Government Intervention: Other Methods (AQA A Level Economics)

State Provision to Correct Market Failure

• Merit goods and public goods are under-provided in a free market, causing a market failure
   

• 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

• Merit goods are beneficial to society but consumers cannot always access them as they are priced out of the market (e.g. private education or healthcare)
  

• To solve the market failure, governments can provide these goods and services
  

The Advantages & Disadvantages of State Provision

Regulation to Correct Market Failure

• Regulation is the process of monitoring and enforcing laws to limit the harm caused by the external costs of consumption or production

• Regulations can limit or prohibit certain behaviours to prevent market failure
  

• Reasons for regulation include preventing exploitation of consumers, taking externalities into account, and reducing consumption of demerit goods

  • For example, certain classes of drugs (demerit goods) are prohibited in the UK

  • Collusion and cartels are banned by competition policy and regulated by the Competition and Markets Authority to prevent abuse of monopoly power

• Regulatory agencies are created to enforce the law and ensure that the rules are not broken

Property Rights and Pollution Permits to Correct Market Failure

Property Rights

• Common pool (access) resources are natural resources over which no private ownership has been established

  • Left to the free market, common pool resources can be over exploited and used in an unsustainable way

  • This results in the tragedy of the commons and environmental market failure
    

• Property rights define the ownership of common pool resources and set out how they can be used

  • By transferring common land over to private ownership, the private owner has a strong incentive to manage the resource and take care of it for future use

  • This internalises the externality and can resolve tragedy of the commons related market failure
     

The Advantages & Disadvantages of Property Rights

Pollution Permits

• Governments calculate an optimum (or preferable) level of pollution

• Governments create a pollution permit market and issue permits to polluting firms

  •  The price of the permit is determined by demand and supply

  • Each permit allows a firm to pollute up to a certain amount. Any surplus can be sold and traded for additional revenue

  • Firms that pollute more have to buy additional permits from less-polluting firms
    

Diagram: The Pollution Permit Market

Firms can sell their unused pollution permits to generate extra company revenue

• The cost of the permit represents an additional cost of production, which should reduce supply and output closer to the socially optimal level

• If the system works effectively, it can correct market failure by reducing the associated negative externalities

• 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
   

The Advantages & Disadvantages of Pollution Permits