fixed quantity hence the vertical line. The demand curve represents the demand for pollution permits by firms, resulting in a price of P1 and a quantity of Q1.

The main problem with trade pollution permits is deciding the level of permits that should be set. In order to do this properly, governments must have perfect information. However, this is often not the case. This results in either too many permits being handed out, having  little impact on existing pollution levels, or too few permits being given out which can massively increase firms costs and force some of them out of the market entirely.

In addition to this, the administration costs involved in a trade pollution permit scheme are high. This is due to the fact that the government must hire people to check the pollution levels of each firm to see whether or not they’re breaking the limit. It can also be very difficult to measure pollution levels which can make the policy difficult to implement.

The best example of a pollution permit scheme in the real world is China’s national cap-and-trade program. This is a national carbon trading scheme and it is aimed at tackling China’s massive pollution problem.

State provision

State provision of public goods

The government may decide to provide merit or public goods themselves as they believe that the free market will not do a good enough job regardless of other types of intervention, such as subsidies. This can be seen in the UK with Education and the NHS. Although these services are paid for through taxes, at the point of consumption they are free to consumers. This is represented by the price 0 in the diagram. The vertical supply line represents the fixed amount of resources that the government provides in the market. This results in a quantity of Q1. However, as the price is 0 it means that there is no price rationing function. As a result of this, there is an excess of demand from units Q1 to D1.

State provision allows the government to make sure that the market which they are providing a good/service in operates at the socially optimum point. This is because unlike private firms, the government takes into account external costs and benefits when providing goods/services. As a result of this, the welfare loss caused by positive externalities as well as missing markets for public goods will no longer exist. In addition to this, state provision enables those who are less well-off to enjoy the benefits that these goods/services bring. This can help to reduce inequalities within society.

The main disadvantage of state provision is the massive opportunity cost to the government. In 2018 the Government plans to spend 18% of their total budget on healthcare, which is around 142.9 billion pounds. If state provision turns out to be unsuccessful in fixing the market failure then it will be a very costly mistake.

In addition to this, the provision of these goods/services by the state gets rid of the profit motive. As a result of this, there can be massive inefficiencies which can be very costly. This is an example of one of the many benefits that the private sector brings which will be lost as a result of state provision. The loss of these benefits is another negative of state provision.

The overall benefit derived from state provision will be based upon the state’s ability to ration the excess demand that exists. If they are unable to do this then large amounts of consumers will miss out on the benefits from the consumption of these goods/services. An example of how the UK government does this is through the use of waiting lists for the NHS service as well as outsourcing some of the work to the private sector.


Provision of information

The government may decide to solve market failure through the provision of information. This can be an effective policy decision when trying to fix markets that have failed as a result of information gaps or asymmetric information.

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