Government Intervention in the Market

What the spec says we need to know about...

• Rational for Government Intervention
• Methods of Government Intervention to Correct Distortions in Individual Markets
• Government Failure
• The Impact of Government Intervention on Market Outcomes

Rational for government intervention

The main reasons for policy intervention are:

• To correct market failure
• To achieve a more equitable distribution of income and wealth
• To improve the performance of the economy

Methods of government intervention to correct distortions in individual markets

TAXATION

Indirect taxes can be imposed on the purchase of goods or services. There are two types of indirect taxes: specific and ad valorem.

Specific taxes are a fixed amount that's charged per unit of a particular good, no matter what the price of that good is. E.g. a set amount of tax could be put on bottles of wine regardless of their price.

Ad valorem taxes are charged as a proportion of the price of a good. E.g. a 20% tax on the price of a good would mean that for a £10 product it's £2 and for a £100 product it's £20.

Indirect taxes increase costs for producers so they cause the supply curve to shift to the left.

A specific tax causes a parallel shift if the supply curve.

An ad valorem tax causes a non-parallel shift of the supply curve, with the biggest impact being on higher priced goods. 

Governments often put extra indirect taxes on goods that have negative externalities, such as petrol, alcohol and tobacco.

Governments may use multiple indirect taxes on one item, e.g. in the UK cigarettes have a specific tax (called excise duty) and an ad valorem tax on their retail price.

The aim of this taxation is to internalise the externality that the good produces, i.e. make the producer and/or consumer of the product cover the cost of its externalities. 

The taxes make revenue for the government which can be used to offset the effects of the externalities.

Another example of a specific tax is by the UK government is landfill tax. This tax aims to reduce the impacts of market failure linked to disposing of waste at landfill sites.

There are advantages and disadvantages to this kind of tax:

• Advantages:
  • The cost of the negative externalities is internalised in the price of the good- this may reduce demand for the good and the level of its production, reducing the effects of the negative externalities
  • If demand isn't reduced, there's still the benefit that the revenue gained from the tax can be used by the government to offset the externalities
• Disadvantages:
  • It can be difficult to put a monetary value on the 'cost' of the negative externalities
  • For goods where demand is price inelastic, the demand isn't reduced by the extra cost of the tax
  • Indirect taxes usually increase the costof production, which reduces the product's international competitiveness
  • Firms may choose to relocate and sell their goods abroad to avoid the indirect taxation. This would remove their contributions to the economy, such as the payment…