Market failure, as we covered in the previous chapter, can occur when the price mechanism fails to allocate resources effectively. The government may choose to intervene in a market when:
- A good is either over or under-consumed.
- It believes it can redistribute income and wealth in a more equitable way.
- Policy changes can lead to an improvement in the performance of the economy.
There are a number of policies that governments have chosen to use when they intervene in a market, each of the following shall be explored in greater detail in this chapter:
- indirect taxation
- price controls
- buffer stocks
- pollution permits
- state provision
Government intervention can be expensive and the policies used may not always lead to an optimal outcome themselves.
Indirect taxes are levied on goods and services bought; they can either be ad valorem or specific taxes.
An ad valorem tax is a percentage of the price of the good; the higher the price of the good, the higher the ad valorem tax will be. Value Added Tax (VAT) is an example of an ad valorem tax; in the UK it is 17.5%. The effect on the supply curve of imposing an ad valorem tax is to pivot the supply curve upwards.
The value of the ad valorem tax increases as the price increases. The impact of imposing an ad valorem tax on the equilibrium point, quantity supplied and price can be seen on the diagram below.
A specific tax is a fixed amount that is added to the price of a good. Excise duties are examples of specific taxes; for example, the additional taxes that are levied on cigarettes, alcohol and petrol. The imposition of a specific tax will shift the supply curve to the left by the value of the tax.
The impact of imposing a specific tax on the equilibrium point, quantity supplied and price can be seen on the diagram below.
The Incidence of Taxation
The incidence of taxation describes how the burden of the tax is shared between customers and sellers.
The diagram above shows how the additional tax affects the market. The following steps show how the incidence of taxation is divided between customers and producers.
- A specific tax is imposed shifting S1 to S2.
- The equilibrium quantity falls from Q1 to Q2 and the price rises from P1 to P2.
- The price the consumer pays rises from P1 to P2.
- The price the producer receives falls from P1 to P3.
- The total value of the tax paid to the government equals the rectangle P2acP3 (both shaded areas); this is calculated by multiplying the value of the tax by the quantity sold.
- The amount of tax paid by the consumer is equal to P2abP1.
- The amount of tax paid by the producer is equal to P1bcP3.
The value of price elasticity of demand will affect the incidence of taxation.
On the diagram above there is a relatively inelastic demand curve. It can be seen that the majority of the tax is passed onto the consumer. The overall effect on the equilibrium is a small decrease in quantity and a large increase in price.
When demand is relatively elastic demand curve the majority of the tax is borne by the producer. The overall effect on the equilibrium is a large decrease in quantity and a small increase in price.
The relationship between elasticity and incidence of taxation is the same when an ad valorem tax is levied on goods.
A subsidy is a payment made to producers by the government. It is paid per unit and will shift the supply curve to the right. Similarly to taxes, the total subsidy per unit is the distance between the supply curves.
The cost to taxpayers, paid by the government, is equal to the subsidy per unit, ab, multiplied by the quantity of the good demand, Q1; this is the shaded area P1abP2. The impact of the subsidy is to reduce the equilibrium price and increase quantity.
Price controls can take the form of either minimum prices, maximum prices or zero pricing.
A maximum price is a price ceiling above which the price is not allowed to rise. It is not a fixed price, therefore it is allowed to fall below this level.
Setting a maximum price at Max P will cause a shortage (excess demand) equal to QD QS.
Maximum prices maybe imposed by the Government during times of shortage. This will lead to queues and the possibility of corruption as bribes are made to obtain goods. Those who are able to pay a higher price will often be able to obtain the goods on the black market (also called a secondary market). Secondary markets will also exist for concerts and sports events.
A minimum price is the opposite of a maximum price, it is a floor that the price is not allowed to fall below this set level. Prices are not fixed at the floor, they are allowed to rise above it.
The minimum price will lead to a surplus in the market (excess supply) equal to QD QS. The price is not allowed to be reduced therefore the effects of the price mechanism and its signals, incentives and rationing will not be felt.
The minimum wage set by the government is an example of a minimum price; workers must not be paid below a minimum price for their labour.
Agricultural markets also have minimum prices to help protect the incomes of farmers. The agricultural market will be discussed in far greater detail later in the course.
Zero pricing is an extreme form of maximum pricing; the maximum price is zero! This means that goods and services are provided free of charge.
This shows that, at a price of zero, there will be a shortage (excess demand) equal to QD QS. This shortage will remain unless the price is raised to the equilibrium of Pe.
In healthcare, the shortage leads to waiting lists that can keep getting longer unless action is taken.
The government has experimented with charging for some previously zero priced goods, for example, the congestion charge aims to ration the number of driving who drive into central London during weekdays.
Buffer stocks aim to stabilise prices and reduce the annual fluctuations in price that are normally associated with agricultural markets. The government purchases food in years when there is a particularly good harvest and then releases it back onto the market when there is a poor harvest.
The government decides to stabilise the price at Pbuffer. When there is a good harvest, the equilibrium price will fall to Pgood. The government buys Qbuffer – Qgood, thereby reducing the quantity available on the market to Qbuffer and increasing the price to Qbuffer. Buffer prices are only used for non-perishable goods, such as grain, wine and milk powder.
Pollution permits are a key feature of what is often called a cap and trade system. The government, or other international agencies, places a cap (limit) on the amount of a particular pollutant. This limit should be at the point where the marginal social cost equals the marginal social benefit.
Firms are then given pollution permits that will allow them to pollute up to a certain level. If a firm pollutes below their set level, they are allowed to trade the unused pollution permits. Other firms can buy these permits and then pollute above their own limit up to the amount that their new permits allow them to.
POTENTIAL PROBLEMS WITH TRADED POLLUTION PERMITS
There are a number of difficulties with pollution permits:
- How does the government decide upon the total level of pollution that is to be allowed?
- How are the pollution permits divided amongst the firms?
- Traded permits may lead to pollution being concentrated in certain geographical areas.
- The cost of running a cap and trade system with pollution permits is likely to be very high.
EU emissions trading scheme (Euts)
In 2004 the EU launched a cap and trade system of carbon trading in an attempt to cut greenhouse gas emissions. Over 10,000 organisations were given allocations for the amount of the gas they can discharge each year.
If businesses exceed their quota, they can buy permits from cleaner organisations, who can benefit by selling their carbon allowances.
In January 2008, the European Commission proposed a number of changes to the scheme, these included the greenhouse gases nitrous oxide and perfluorocarbons to the cap and trade system.
State provision of goods and services has fallen significantly since the privatisation of many of the formally state owned companies. At present the Royal Mail and Network Rail are the two biggest state-owned businesses.
The government uses private sector business now to provide services that state owned organisations used to carry out, for example cleaners in schools and hospitals, running prisons and waste collection.
Government Regulation and Legislation
The government is able to pass laws that may attempt to correct for market failure. The government could ban the sale of any goods or services that it felt was too bad for society to be sold at all.
Just because the government intervenes in a market, it does not necessarily result in an improvement in economic welfare; government failure occurs when government intervention in the economy leads to the misallocation of resources. Governments may create, rather than remove, market distortions.
There are a number of potential sources of government failure.
There is no reason why the government will have more information that the market. If the government suffers from the same level of inadequate information as the market does, then market failure will be inevitable.
Self-interest will often prevent politicians from making decisions than will remove market failure. Decisions about building roads, hospitals and schools will be governed by many competing factors, not all of them economic.
In the run up to an election, the government may try to implement policies that will maximise the chances of re-election rather than solving market failure and securing the long term stability of the economy
Special Interest Groups
These will aim to influence policy and change the outcome of particular markets. Effective campaigning and marketing may make it politically impossible to do the ‘right thing’.
Governments are often accused of being too large and, therefore, too expensive. Increasing the role in plays in the economy will lead a bigger government that will cost more money. This begs the question: is the allocation of resources in the government a source of market failure in itself?
Government will often make decisions that are short term fixes rather than long term solutions.
Regulatory capture occurs when a government regulatory agency which is supposed to be acting in the public interest begin to operate in favour of those businesses in the industry that it should be overseeing.