Theme 1 Topic 4

Question 1

Governments intervene to reduce market failure to : (5)

Answer 1

1. Eliminate negative externalities
2. Maximise positive externalities
3. Increase supply of merit goods
4. Reduce supply of demerit goods
5. Supply public goods that would be under supplied by the market

Question 2

Reduce inequalities in the distribution of income and wealth : (3)

Answer 2

1. Unequal distribution can lead to poverty
2. Tensions in society can be created
3. A breakdown in society causes further market failure

Question 3

Governments intervene to support UK industry :

Answer 3

Full employment is a government target.

Certain industries are more important than others as they employ large amounts of labour.

Infrastructure is essential if businesses are to provide quality services.

Question 4

6 ways in which a government can intervene to correct market failure :

Answer 4

1. Indirect tax
2. Subsidies
3. Maximum and minimum prices
4. Trade pollution permits
5. State provision of public goods
6. Regulation

Question 5

Taxation ?

Answer 5

Medium through which governments finance their spending and control the economy.

Question 6

Indirect tax?

Answer 6

Tax on a good or service.

Question 7

Direct tax ?

Answer 7

levied directly on an individual or an organisation’s income/profits and is paid directly to the government by the taxpayer.

Question 8

Incidence/burden tax ?

Answer 8

The amount that the consumer (or producer) will pay for the tax.

Question 9

Specific tax ?

Answer 9

Set amount per unit.

Parallel shift upwards in the supply curve.

Question 10

Ad valorem tax ?

Answer 10

% of the price of the good/service.

The more expensive tje product, the greater the tax on it.

Shifts supply curve upwards yet also tilts.

As prices increase, so do taxes.

Question 11

Indirect tax graph :

Answer 11

It increases the cost of supply for a firm, leading to a shift in supply to the left and upwards.

Quantity supplied falls. Prices increase (P-P1)l

Increase im tax causes price to rise by the vertical distance between the supply curve.

The incidence of the tax paid for by the producer is from P to P0.

The incidence of tax paid for by the consumer is from P1 to P.

Question 12

2 Advantages of indirect taxes :

Answer 12

1. It internalizes the externality, leading to production at the social equilibrium and maximizing social welfare.
2. It raises government revenue, which can be used to address the externality (e.g. education), potentially making goods more elastic over time. The effect depends on how the government uses the revenue.

Question 13

3 disadvantages of indirect taxes :

Answer 13

1. It’s hard to determine the size of the externality, making it difficult to set the right tax. The government faces imperfect information.
2. If demand is inelastic, the tax won’t effectively reduce output.
3. Taxes are regressive, meaning lower-income individuals spend a larger percentage of their income on indirect taxes than higher-income individuals.

Question 14

Examples of indirect taxes for externalities :

Answer 14

Fuel duties, landfill taxes, sugar taxes.

Question 15

examples of subsidies :

Answer 15

biofuels, solar panels.

Question 16

subsidies graph :

Answer 16

cause a decrease in costs of supply for a firm.
causes a shift in the supply curve down and to the right.
quantity supplied will increase by Q to Q1.
prices will fall from P to P1.

it causes supply to fall by a vertical distance between the supply curves.
it is shared between consumer and producer.

upper area : gain to consumers
lower area : gain to producers
both areas : government expenditure on subsidy

vertical line : incidence of subsidy in government

Question 17

2 advantages of subsidies :

Answer 17

1. society reaches the social optimum output and welfare is maximised.
2. they can have other positive impacts (e.g. encouraging exports)

Question 18

3 disadvantages of subsidies :

Answer 18

1. high opportunity cost for the government as they spend lots of money.
2. difficult to target since the exact size of the externality is unknown
3. once introduced, they are difficult to remove.

Question 19

price control ?

Answer 19

when the government sets max or min prices for a good/service

Question 20

advantage of max + min prices :

Answer 20

max price ensures all goods are affordable yet minimum prices ensure producers get a fair price.

these can reduce poverty and increase equality

Question 21

disadvantage of max + min prices :

Answer 21

hard for the government to know where to set prices.
hard to know the size of the externalities.
has implications on the size of excess supply/demand.

Question 22

maximum price graph :

Answer 22

• A maximum price at P1 causes excess demand (Q1Q2) because consumers want more at the lower price.
• The government may set a maximum price to protect consumers from being exploited.

Question 23

minimum price graph :

Answer 23

• A minimum price at P1 causes excess supply (Q1Q2) because firms want to supply more at the higher price.
• The National Minimum Wage (NMW), introduced in 1999, aimed to redistribute income to low-paid workers.
• Some argued that it could lead to lower demand for workers, causing excess supply of labor (unemployment).

Question 24

what is a minimum price ?

Answer 24

• A minimum price is the lowest price suppliers can legally charge for a good.
• It’s used for goods with negative externalities to increase price and reduce consumption.
• For it to be effective, the minimum price must be set above the current equilibrium price.

Question 25

what is a maximum price ?

Answer 25

- A **maximum price** is the highest price suppliers can legally charge for a good. - It’s used for goods with **positive externalities** and to **prevent monopolies** from exploiting consumers. - For it to be effective, the maximum price must be set **below the current equilibrium price**.

Question 26

what is a buffer stock scheme ?

Answer 26

- Both maximum and minimum prices are set. - Government buys excess supply when the price is below the minimum. - Government sells stock to meet excess demand when the price exceeds the maximum. - Prevents price fluctuations and provides stability. - Increases government costs.

Question 27

What is a subsidy ?

Answer 27

Money grant given to firms by the government to reduce costs of production and encourage an incessant in output.

Question 28

Tradable pollution permits :

Answer 28

- Firms are allowed to produce a legal level of pollution each year. - Permits are tradable on the market. - Firms can sell unused permits to those exceeding their allowance. - Provides a financial incentive for firms to reduce pollution. - Trading schemes aim to reduce global CO2 emissions. - Difficult to assess the correct amount and level of permits to provide.

Question 29

How do tradable pollution permits work

Answer 29

- Owners can pollute up to a specific amount, with the government controlling the total number of permits. - Companies must buy permits to pollute, encouraging the use of greener technology to cut costs and increase profits. - Companies exceeding their pollution limits face legal action.

Question 30

Tradable pollution permits graph:

Answer 30

The government issue a fixed amount of pollution rights in the economy. Therefore, supply is perfectly inelastic as it can’t change. If there is an increase in demand for pollution permits demand will shift right and prices increase. Firms will either pay more for the right to pollute, or they will be incentivised to reduce pollution. Governments can enforce stricter pollution control by reducing the number of tradable permits to Q1. causes a shift in supply to the left, leading to higher prices and a higher cost to firms of creating pollution

Question 31

Advantages of tradable pollution permits :

Answer 31

- The government caps the number of permits, ensuring pollution falls to target levels, maximizing social welfare. - The government raises revenue by selling permits and fining firms that exceed their pollution limits. - Encourages companies to use and invest in green technology. - Firms decide whether to cut pollution or buy more permits, promoting efficiency.

Question 32

Disadvantages of tradable pollution permits :

Answer 32

- Monitoring and policing can be expensive and must be done well for the system to work; fines must be large enough to ensure firms follow regulation. - Higher costs for businesses may be passed onto consumers. - It can be difficult for the government to determine the correct number of permits to allow.

Question 33

Example of tradable pollution permit

Answer 33

- The US Sulphur trading scheme reduced sulphur dioxide by 40%. - The EU Emissions Trading Scheme (ETS), launched in 2005, achieved a 21% reduction in greenhouse gases. - The ETS has expanded to include other greenhouse gases like nitrous oxide and the airline industry. - A similar permit scheme has been introduced in China.

Question 34

State provision of public goods

Answer 34

- **State provision** occurs when the government intervenes in the market to supply a good or service. **Merit Good** - The government supplies goods like education and healthcare (e.g., NHS) because society believes these are underprovided by the market. **Public Good** - The government supplies goods like defense and infrastructure (e.g., roads) because they would be underprovided by the **private sector** due to the free rider problem.

Question 35

Advantage of state provision of public goods

Answer 35

- **Corrects market failure** (provides important goods that would otherwise not be provided) leads to improved social welfare. - helps **equality** (ensuring everyone has access to basic goods) - Provides benefits, (improving economic growth by ensuring a healthy workforce through healthcare). - **Competitive tenders** can ensure efficiency in the provision of goods.

Question 36

Disadvantage of state provision of public goods

Answer 36

- **Expensive** and represents a high **opportunity cost** for the government; administration costs are a problem. - Without market involvement, the government may produce the wrong combination of goods, as consumers can't indicate preferences (e.g., too many soldiers, too few hospital beds). Democracy can reduce this issue, allowing consumers to vote for parties with similar aims. - The government may be **inefficient** at production due to a lack of incentives to cut costs. - **Corruption** and **conflicting objectives** may arise among government officials.

Question 37

Example of state provision of public goods

Answer 37

- In the UK, the government provides goods like roads, education, and healthcare. - The NHS suffers from severe **underfunding**, and many schools face **budget cuts**. - More money is spent on improving **railways** than **roads**, despite **92% of journeys** in the UK being made on roads, suggesting **incorrect resource allocation**.

Question 38

Provision of information

Answer 38

- Ensures that economic units can maximize decisions when consuming and producing goods and services. - When there is **asymmetric information**, the government provides information to help people make informed decisions. - The government may **force companies** to provide information. **Examples**: - In the **job market** - For **dangerous products** - Providing **economic data** to help firms plan for the future

Question 39

Advantages of provision of information

Answer 39

- Helps consumers act **rationally**, allowing the market to function properly. - Best when used alongside other policies, such as making demand more **elastic** in the long run, helping **indirect taxes** become more effective at reducing output.

Question 40

Disadvantages of provision of information

Answer 40

- Can be **expensive** for the government, incurring an **opportunity cost**. - The government may not always have all the **information**, making it difficult to inform consumers. - Consumers may **ignore** the information provided due to **irrational behavior**.

Question 41

Example of provision of information :

Answer 41

- **Information provision** includes labels on cigarette packages and campaigns on speeding, obesity, drinking, and smoking. - **Consumer protection laws** and **industry standards** help address issues with second-hand products. - The **traffic light system** (green, orange, red) on food labels helps consumers easily identify healthier options. - Despite these efforts, many consumers still engage in **harmful** and **dangerous activities**.

Question 42

Regulation :

Answer 42

- The government seeks to provide **effective competition** within markets. - This can lead to **greater choice** and **lower prices**. - It creates conditions for continued **investment** in key infrastructure areas of the economy. **Examples**: - In the **water** and **energy** industries.

Question 43

How does regulation occur :

Answer 43

- When **MSC = MSB**, it ensures full information on products. - The government can introduce **regulatory bodies** such as **OFCOM** for communications and **OFGEM** for energy. - These bodies ensure that firms follow **regulations**.

Question 44

Advantages of regulation :

Answer 44

This can ensure consideration of externalities, prevent exploitation of consumers and keep consumers fully informed. This will help to overcome market failure and maximise social welfare.

Question 45

Disadvantages of regulation :

Answer 45

- **Laws** can be **expensive** for the government to monitor, incurring an **opportunity cost**. - They don't account for the **different costs** of following laws for different companies. Compared to tradable pollution permits, **regulation** is less efficient at reducing pollution. - Firms may **pass on costs** to consumers through **higher prices**. - Excessive regulation can reduce **competition** and **efficiency**, increasing bureaucracy and limiting innovation.

Question 46

Examples of regulation :

Answer 46

A number of regulations are in place to correct market failure in the UK such as: EU fishing quotas, smoking bans, and maximum vehicle CO2 emissions.

Question 47

Synoptic point :

Answer 47

- **Government intervention** in individual markets often has **macroeconomic consequences**. - It impacts the **government budget**, either raising revenue or increasing spending through these policies. - Policies that raise business costs, such as **indirect taxes**, **regulation**, and **tradable pollution permits**, can reduce **international competitiveness** and **LRAS**.

Question 48

What is government failure

Answer 48

Government intervention in the market causes a net welfare loss + a mis allocation of resources Total social costs exceed social benefits

Question 49

Law of unintended consequences

Answer 49

- **Unintended consequences** occur when government intervention leads to unexpected outcomes. - This can result from **inadequate information**, **conflicting objectives**, and **administrative costs**. - Consumers and producers may react unexpectedly to new policies, causing them not to have the intended effect. **Example**: The **buffer stock scheme** under the **CAP** aimed to smooth price fluctuations but caused **overproduction** in the EU and **price drops** globally due to cheap surplus exports.

Question 50

Distortion of price signals

Answer 50

- The government tries to create **incentives** and **disincentives** to influence the behavior of individuals and firms. - This helps to create **markets** that wouldn't survive in their current state without government support. - However, this **distorts** the free functioning of the market and leads to **distorted prices**. - As a result, the government may inadvertently create **inefficiencies** rather than correcting them.

Question 51

Excessive administrative costs :

Answer 51

- **Administrative costs** are the expenditures the government spends when intervening in markets. - These costs can mean that the **benefits** from government intervention are outweighed by the costs. - Government **bureaucracy** often leads to higher costs. - **Budgets** are constrained, especially during **recessions**, forcing the government to make tough decisions about where to spend money. - Sometimes, **incorrect decisions** are made, where the costs do not achieve the expected benefits. **Example**: - A significant portion of money allocated to the **NHS** is spent on **organizational administration** rather than directly on **medical care**.

Question 52

Information gaps (government failure)

Answer 52

Government decisions rely on data, but the information is always limited, and they cannot predict the future. - **Cost and benefit forecasts** often go wrong, leading to investments where **costs exceed benefits**, resulting in **welfare loss**. - It is **impractical** and often **impossible** for the government to obtain all the necessary information.

Question 53

types of government failure :

Answer 53

1. Unintended consequences 2. Distortion of price signals 3. Excessive administrative costs 4. Information gaps

Question 54

What is regulatory capture ?

Answer 54

When governments try and regulate monopoly power. The interests of society are overlooked by the interests of CEOs and managers and firms in the industry. The influence the regulator to reduce the extent of the regulation. Regulation works in the interest of the firm not society. Regulatory authorities are very expensive to maintain so costs can outweigh the benefits of monopoly regulation, leading to government failure.