1.3.6 - Government intervention in markets
- Syllabus
- 2018
- Topic
- 1.3.6
- Level
- AS
Learning objectives
1.3.61a - purpose of government intervention, including reference to methods of market failure.The purpose of government intervention, including reference to methods of market failure. government1.3.61b - Methods of intervention: intervention • indirect taxation (ad valorem and specific) •Methods of intervention: intervention; indirect taxation (ad valorem and specific); subsidies; maximum and minimum (guaranteed) prices.; tradeable pollution permits; extension of property rights; state provision; regulation; provision of information.1.3.61c - Contexts in which governments may intervene: • health • housing • education • transportContexts in which governments may intervene:; health; housing; education; transport; environment; energy; agriculture; commodities.1.3.62a - 'Government failure' as intervention that results in a net welfare failure loss'Government failure' as intervention that results in a net welfare failure loss.1.3.62b - Causes of government failureCauses of government failure include information gaps, lack of incentives, unintended consequences, excessive administrative costs and moral hazard.
Why governments intervene in markets
Governments intervene when the market allocation is judged inefficient: output may differ from the social optimum because of externalities, public-good non-provision, imperfect information, moral hazard or bubbles. Intervention aims to change incentives, prices, information, rights or direct provision so resources move closer to the socially efficient allocation.
| Market-failure diagnosis | Possible intervention aim |
|---|---|
| negative externality and overproduction | make decision-makers face more of the external cost and reduce output |
| positive externality and underconsumption | lower access barriers or increase perceived/private benefit |
| public-good non-provision | finance or provide the non-rival, non-excludable good |
| information gap | improve relevant information or protect poorly informed parties |
| unstable incentives or risk transfer | constrain behaviour, monitoring or exposure to losses |
Success requires comparing the intervention's welfare gain with all opportunity, administration and unintended costs. Correcting a market failure is the purpose; it does not guarantee the result.
Equity, political popularity or higher government revenue can influence policy, but this objective specifically requires intervention with reference to market failure.
Eight methods of government intervention
| Method | Main mechanism | Key risk or limitation |
|---|---|---|
| indirect tax: specific or ad valorem | raises firms' effective costs and price, reducing equilibrium quantity; specific is fixed per unit, ad valorem is a percentage of value | incidence and quantity response depend on PED/PES; evasion and administration cost |
| subsidy | lowers effective production cost, shifting supply right and increasing quantity | fiscal opportunity cost, weak targeting or dependency |
| maximum price | binding ceiling below equilibrium lowers legal price but creates excess demand | shortages, queues, quality decline or informal markets |
| minimum guaranteed price | binding floor above equilibrium raises legal price but creates excess supply | disposal, buffer-stock or purchasing costs and overproduction |
| tradeable pollution permits | caps permitted emissions and lets firms buy or sell permits | too many permits produce a low price and weak incentive; monitoring is required |
| extension of property rights | assigns enforceable rights so parties can negotiate over spillovers | negotiation may fail with many parties, unclear harm or high transaction costs |
| state provision | government finances or supplies goods/services directly | tax cost, weak incentives, rationing and possible inefficiency |
| regulation | sets legal standards, limits, bans or requirements | enforcement cost, inflexibility, avoidance and unintended substitution |
| provision of information | labels, campaigns or disclosures reduce relevant knowledge gaps | information may be ignored, misunderstood or insufficient when other constraints bind |
For a tax or subsidy, shift supply and compare the new equilibrium price and quantity, then identify the consumer/producer wedge and government revenue or spending. For a price control, keep the curves fixed, place the legal price on the correct side of equilibrium, and read quantity demanded and supplied at that price.
A permit market works only if the total cap is scarce enough to create a meaningful permit price. Firms with low abatement costs reduce emissions and may sell permits; firms with high abatement costs may buy them. Tightening the cap shifts permit supply left and, other things equal, raises the permit price.
A named policy is not automatically effective. Analyse the binding level, behavioural response, enforcement, opportunity cost and whether the intervention targets the diagnosed failure.
Choosing intervention for the context
| Context | Plausible market-failure focus | Methods that could target it |
|---|---|---|
| health | information gaps, external costs/benefits, affordability | information, regulation, taxes, subsidies or state provision |
| housing | affordability, externalities, information or unstable bubbles | price controls, regulation, state provision or information |
| education | external benefits and information gaps | subsidies, information or state provision |
| transport | congestion, emissions and network benefits | taxes, permits, regulation, subsidies or provision |
| environment | external costs and unclear property rights | taxes, permits, regulation or extension of rights |
| energy | pollution, security, affordability and information | taxes/subsidies, price controls, regulation or information |
| agriculture | volatile prices, externalities and food supply | guaranteed prices, taxes/subsidies, regulation or information |
| commodities | price volatility, externalities and resource depletion | buffer-linked price floors, taxes, permits or regulation |
Start with the failure and objective, then compare instruments by effectiveness, distribution, time lag, fiscal/administrative cost, enforceability and unintended consequences. More than one method may be combined, but each needs a distinct job.
Context does not determine one universally correct policy. For example, a maximum housing rent may improve affordability for tenants who secure a property while also creating shortage or reducing long-run supply.
What government failure means
Government failure occurs when government intervention causes a net welfare loss: the total social costs created by the intervention exceed its total social benefits, leaving resources more inefficiently allocated than the relevant alternative.
| Outcome | Interpretation |
|---|---|
| policy creates benefits greater than all social costs | intervention may improve welfare, even if it is imperfect |
| policy creates costs greater than benefits | net welfare loss and government failure |
| policy does not fully correct the original failure | not enough by itself to prove government failure; compare net effects |
A high indirect tax may reduce an external cost but also encourage illegal smuggling, consume enforcement resources and lose revenue. It is government failure only if these and other social costs outweigh the welfare benefit of the reduction in harmful activity.
An unpopular policy, administrative error or unintended effect is not automatically government failure. The defining test is net welfare loss relative to a relevant counterfactual.
Five causes of government failure
| Cause | How it can create net welfare loss |
|---|---|
| information gaps | government misjudges costs, benefits, behaviour or the scale/location of the problem, so the instrument or level is poorly targeted |
| lack of incentives | protected or state-run organisations may face weak pressure to control cost, innovate or respond to users |
| unintended consequences | people adapt through substitution, avoidance, black markets or changed quality, offsetting the policy aim and creating new costs |
| excessive administrative costs | design, monitoring, enforcement and compliance use resources that may exceed the policy's welfare gain |
| moral hazard | guarantees, subsidies or expected rescue reduce exposure to loss and encourage riskier behaviour |
For any policy, state the cause, show the behavioural or implementation mechanism, identify who bears the additional cost, and compare it with the intended welfare gain. Several causes may reinforce one another: an information gap can lead to a poorly designed rule that is costly to enforce and easy to evade.
A large tax difference across a border may encourage fuel smuggling. This is an unintended consequence; policing and seizure add administrative cost, while lost revenue and illegal activity may offset the tax's externality benefit.
Market failure and government failure are different diagnoses. Externalities, public goods and asymmetric information can justify intervention; the five causes here explain why that intervention may itself reduce net welfare.