6.

Government intervention and

failure
19-23 July

Anderton: unit 24, pgs 129-136

Anderton: unit 25, pgs 137-140
Powell: 5.8, pgs 116-121
Powell: 5.9, pgs 121-124
Learning objectives
• To analyse and evaluate the different types of government
intervention using appropriate examples and graphs
• To analyse and evaluate the causes and consequences of government
failure
Government intervention

Methods to correct market failure

Government intervention – overview of
methods to correct market failure
• Taxes
• Subsidies
• Price controls
• Regulation/legislation
• State provision
• Information provision
Government intervention – taxes

What is the market failure in the first place that needs government
intervention?

How do taxes correct market failure?

What are the downsides to imposing taxes?

Government intervention – taxes
• How/why did market fail?
• Firms are generating negative externalities in production.

• Government intervention:
• Impose taxes

• Taxes raise cost of production for firms that produce those negative
externalities. With higher costs, firms are likely to supply less.

• However, the amount of taxes to impose/raise depends on whether

negative externalities can be eliminated, and where MSC=MSB.
 Imposition of a tax to correct market failure:
S2 curve to the left of the original S1 curve;
Where MSC>MPC, a tax (vert distance) is imposed

Anderton: pg. 129, figure 1, 2

Government intervention – taxes
• Downsides to imposing taxes
• The right level of tax to impose is difficult to determine
• This may be because the government has imperfect information e.g. not knowing the
exact size of market failure, or underestimates the impact of taxes on market.
• Conflict of objectives
• On the one hand, taxes are imposed to raise revenues.
• On the other hand, the government wants to correct market failure.
• Taxes are unpopular
• Policies may be met with backlash
Government intervention –
subsidies

What is the market failure in the first place

that needs government intervention?

How do subsidies correct market failure?

What are the benefits and downsides of

providing subsidies?
Government intervention – subsidies
• How/why did market fail?
• Firms are generating positive externalities in production, however, those
goods produced are underprovided. In other words, society wants more of
those goods.

• Government intervention:
• Provide subsidies

• Subsidies allow firms to cushion cost of production, thereby

encouraging firms to produce more goods/ more positive externalities
in production.
 Provision of subsidies to correct market failure
S2 curve to the right of the original S1 curve
Where MPC>MSC, a subsidy (vert distance) is provided

Anderton: pg. 130, figure 3, 4

Government intervention – subsidies
• Benefits of providing subsidies
• Output of merit goods can be increased
• E.g. government subsidises education and healthcare services, which encourage increase
in supply (and lower prices that consumers pay)
• Inequalities can be reduced
• E.g. government subsidises on prices of essential foods
• Improving factor mobility
• E.g. government subsidies housing for employees wo wish to move away from areas of
high unemployment. Or to firms who wish to relocate from areas of high unemployment
• Can stir up competition in the market
• E.g. government provides subsidies for new entrants in the market. With competition,
prices can be kept low.
• Information failure can be corrected
• E.g. government subsidises provision of information to members of society deprived
from information.
Government intervention – subsidies
• Downsides to providing subsidies
• Subsidies are difficult to target
• How much subsidies should the government provide? Too high or too low may be caused
by information failure on the part of the government.
• Conflicts with other policies
• E.g. on the one hand, providing subsidies; on the other hand, imposing regulation
• Subsidies can be difficult to remove
• Once subsidies are provided, this can effectively raise incomes. Removing or lowering
subsidies on the other hand can spark protests from beneficiaries.
Government intervention –
price controls

What is the market failure in the first place that needs government
intervention?

How do price controls correct market failure?

What are the downsides to implementing price controls?

Government intervention – price controls
• How/why did market fail?
Too expensive!
• Merit goods – generate positive externalities
– but expensive for consumers to afford
• Demerit goods – generate negative
externalities – yet are priced too low that
consumers can easily pay for

• Government intervention: price controls

• Set maximum prices for merit goods
• Set minimum prices for demerit goods Not high enough a price
to deter consumption!
Government intervention – price controls
• Setting a maximum price for merit goods
• The maximum price that consumers only need to pay for merit goods so that
they are more affordable

• Setting a minimum price for demerit goods

• The minimum price that consumers have to pay for demerit goods so as to
deter or discourage consumption, thereby eliminating or reducing negative
externalities of consumption.
 Setting a price control by way of a maximum price / minimum price

Maximum price (below equilibrium) Minimum price (above equilibrium)

for merit goods for demerit goods

Anderton: pg. 131, figure 5; pg. 132, figure 6

Government intervention – price controls
• Downsides to setting a maximum price
• Black markets
• Goods are bought and resold at higher prices
• Insufficient allocation to consumers…
• … as the maximum price results in a shortage (excess demand).
• Wasted resources
• Buyers expend money, time and effort to cope with shortages.
• Inefficiently low quality
• Because the price is lower than the equilibrium price that producers ideally want to sell
the goods at, these goods may come in poor conditions.
Government intervention – price controls
• Downsides to setting a minimum price
• Black markets
• Illegal under-the-table transactions
• Insufficient allocation of sales among producers…
• … as the minimum price results in a surplus (excess supply)
• Wasted resources
• Producers expend money, time and effort to find buyers and resolve surpluses
• Inefficiently high quality
• Because the price is higher than the equilibrium price, these goods may come in
unnecessarily too good a quality.
Government intervention –
regulation/legislation

What is the market failure in the first place that needs government
intervention?

How does regulation correct market failure?

What are the downsides to implementing regulation?

Government intervention –
regulation/legislation
• Examples:
• Regulations may be implemented to see to reducing information gaps/failure
• Airlines may be forced to disclose all the charges for an airline ticket at the
start of the booking processes rather than at the end
• Banks may be forced to tell customers the rate of interest on loans
• Laying down maximum pollution levels of banning pollution-creating activities
altogether

• Downside to implementing regulations

• The government may not know the right level of regulation to fix. Ideally, it
should be whether economic benefit arising from a reduction in externality
equals the economic cost imposed by the regulation.
Government intervention –
state provision

What is the market failure in the first place that needs government
intervention?

How does state provision correct market failure?

What are the downsides to state providing goods?

Government intervention – state provision
• How/why did market fail?
• Markets do not want to provide public goods,
because of the free rider problem.
• Markets may be providing merit goods, but
those goods are underprovided to socially
optimal levels.

• Government intervention:
• State provides those public goods and merit
goods
 State provision of public goods and merit goods to correct market failure
Government’s supply > market supply

Direct provision of a public good Direct provision of a merit good

Anderton: pg. 133, figure 7, 8

Government intervention – state provision
• Downsides to direct provision of public and merit goods
• Inefficient production
• Government has no incentive to cut costs to the minimum
• Sometimes, a wrong mix of goods produced
• Especially if goods are provided free to taxpayers e.g. providing too many soldiers and too few
hospital beds.
• In contrast, markets give consumers opportunity to buy those goods that give the
greatest satisfaction.
Government
intervention –
information provision

What is the market failure in the

first place that needs government
intervention?

How does information provision

correct market failure?
Government intervention – information
provision
• How/why did market fail?
• Imperfect information – whether information failure/gap, or asymmetric
information

• Government intervention:
• To regulate firms to provide/disclose necessary information
• To step in wherever and whenever information is imperfect

• E.g. running advertising campaigns to deliver messages about not

smoking, dangers of drink-driving, etc.
• Or sometimes, the government forces parties to a transaction to release
information, such as the dangers of smoking on cigarette packaging.
Government failure: causes and
consequences
Government failure
• If markets can fail, so too can governments.

• Government failure occurs when it intervenes in the market but this

intervention leads to net loss of economic welfare rather than a gain.

• Government failure arises when the total social costs arising from
intervention are greater than the total social benefits created by the
intervention.
Causes of government failure – overview
• Distortion of price signals
• Unintended consequences
• Excessive administrative costs
• Information gaps
• Conflicting objectives
Causes and consequences of government
failure – distortion of price signals
• E.g. of cause: Government
• Government intervenes to support domestic
farmers by imposing tariffs on agricultural Supports
imports.

• Consequences:
• Domestic consumers pay higher prices
• Farmers are growing crops on land that could be
more efficiently used to grow something else However, higher prices

• Government failure thus occurs, if the losses

to consumers and to efficiency are greater
than the gains to farmers
Causes and consequences of government
failure – unintended consequences
• E.g. of cause: Government
• The EU implemented in 1962 the Common
Implements
Agricultural Policy (CAP)

• Consequences:
• Consumers across EU paid higher prices for
food
• Depressed world prices for certain
agricultural products. However, higher
prices for food;
• Under the CAP, the EU bought up certain products Depressed world
at minimum price, then disposed of the produce prices for agricultural
by selling it below price onto world markets. products
Causes and consequences of government
failure – administrative costs
• E.g. of cause: Government
• Government intervenes by putting in place a
scheme to help unemployed get jobs Implements

• Consequences:
• High administrative cost for every applicant
who passes through the scheme
• No guarantee that every applicant gets a job,
but still there will be administrative cost
incurred However, high
administrative costs
• Government failure may result, as those
costs may outweigh the benefits of those
who successfully get employed
Causes and consequences of government
failure – information gaps
• E.g. of cause: Government
• If markets have information failure, so too
builds
have governments
• E.g. government wants to build infrastructure
and weighs up costs and benefits

• Consequences:
• Wrong projections of costs and benefits
• This leads to making wrong policies Weighs costs vs benefits

• This constitutes government failure However, underestimates

costs, due to lack of info
Causes and consequences of government
failure – conflicting interests
• E.g. of cause: Government
• E.g. government may want to cut taxes but increase
spending on defence. Spends $

• Consequences:
• Making such a decision (to increase spending on
defence) involves an opportunity cost.
• The welfare gain of the foregone alternative could be
higher than the welfare gain of the chosen option.
• Government failure may result, as they pick the
objective that gives lower welfare gain than the However, could have used
other objective. money elsewhere where
country can gain more
• Government may do this for reasons such as own welfare benefits
political beliefs and lack of information.
Summary
 Government

Government’s intervention to correct market failure

Taxes Subsidies Price controls Regulation/legislation State provision Information provision

But government can fail to implement those interventions. Causes:

Distortion of price signals Unintended consequences Administrative costs Information gaps

Market

Market failure

Externalities Merit goods Demerit goods Public goods Imperfect information

In summary,
• Government intervention:
• Taxes
• Subsidies
• State provision
• Regulation/Legislation
• Information provision
• Price controls
• Government failure: causes and consequences
Questions to cover
• Anderton: unit 24, page 130, question 1 on indirect taxes
• Anderton: unit 24, page 131, question 2 on subsidies
• Anderton: unit 24, page 132, question 3 on price controls
• Anderton: unit 24, page 133, question 4 on regulation
• Anderton: unit 24, page 136, data response “Carbon dioxide
emissions from motor vehicles”, all questions on government
intervention to correct market failure
• Anderton: unit 25, page 140, data response “Government failure”,
questions 1 and 2 on market failure, government intervention and
government failure
Anderton: unit 24, page 130, question 1 on indirect taxes
Anderton: unit 24, page 131, question 2 on subsidies
Anderton: unit 24, page 132, question 3 on price controls
Anderton: unit 24, page 133, question 4 on regulation
Anderton: unit 24, page 136, data response “Carbon dioxide emissions from motor vehicles”, all questions on government
intervention to correct market failure
Anderton: unit 25, page 140, data response “Government failure”, questions 1 and 2 on market failure, government intervention
and government failure