Economics Market Failure and Government Intervention Syllabus

Define an indirect (expenditure) tax and give the two types.

A tax levied on spending / on goods and services, paid to government by producers. Types: specific (a fixed amount per unit, e.g. $\$2$ per litre) and ad valorem (a percentage of price, e.g. $20\%$ VAT).

How does a specific tax versus an ad valorem tax shift the supply curve?

A specific tax shifts supply upward by a constant vertical amount (parallel shift); an ad valorem tax shifts supply upward by a growing amount (the curves diverge, pivoting) since the tax rises with price.

How is the incidence (burden) of an indirect tax split, and what determines it?

The burden is shared between consumers (higher price) and producers (lower net revenue). The more price-inelastic side bears the greater share; if demand is more inelastic than supply, consumers bear most of the tax.

Define a subsidy and state its effect on the supply curve and price.

A per-unit payment from government to producers to lower costs; it shifts the supply curve downward/rightward, lowering the price consumers pay and raising the effective price producers receive, increasing output.

What is the total government cost of a per-unit subsidy of $s$ at quantity $Q$?

$\text{Subsidy cost} = s \times Q$ (subsidy per unit multiplied by the new equilibrium quantity).

What is a Pigouvian tax and what is its optimal size?

A tax on a negative-externality good designed to internalise the externality. Set the tax equal to the marginal external cost at the social optimum so that $MPC + \text{tax} = MSC$, moving output to $Q^{*}$.

Define a price ceiling (maximum price) and state its market effect if binding.

A legal maximum price set below the equilibrium price. Being below equilibrium, it causes quantity demanded to exceed quantity supplied, creating a shortage (excess demand), e.g. rent controls.

Define a price floor (minimum price) and state its market effect if binding.

A legal minimum price set above the equilibrium price. Being above equilibrium, quantity supplied exceeds quantity demanded, creating a surplus (excess supply), e.g. minimum wage or agricultural price supports.

What non-price consequences can arise from a binding price ceiling?

Shortages lead to queues, rationing, deterioration of quality, and the emergence of black (parallel) markets where the good is resold above the ceiling.

How can a government maintain a minimum price (price floor) for a good?

By buying up the resulting surplus (buffer-stock purchases) and/or storing, exporting, or destroying it, which is costly to the government/taxpayer.

What is a buffer stock scheme?

A price-stabilisation scheme where a government/agency sets a price band, buys and stores output when the price is low (below the floor) and releases stock when the price is high (above the ceiling) to stabilise prices.

What are tradable pollution permits (cap-and-trade)?

A government sets a total cap on emissions and issues a fixed number of permits; firms may buy and sell permits, so those that can cut pollution cheaply sell to those for whom cutting is expensive, achieving the cap at least cost.

Why are tradable permits considered economically efficient for pollution control?

Trading creates a market price for pollution; abatement is done by the lowest-cost abaters, so the emissions target is met at the minimum total cost to society, and the cap can be tightened over time.

Compare a carbon tax with tradable permits in terms of price versus quantity certainty.

A carbon tax fixes the price of emitting (certain price, uncertain quantity of emissions); tradable permits fix the quantity of emissions via the cap (certain quantity, uncertain permit price).

Distinguish government regulation from government provision as intervention methods.

Regulation uses rules, standards, bans and licensing to control behaviour (command-and-control); provision means the government directly supplies the good/service (e.g. state healthcare, defence), often funding it through taxation.

Give an advantage and a disadvantage of using regulation to correct market failure.

Advantage: simple, clear, and enforceable, with immediate effect (e.g. an outright ban). Disadvantage: no flexibility or incentive to do better than the standard, high monitoring/enforcement costs, and risk of black markets.

What are unintended consequences of government intervention?

Outcomes not intended by policymakers, often adverse, e.g. minimum prices creating surpluses, subsidies encouraging overproduction, or bans creating black markets — a key reason intervention can cause government failure.

Define government failure.

Where government intervention to correct market failure leads to a net welfare loss / a misallocation of resources worse than or additional to the original market failure.

List key causes of government failure.

Information gaps, unintended consequences, administrative/enforcement costs, regulatory capture, political self-interest and short-termism, and distortion of price signals leading to excess demand or supply.

Define regulatory capture.

When a regulatory agency, created to act in the public interest, comes to advance the commercial or political interests of the industry it is meant to regulate, because that industry has the strongest incentive and information to influence it.

How do information and administrative costs contribute to government failure?

Governments often lack full information to set optimal taxes/subsidies/prices, and intervention requires costly bureaucracy to administer, monitor and enforce; these costs can exceed the welfare gains from correcting the market failure.

What does the distribution of income refer to, and how is it different from wealth?

Income is a flow of earnings over a period (wages, interest, rent, profit, transfers); wealth is a stock of assets held at a point in time (property, savings, shares). Distribution concerns how these are spread across the population.

What is the Lorenz curve?

A graph plotting the cumulative percentage of total income (vertical axis) against the cumulative percentage of the population ranked from poorest to richest (horizontal axis); the further it bows from the 45° line of perfect equality, the greater the inequality.

Define the Gini coefficient and give its range.

A summary measure of inequality equal to the area between the Lorenz curve and the line of equality divided by the total area under the line of equality. It ranges from $0$ (perfect equality) to $1$ (perfect inequality).

Distinguish absolute poverty from relative poverty.

Absolute poverty is having income below a fixed subsistence level needed for basic necessities (e.g. the World Bank line of $\$2.15$ per day). Relative poverty is having income below a set proportion (e.g. $60\%$) of the society's median income.

Distinguish equity from equality in income distribution.

Equality means everyone has the same amount; equity means fairness in distribution, which is a normative concept and does not necessarily mean equal shares (e.g. rewarding effort or need).

What is the poverty trap (unemployment/earnings trap)?

A situation where a low-income person gains little from earning more because rising earnings simultaneously lose means-tested benefits and incur income tax, producing a very high effective marginal 'tax' rate that discourages work.

List the main policies governments use to redistribute income and reduce poverty.

Progressive taxation, transfer/welfare payments (benefits, pensions), a minimum wage, and provision of free or subsidised merit goods such as education and healthcare (benefits in kind).

Distinguish progressive, proportional and regressive taxes.

Progressive: the average tax rate rises as income rises (e.g. income tax). Proportional: the average rate stays constant (flat tax). Regressive: the average rate falls as income rises, so it takes a larger share of the poor's income (e.g. VAT).

State the equity–efficiency trade-off in redistribution.

Redistributive policies (high progressive taxes, generous benefits) can reduce inequality but may blunt incentives to work, save and invest, reducing efficiency and output; policymakers must balance greater equity against possible lost efficiency.

How can government provision of merit goods (benefits in kind) reduce inequality?

Providing free/subsidised education, healthcare and housing gives low-income households real 'in-kind' income and access to services they could not otherwise afford, narrowing effective inequality and improving long-term social mobility.