1.5.2 Methods of government intervention to correct distortions in individual markets

Can you remember 5 reasons for government intervention?

AQA ECON 1: MARKETS AND MARKET FAILURE

1.5.2 WHAT YOU NEED TO KNOW

Candidates should be able to use basic economic models to analyse and evaluate the use of indirect taxation, subsidies, price controls, buffer stocks, pollution permits, state provision and regulation to correct market failure

THE WAYS IN WHICH GOVERNMENTS INTERVENE TO

CORRECT MARKET FAILURE

There are a number of ways in which governments can intervene to correct market failure

These include:

Indirect taxes

Subsidies

Price controls

Buffer stocks

Pollution permits

State provision

Regulation

INDIRECT TAXES

Taxation is the medium through

which governments finance their spending

and control the economy. It is a

charge imposed on products, individuals

and businesses.

An indirect tax is a tax on a good or a service.

A direct tax is a tax on an individual or an

organisation.

The incidence (or burden) of tax is the

amount that the consumer (or

producer) will pay for the tax.

The imposition of an indirect tax will lead to an increase in the cost of supply for a firm. This will lead to a shift in the supply curve up and to the left. Quantity supplied will decrease by Q-Q1. P will increase from P to P1.

The increase in tax has caused the price to rise by the vertical distance between the supply curves. The incidence (amount) of the tax paid for by the producer is shown by the blue line (equivalent to P-P0). The incidence of the tax paid for by the consumer is shown by the green line (P1-P).

The revenue raised for the government by the tax is the distance from P0 to P1 multiplied by Q1.

S with tax

Price

Quantity

D

P

Q

S

P1

Q1

P0

Tax

What would be the impact of an indirect tax on alcohol, cigarettes, fatty foods and gambling?

To what extent do the government tax products because they are demerit goods?

SUBSIDIES

A subsidy is a financial incentive to produce or consume

a given product.

S

Price

Quantity

D

P

Q

S with subsidy

P1

Q1

Subsidy

The imposition of a subsidy will lead to a decrease in the cost of supply for a firm. This will lead to a shift in the supply curve down and to the right. Quantity supplied will increase by Q-Q1. P will decrease from P to P1.

The subsidy has caused supply to rise by the vertical distance between the supply curves. The subsidy will be shared between the consumer and the producer.

Should the government be using subsidies to combat climate change? Use a diagram to show how this might work.

Do wind farms rely too heavily on

government subsidies?

PRICE CONTROLS

A price control is when the

government set maximum or

minimum prices for a good or service.

SPrice

Quantity

D

P

Q

P1

The imposition of a minimum price at P1 will lead to excess supply of Q1 Q2 as firms will wish to supply more at a higher price.

The national minimum wage was introduced by the Labour Government in 1999 in attempt to redistribute income to low paid workers.

Some commentators suggested that the demand for workers would be lower than the equilibrium level and there would be an excess supply of labour.

Minimum wagein the UK.

Q1 Q2

PRICE CONTROLS

Should there be controls on rent in order to provide affordable

housing?

SPrice

Quantity

D

P

Q

P1

The imposition of a maximum price at P1 will lead to excess demand of Q1 Q2 as consumers will wish to demand more at a lower price.

The government may wish to impose a maximum price to prevent the consumer from being exploited.

Ticket prices at the 2014 World Cup. Do you think FIFA could charge more

for a final ticket.

Q1 Q2

BUFFER STOCKS

A buffer stock occurs when the

government store agricultural products and commodities in order to maintain stable prices in a

market.

This is common in agricultural markets where supply can be severely affected by weather conditions.

SPrice

Quantity

D

Q

S1

P

Q1

The government keep stock in reserve in order to maintain market equilibrium and guarantee farmers a minimum price for their produce.

The government set a target price of P where output is Q. If there is a decrease in supply e.g. due to a poor harvest the supply curve will shift to S1. The government will release some of its buffer stock and increase supply back to its original equilibrium at PQ.

If there is a bumper harvest supply will increase to S2. The government will buy up stock in order to increase price. Again, the market returns to equilibrium at PQ.

S2

Q2

POLLUTION PERMITS

Pollution permits allow firms to produce a legal level of pollution every year

Permits are tradable on the market

If a firm does not use all of its permits it can sell them to other firms that pollute above their allowance

This provides a financial incentive for firms to reduce pollution

Trading schemes seek to reduce CO2 emissions globally

It is difficult to assess the amount and level of permits to provide to firms

Pollution permits seek to provide an incentive

to businesses on a global scale to reduce

CO2 emissions.

Due to the recession EU production has fallen so there has been an excess of

pollution permits on the market.

This increase in supply of pollution permits

has been coupled with a fall in demand as firms produce less.

This has led to a fall in their price making the scheme less effective.

Using the market to reduce negative externalities.

POLLUTION PERMITS

Price(pollution

rights)

Quantity(pollution rights)

D

P

Q

S (legal right to pollute)

P1

D1

The government issue a fixed amount of pollution rights in the economy. Therefore, supply is perfectly inelastic as it cannot change.

If there is an increase in demand for pollution permits (the legal right to pollute) demand will shift from D to D1 and the price of these tradable permits will increase.

Firms will either pay more for the right to pollute or they will be incentivised to reduce pollution. Those who do not need their permits can sell them on the market.

Governments can enforce stricter pollution control by reducing the number of tradable permits to Q1. This will lead to a shift in the supply curve to S1 leading to higher prices and a higher cost to firms of creating pollution.

S1

Q1

Recap.What is meant by the term perfectly inelastic supply?

How do pollution permits work?

STATE PROVISION

State provision occurs when the government (or state) intervenes in the market in order to supply a good or a service

This will occur if the government believes that the product is:

A merit good

The government supplies goods and services such as state education and health e.g. NHS as society believes that these are under provided by the market mechanism

A public good

The government supplies goods and services such as defence and infrastructure e.g. roads as these would be under provided by the private sector due to the free rider problem

State provision occurs when goods

and services are either merit goods or

public goods. The government will

intervene to ensure that an adequate supply of these

products is available to the market.

How important is state provision of

education in Brazil?

REGULATION

Regulation is undertaken by government to create competitive markets

The government believes that this will protect the interests of consumers so that they are not exploited by firms

Effective regulation will lead to greater choice and lower prices

Regulation takes place in a number of industries such as telecoms, water and energy

A key reason for regulation is to create conditions for continued investment in infrastructure in important areas of the economy

Regulation occurs when the

government seeks to provide effective

competition within markets.

Do e-cigarettes need regulation?

QUICK TEST

One reason that governments intervene is

a) To increase the supply of demerit goods

b) To reduce the supply of merit goods

c) To issue pollution permits

d) To minimise negative externalities

Can you explain your answer?

QUICK TEST

As a result of a government subsidy the supply curve shifts from S to S1. The subsidy is shown by

a) xy

b) wy

c) yz

d) xz

Can you explain your answer?

S

Price

Quantity

D

S1

x

yz

w

QUICK TEST

The Government wants to encourage greater supply of a merit good. Which action would be appropriate?

a) Reduce subsidies

b) Increase taxation

c) Reduce regulations

d) Issue less tradable pollution permits

Can you explain your answer?

TEST YOURSELF

1. To what extent can regulations be used to correct market failure in the fast food industry?

2. To what extent is the provision of information through health warnings on cigarettes the most effective way to correct market failure in this industry?

3. Discuss the extent to which a subsidy to producers of organic fruit and vegetables might increase their consumption, thus generating positive externalities.

4. Discuss the extent to which pollution permits are the most effective way of correcting market failure caused by CO2 emissions.

5. Discuss whether indirect taxes on aircraft travel should be increased.

6. Discuss the extent to which all health care should be provided privately.

The final question on ECON 1 is worth 25

marks.

You should build your argument through a

number of steps:

1. Knowledge and understanding

2. Application3. Analysis4. Evaluation

It is important to ensure that each step is evident before moving up to the

next exam skill e.g. knowledge then application, then

analysis, then evaluation.

Have you used a diagram to analyse your answer? Subsidies, indirect taxes, pollution permits,

externalities, demand and supply etc. Economics is rooted in diagrams. They are your friend – use them!

To what extent do the costs of HS2 outweigh the benefits?