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) 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 Cost Quantity MPC=S MPB=MSB=D Q free mkt Q with tax P fm Tax/unit MSC1 = S1 (with tax) P with tax

Specific Indirect Tax: Tax charged per unit sold (so tax / unit is constant as price rises & supply curve shifts parallel) 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 Cost Quantity MPC=S MSC1 = S1 (with tax) MPB=MSB=D Q free mkt Q with tax P fm P with tax Tax/unit

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 producer pays MPB=MSB=D Q socially optimum Q free 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 Subsidy A payment, usually from the government, to encourage production of consumption 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?

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 Demand for some goods may be inelastic. 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.