Essential guidance on economics exam technique:
AS Market Failure
Government Intervention in the Market
In a free market economic system, scarce resources are allocated through the price mechanism where the preferences and spending decisions of consumers and the supply decisions of businesses come together to determine equilibrium prices. The free market works through price signals. When demand is high, the potential profit from supplying to a market rises, leading to an expansion in supply (output) to meet rising demand from consumers. Day to day, the free market mechanism remains a tremendously powerful device for determining how resources are allocated among competing ends.
Intervention in the market
The government may choose to intervene in the price mechanism largely on the grounds of wanting to change the allocation of resources and achieve what they perceive to be an improvement in economic and social welfare. All governments of every political persuasion intervene in the economy to influence the allocation of scarce resources among competing uses
What are the main reasons for government intervention?
The main reasons for policy intervention are:
Options for government intervention in markets
There are many ways in which intervention can take place – some examples are given below
Government Legislation and Regulation
Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking in the workplace. The laws of competition policy act against examples of price-fixing cartels or other forms of anti-competitive behaviour by firms within markets. Employment laws may offer some legal protection for workers by setting maximum working hours or by providing a price-floor in the labour market through the setting of a minimum wage.
The economy operates with a huge and growing amount of regulation. The government appointed regulators who can impose price controls in most of the main utilities such as telecommunications, electricity, gas and rail transport. Free market economists criticise the scale of regulation in the economy arguing that it creates an unnecessary burden of costs for businesses – with a huge amount of “red tape” damaging the competitiveness of businesses.
Regulation may be used to introduce fresh competition into a market – for example breaking up the existing monopoly power of a service provider. A good example of this is the attempt to introduce more competition for British Telecom. This is known as market liberalisation.
Direct State Provision of Goods and Services
State funding can also be used to provide merit goods and services and public goods directly to the population e.g. the government pays private sector firms to carry out operations for NHS patients to reduce waiting lists or it pays private businesses to operate prisons and maintain our road network.
Fiscal Policy Intervention
Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand within the economy.
Intervention designed to close the information gap
Often market failure results from consumers suffering from a lack of information about the costs and benefits of the products available in the market place. Government action can have a role in improving information to help consumers and producers value the ‘true’ cost and/or benefit of a good or service. Examples might include:
These programmes are really designed to change the “perceived” costs and benefits of consumption for the consumer. They don’t have any direct effect on market prices, but they seek to influence “demand” and therefore output and consumption in the long run. Of course it is difficult to identify accurately the effects of any single government information campaign, be it the campaign to raise awareness on the Aids issue or to encourage people to give up smoking. Increasingly adverts are becoming more hard-hitting in a bid to have an effect on consumers.
The effects of government intervention
One important point to bear in mind is that the effects of different forms of government intervention in markets are never neutral – financial support given by the government to one set of producers rather than another will always create “winners and losers”. Taxing one product more than another will similarly have different effects on different groups of consumers.
The law of unintended consequences
Government intervention does not always work in the way in which it was intended or the way in which economic theory predicts it should. Part of the fascination of studying Economics is that the “law of unintended consequences” often comes into play – events can affect a particular policy, and consumers and businesses rarely behave precisely in the way in which the government might want! We will consider this in more detail when we consider government failure.
Judging the effects of intervention – a useful check list
To help your evaluation of government intervention – it may be helpful to consider these questions:
Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarce resources among competing ends? E.g. does it improve allocative, productive and dynamic efficiency? For example - would introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked to the growing problem of obesity?
Effectiveness of a policy: i.e. which government policy is most likely to meet a specific economic or social objective? For example which policies are likely to be most effective in reducing road congestion? Which policies are more effective in preventing firms from exploiting their monopoly power and damaging consumer welfare? Evaluation can also consider which policies are likely to have an impact in the short term when a quick response from consumers and producers is desired. And which policies will be most cost-effective in the longer term?
Equity effects of intervention: i.e. is a policy thought of as fair or does one group in society gain more than another? For example it is equitable for the government to offer educational maintenance allowances (payments) for 16-18 year olds in low income households to stay on in education after GCSEs? Would it be equitable for the government to increase the top rate of income tax to 50 per cent in a bid to make the distribution of income more equal?
Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engage in economic activity? Inter-generational equity is an important issue in many current policy topics for example decisions on which sources of energy we rely on in future years.
|Author: Geoff Riley, Eton College, September 2006|
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