• 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 PeQe?- where?MSB = MPC
  • Market failure exists as?MSC > MSB?at equilibrium
  • Optimum level of output is at?Qopt
  • 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 (Qopt)
  • 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 PeQe?- where?MPB = MSC
  • Market failure exists as?MSC > MSB?at equilibrium
  • Optimum level of consumption is at?Qopt
  • 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?(Qopt)
  • 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 PeQe?- where?MPB = MSC
  • Market failure exists as?MSB > MSC?at equilibrium
  • Optimum level of output is at?Qopt
  • 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 (Qopt)
  • 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 (Pmax) which sits below the free market price (Pe) and creates a condition of excess demand (shortage)

Diagram Analysis

• Initial?market equilibrium?is at PeQe
• A?maximum price?is imposed at?Pmax
  • The lower price?reduces the incentive to supply?and there is contraction in QS from Qe?→ Qs
  • The lower price increases the incentive to consume?and there is an extension in QD from Qe?→ Qd
  • This creates a condition of?excess demand QsQd
• 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 (Pmin) which sits above the free market price (Pe) and creates a condition of excess supply (surplus)

Diagram Analysis

• Initial?market equilibrium?is at PeQe
• A?minimum price?is imposed at?Pmin
  • The higher price?increases the incentive to supply?and there is an extension in QS from Qe?→ Qs
  • The higher price decreases?the incentive to consume?and there is a contraction in QD from Qe?→ Qd
  • This creates a condition of?excess supply QdQs

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