1.4.1 Government Intervention in Markets

• Nearly every economy in the world is a mixed economy and has varying degrees of government intervention
• Governments intervention is necessary for several reasons

A diagram showing several reasons for government intervention in mixed economic systems

• Correct market failure: in many markets there is a less than optimal allocation of resources from society's point of view
  • In maximising their self-interest, firms and individuals will not self-correct this allocation of resources and there is a role for the government
  • They often achieve this by influencing the level of production or consumption
• Earn government revenue: governments need money to provide essential services, public and merit goods
  • Revenue is raised through intervention such as taxation, privatisation, sale of licenses (e.g. 5G licenses), and sale of goods/services
• Promote equity: to reduce the opportunity gap between the rich and poor
• Support firms: in a global economy, governments choose to support key industries so as to help them remain competitive
• Support poorer households: poverty has multiple impacts on both the individual and the economy 
  • Intervention seeks to redistribute income (tax the rich and give to the poor) so as to reduce the impact of poverty

• Four of the most common methods used to intervene in markets are indirect taxation, use of subsidies, maximum prices, and minimum prices
  
  

Indirect Taxation

• An indirect tax can be either ad valorem or specific

Ad Valorem Tax

• Value added tax (VAT) is 20% in the UK in 2022. The more goods/services consumed, the larger the tax bill 
  • This causes the second supply curve to diverge from the original supply curve
  • VAT raises significant government revenue
    
    

A diagram showing an ad valorem tax (VAT) and the tax incidence for producers and consumers

Diagram Analysis

• Initial equilibrium is at P₁Q₁
• Supply shifts left due to the tax from S → S + tax
  • The two supply curves diverge as percentage tax means more tax is paid at higher prices
• Consumer incidence of tax is (P₂ - P₁) x Q₂ - Area A
• Producer incidence of tax is (P₁ - P₃) x Q₂ - Area B
• New equilibrium is at P₂Q₂
  • Final price is higher (P₂) and QD is lower (Q₂)
    
    

Specific Tax on Negative Externality of Production

• Governments frequently tax firms that pollute or create harmful external costs in production

A diagram that shows the impact of a tax on a product that is over-provided in society. The tax reduces the welfare loss and moves production closer to the optimum level of production

Diagram Analysis

• The free-market equilibrium is at P_eQ_e - where MSB = MPC
  • Market failure exists as MSC > MSB at equilibrium
  • Optimum level of output is at Q_opt
  • There is over-provision of this product
• A specific tax shifts the supply curve left from S → S₁
  • The tax does not completely eradicate the welfare loss but moves the market closer to the optimum level of output (Q_opt)
  • The welfare loss has been reduced as shown in the diagram
• The new market equilibrium is at P₁Q₁
  • This is a higher price and less output
  • There is less over-provision and so less market failure
  • The external costs have been reduced

Specific Tax on Negative Externality of Consumption

• Governments frequently tax demerit goods such as cigarettes, alcohol, fatty foods, and polluting vehicles

A diagram that shows the impact of a tax on a product that is over-consumed in society. The tax reduces the welfare loss and moves consumption closer to the optimum level of production

Diagram Analysis

• The free-market equilibrium is at P_eQ_e - where MPB = MSC
  • Market failure exists as MSC > MSB at equilibrium
  • Optimum level of consumption is at Q_opt
  • There is over-consumption of this product
• A specific tax shifts the supply curve left from S → S₁
  • The tax does not completely eradicate the welfare loss but moves the market closer to the optimum level of output (Q_opt)
  • The welfare loss has been reduced as shown in the diagram
• The new market equilibrium is at P₁Q₁
  • This is a higher price and lower output
  • There is less over-consumption and so less market failure
  • The external costs have been reduced
    
    

Subsidies

• Governments frequently use subsidies to encourage production/consumption of merit goods such as energy efficient products, electric vehicles, healthcare, and education

A diagram that shows the impact of a subsidy on a product that is under-consumed in society. The subsidy reduces the potential welfare gain and moves consumption closer to the optimum level 

Diagram Analysis

• The free-market equilibrium is at P_eQ_e - where MPB = MSC
  • Market failure exists as MSB > MSC at equilibrium
  • Optimum level of output is at Q_opt
  • There is under-consumption of this product
• A subsidy shifts the supply curve right from S → S₁
  • It does not completely eradicate the potential welfare gain but moves the market closer to the optimum level of output (Q_opt)
  • The potential welfare gain has been reduced as shown in the diagram
• The new market equilibrium is at P₁Q₁
  • This is a lower price and higher output
  • There is less under-consumption and so less market failure
  • Some of the external benefits available have been realised
    
    

Maximum Prices

• Governments will often use maximum prices in order to help consumers. Sometimes they are used for long periods of time e.g. housing rental markets. Other times they are short-term solutions to unusual price increases e.g. petrol
• A maximum price is set by the government below the existing free market equilibrium price and sellers cannot legally sell the good/service at a higher price

A diagram that shows the imposition of a maximum price (P_max) which sits below the free market price (P_e) and creates a condition of excess demand (shortage)

Diagram Analysis

• Initial market equilibrium is at P_eQ_e
• A maximum price is imposed at P_max
  • The lower price reduces the incentive to supply and there is contraction in QS from Q_e → Q_s
  • The lower price increases the incentive to consume and there is an extension in QD from Q_e → Q_d
  • This creates a condition of excess demand Q_sQ_d
• Some consumers benefit as they purchase at lower prices
  • Others are unable to purchase due to the shortage
  • This unmet demand usually encourages the creation of illegal markets (black/grey markets)

Minimum Prices

• Governments will often use minimum prices in order to help producers or to decrease consumption of a demerit good e.g. alcohol
• A minimum price is set by the government above the existing free market equilibrium price and sellers cannot legally sell the good/service at a lower price
• Minimum prices are also used in the labour market to protect workers from wage exploitation. These are called minimum wages
  
  

A diagram that shows the imposition of a minimum price (P_min) which sits above the free market price (P_e) and creates a condition of excess supply (surplus)

Diagram Analysis

• Initial market equilibrium is at P_eQ_e
• A minimum price is imposed at P_min
  • The higher price increases the incentive to supply and there is an extension in QS from Q_e → Q_s
  • The higher price decreases the incentive to consume and there is a contraction in QD from Q_e → Q_d
  • This creates a condition of excess supply Q_dQ_s
    
    

Differences in Government Responses to the Excess Supply

• In agricultural markets, if a minimum price is set by the government producers benefit as they receive a higher price
  • Governments will often purchase the excess supply and export it
• In demerit markets, producers suffer as QD contracts
  • Governments will not purchase the excess supply
  • Producers usually lower their output in the market to match the QD at the minimum price
    
    

Trade Pollution Permits

• Governments create a pollution permit market and issue permits to polluting firms
  • This helps to reduce negative externalities of production 
  • Each permit is typically valid for the emission of one ton of pollutant
  • More polluting firms have to buy additional permits from less polluting firms
  • The price of the permit represents an additional cost of production
• If the price of additional permits is more than the cost of investing in new pollution technology, firms will be incentivised to switch to cleaner technology:
  • Firms can then sell their spare permits and gain additional revenue
    
    

State Provision of Public Goods

• Public goods are beneficial for society and are not provided by private firms due to the free rider problem
• They are usually provided free at the point of consumption, but are paid for through general taxation
• Examples include roads, parks, lighthouses, national defence
  
  

Provision of Information

• Information gaps cause market failure
• Governments can set up information portals so as to reduce the asymmetric information
• Examples include job centres, consumer rights websites, nutritional labels
  
  

Regulation

• Governments create rules to limit harm from negative externalities of consumption/production
  • They create regulatory agencies to monitor that the rules are not broken
  • There are more than 90 regulators in the UK
  • Individuals or firms may be fined/imprisoned for breaking the rules
• Examples of some industry regulators include the Environment Agency, Ofsted, and the Financial Conduct Authority