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Government Intervention in Markets

Government Responses to Market Failures

Governments address market failures by using tools to affect the consumption of certain goods and services.
Government intervention in markets, or government involvement that impacts the free market system, can occur when governments attempt to address market failures. They supply certain goods and services, such as schools and bridges. Governments also use tools such as regulations and taxes to steer consumption in a direction that is beneficial to society as a whole. For example, builders must construct homes that meet safety regulations, despite the fact that they could provide a cheaper product without having to meet those standards. Also, the government uses taxes to fund public libraries because private companies do not have the incentive to provide free books to people, but it is in society's interest to have a literate population. Whereas businesses and individuals often make decisions based on their own best interests (such as profit maximization), government policies consider the welfare of an entire society. Governments can incentivize businesses to act in the interest of society as a whole through market approaches, such as monetary benefits to decreasing the amount of pollution made during production, or through public awareness campaigns regarding the benefits of solar power.


Regulations alter the demand for goods or change the supply in the market.

Consider government intervention in the marketplace to address externalities—costs or benefits from economic activities that affect all of society. With positive externalities, there is an underconsumption of goods. Governments try to increase the consumption of these products with rules and regulations. For example, the government requires a certain percentage of gasoline to come from renewable fuel, which provides a new market for corn farmers.

Regulations can also address negative externalities. For example, airport takeoffs and landings are restricted at night to reduce noise for nearby residents. Pollution regulations prevent industrial manufacturers from dumping hazardous waste into local water supplies.

Governments have also tried to reduce cigarette consumption by banning cigarette use in specified locations. In recent years, vaping (the use of e-cigarettes) has become a popular alternative to cigarette smoking. Over the past decade, a large part of the significant decrease in cigarette consumption was caused by taxes and regulations, as well as the substitution of the more socially acceptable option, vaping.

Taxes and Subsidies

Taxes decrease demand for a good or service by raising the price the consumer pays. Subsidies increase demand for a good or service by lowering the price the consumer pays.
With negative externalities, there is an overconsumption of certain goods. Governments try to decrease consumption to levels optimal, or best, for society as a whole. An excise tax, which is tax levied on specific goods such as alcohol, gasoline, and cigarettes, is usually paid by the consumer at the time of purchase and is used to reduce the consumption of certain goods or services. By raising the price of the good or service, the government aims to decrease the quantities consumed. Excise taxes also generate government revenue. For example, smoking cigarettes produces a negative externality called secondhand smoke. To reduce cigarette consumption, the government places an excise tax on cigarettes, increasing the price of the cigarettes. The government, not the producer, receives the revenue from the additional increase in price and can use the tax revenue to address related issues like air quality or health issues.
An excise tax, paid by the consumer at the time of purchase, shifts the demand curve down by the size of the tax. The equilibrium price falls from Porig to Psell and the equilibrium quantity decreases from Qorgin to Qtax. This new equilibrium price is the price that buyers will pay to the sellers and represents the amount sellers receive.
Effluent taxes have a similar effect to excise taxes, but in this case the tax is paid by the producer instead of the consumer. An effluent tax is a fee paid by a company to discharge a sewer. When producers manufacture products, an associated negative externality is pollution of the surrounding environment. By making the producer pay a tax for the pollution it produces, the government hopes to decrease the quantity of pollution produced.

The impact on consumption will be affected by the elasticity of demand for a good or service. When prices increase, elastic goods have larger decreases in quantities consumed than inelastic goods. If the price of an elastic good increases, consumers choose another, less expensive option. This may cause the producer to shift resources to supplying more profitable goods or close the business. Conversely, if the demand is inelastic, then the decrease in consumption may be small. For example, increases in taxes on gasoline tend to have very little effect on levels of driving and gasoline consumption.

The relative elasticity of a product's supply and demand affects who shoulders the burden of the higher cost arising from excise taxes. Taxes generate revenue for the government. If a good has elastic demand and inelastic supply, this means it is hard for the producer to lower the supply but easy for the consumer to lower the demand. As a result, the producer must lower the price so that the consumer does not see a price increase with the added tax and continues to buy the product. This means that the producer absorbs more of the tax burden. Conversely, if a good has inelastic demand and elastic supply, then the producer has the option of reducing the supply if the consumer is not willing to pay the higher price with the added tax. However, because demand is inelastic, the consumer pays the higher price and absorbs more of the tax burden. Insulin is an example of a good where supply is more elastic than demand, because consumers tend to buy the same amount regularly regardless of changes in price. Both of these situations illustrate that when there are taxes, there is a difference between the cost for producers and the price that consumers pay, which is different from what happens without government intervention.

Excise taxes also create deadweight loss by reducing the equilibrium quantity in the market. When an excise tax is imposed, the price paid by the consumer is above the equilibrium level and the price that the producer receives is below the equilibrium level. This keeps people from buying products they would have purchased at lower prices and keeps producers from supplying as much as they would have at higher prices. The relative portions of the tax burden shouldered by the producer and consumer depend on the relative elasticity of the supply and demand of the product or service. Although the government does receive revenue in this process, the overall result is a deadweight loss to the society. Government revenue is considered as a portion of total surplus with consumer and producer surplus, but losses to society are measured only by the amount of deadweight loss.
When demand is perfectly inelastic, consumers are relatively unresponsive to changes in price, like with insulin (see graph on the left), consumers pay the full price of the tax. The tax revenue comes only from consumers. When the elasticity of demand and supply are similar, like with payroll taxes, both producers and consumers share the increase in price and contribute to tax revenue (see graph on the right).
Governments also provide a subsidy, or monetary support, for an industry that keeps the prices of goods and services low. The government subsidizes the cost of milk by paying dairy farmers when the price of milk goes too low so the farmers can afford to keep providing the market with milk. Because subsidies lower the prices paid by the consumer, they encourage an increase in consumption.
Subsidies, or monetary payments to producers, cause the supply curve to shift outward. This outward shift results in a lower equilibrium price (P1 to P2) and a higher equilibrium quantity (Q1 to Q2).

Market Approaches

Market approaches offer a flexible and efficient way of solving for market failures and accounting for social costs and benefits.

Market approaches are methods that allow the government to affect externalities through the market itself, rather than by enforcing regulations, collecting taxes, or offering subsidies. In the case of externalities, the effects of market exchanges on a third party that is neither the buyer nor seller, governments can intervene by helping markets take social costs and social benefits into account. Some of these approaches are laws implemented by the government that firms must meet, and some of these tools are market-oriented, and provide incentives to firms who take these social costs and benefits into account. These approaches and tools are different depending on whether the externalities are negative or positive.

In the case of negative externalities, the government wants to assist firms in taking social costs—costs of externalities—into account during production. The result of taking negative externalities into account is that the social cost is built into the supply curve in the form of higher input costs and a curve shift to the right. The most common example of a negative externality is pollution. Market approaches create incentives, and allow firms flexibility in reducing pollution. Two main approaches used are trade-able permits (AKA cap-and-trade) and better defined property rights. In the trade-able approach, the government starts by determining the pollution quantity it will allow, and then deciding the number of permits allowed. They then divide the permits among the firms. The firms can then trade or sell the permits. The final step is to make the permits shrinkable to reduce the amount of allowable emissions after a period of time. This allows firms to decide whether they are going to spend money to modernize their facilities to eliminate pollution or buy the permits. It also provides firms that do spend the money an incentive as they can recoup some of that money by selling their permit if they lower their pollution, and it allows older facilities not to spend lots of money modernizing as they can just purchase permits—firms like this flexibility. The outcome is a more efficient reduction in emissions, because firms were allowed to flexibly assess their marginal benefits and marginal costs of reducing pollution. Another method is to better define property rights. Defining property rights and legal responsibility in a more detailed and explicit way will allow private parties to solve externalities without government intervention.

In the case of positive externalities, social benefits that affect third parties are not being taken into account. Governments can increase positive externalities by raising public awareness to encourage consumption of a good. For example, governments may create public education broadcasts about the benefits of installing home solar panels.