Download Government Intervention to Solve Market Failure

Government Intervention on externalities
Purpose of intervention with reference to market
failure and using diagrams in various contexts:
 indirect taxation (ad valorem and specific)
 subsidies
Taxes
• Indirect taxes can be charged for a number of
reasons; one is to reduce the production /
consumption of a good
(they also can raise lots of revenue for gov’t!)
• Purpose is to increase the cost of production of firms
• Increased costs get passed on to the customer with a
higher price, reducing consumption
• Firms may also be deterred from producing so much
due to the higher costs
• Can be used to reduce externalities (internalise the
externality) or to reduce use of demerit goods
Ad Valorem Indirect Tax:
Tax charged as a percentage of the sale price
(so tax / unit rises as price rises & supply curve pivots)
MSC1 = S1 (with tax)
Cost
Tax/unit
Government impose a tax on
production
MPC=S
Supply costs increase therefore
supply overall falls
P with tax
P fm
MPB=MSB=D
Q
Q
with
tax
free
mkt
Quantity
Tax needs to be set so that
negative externalities are
eliminated and the MSC=MSB
Specific Indirect Tax:
Tax charged per unit sold
(so tax / unit is constant as price rises
& supply curve shifts parallel)
Cost
MSC1 = S1 (with tax)
Tax/unit MPC=S
P with tax
P fm
MPB=MSB=D
Q
Q
with
tax
free
mkt
Quantity
Government impose a tax on
production
Supply costs increase therefore
supply overall falls
Tax needs to be set so that
negative externalities are
eliminated and the MSC=MSB
Who pays the tax – reminder:
When indirect taxes are charged, the cost of the tax can be paid by the
producer, passed on to consumers or both (usually both!)
For more information on this, refer back to the work done on
‘incidence of tax / subsidy’.
MSC
Cost
MPC=S1
consumer pays
MPC=S
P so
tax
P fm
MPB=MSB=D
producer pays
Q
Q
socially free
optimum mkt
Quantity
1. Taxation
Government Intervention to correct
Market Failure:
Taxation aims to ‘get the price right’. It causes the supply
curve to shift left, increasing price and reducing output.
This discourages consumption of demerit goods.
•
•
•
Private costs become
much closer to social
costs.
Large source of
government revenue.
Consistent with
polluter pays
principle.
• Difficult to
determine the
amount of tax.
• Some goods have
inelastic demand.
• Producer does not
always bear the
cost of the tax.
Subsidies
• Provided to encourage
production and
consumption of a more
socially beneficial
alternative
• Eg. subsidies for
construction of carbon
neutral energy
production, subsidies
for public transport,
subsidies for
Nicorette?
Subsidy
A payment, usually from
the government, to
encourage production of
consumption
2. Subsidies
Government Intervention to correct
Market Failure:
Government should subsidise merit goods, those with
positive externalities. This increases supply and
consumption but prices are kept low.
• Provide an incentive for producers to reallocate
production in line with government policy.
• Reduce the market price of products which
generate positive externalities.
• Assist poor families.
• External benefits to health and productivity.
2. Subsidies
•
•
•
•
•
•
•
•
•
Government Intervention to correct
Market Failure:
Demand for some goods may be inelastic.
Difficult to calculate size of subsidy.
Does not guarantee that producers pass on savings to
customers.
Factors other than price determine demand for the
product.
Government spending opportunity cost.
Difficult to determine effectiveness
Can be associated with information failure and
government failure.
Can encourage inefficiency (e.g. UK farmers)
Excessive subsidies could mean that demand outstrips
supply (food queues and rationing).
Maximum Prices
Market failure may occur when people cant buy basic
necessities such as food and clothing.
The government or an industry regulator
can set a maximum price to prevent the
market price from rising above a certain
level.
To be effective, a maximum price has to be set
below the free market price.
A price ceiling set above the free market equilibrium
price would have no effect whatsoever on the market –
because for a price floor to be effective, it must be set
below the normal market-clearing price.
Black Markets
A black market (or shadow market) is an illegal market in
which the market price is higher than a legally imposed price
ceiling. Black markets develop where there is excess
demand. Some consumers are prepared to pay higher prices
in black markets in order to get the goods or services they
want.
With a shortage, higher prices are a rationing device.
Good examples of black markets include tickets for major
sporting events, rock concerts and black markets for
children's toys and designer products that are in scarce
supply.
Some goods have significant
externalities in consumption.
May attempt to correct the resulting
market failure by raising their price to
a level where MSC=MSB
To be effective, a maximum price has to be set
above the free market price.
The issue is the black market if the excess
supply makes its way to market.