Government microeconomic intervention (A Level)

8.1 Government policies to achieve efficient resource allocation and correct market failure

Taxes and subsidies

A tax equal to the marginal external cost (a Pigouvian tax) internalises the externality, moving output to the social optimum. A subsidy to a good with positive externalities (education, vaccination) raises output towards the optimum. Problems: measuring the externality, accurate rates, evasion, regressive effects, and cost of subsidies.

Regulation and property rights

• Regulation: maximum emissions, safety standards, minimum quality, age restrictions. This includes prohibitions (an outright ban, for example on a dangerous chemical) and licences (a permit needed to carry out an activity, such as fishing or running a business, which can limit the number of firms or amount of activity).
• Tradable pollution permits: a cap on total pollution; firms trade permits, so cuts happen where they are cheapest.
• Property rights: assigning ownership so that owners bear costs; Coase argued bargaining can solve externalities when rights are clear and costs are low.

Provision of public and merit goods

Public goods are provided by the state (non-rival, non-excludable). Merit goods may be provided directly, subsidised or made compulsory; demerit goods are taxed or banned. Information failure is tackled by labelling, education, advertising.

Privatisation and nationalisation

Privatisation: selling state assets; may raise efficiency (profit motive), revenue and competition, but risks private monopoly, neglect of social aims and short-termism. Nationalisation: taking industries into public ownership, to protect natural monopolies, strategic industries and social aims, but may bring inefficiency, political interference and losses.

Competition policy and regulation of monopoly

Competition policy prevents anti-competitive behaviour: cartels, mergers that harm consumers, abuse of dominance. Regulators use price caps (RPI − X) to control monopoly prices while giving firms an incentive to cut costs; rate-of-return regulation limits profit; windfall taxes; breaking up monopolies; promoting contestability.

Cost–benefit analysis (CBA)

CBA assesses a project by valuing all social costs and benefits, including externalities, and discounting future values to present values. A project is worthwhile if social benefits exceed social costs (positive net present value).

Limitations: hard to value intangible items (environment, life), choice of discount rate, uncertainty and distribution effects (who gains and loses).

Government failure

Intervention may fail: information gaps, unintended consequences, administrative costs, regulatory capture, short-term political motives, and inefficient state provision. The balance between market and state is a value judgement.

Other measures: specific and ad valorem indirect taxes correct negative externalities (a specific tax is a fixed amount per unit; ad valorem a percentage), production quotas limit output of harmful goods, deregulation removes rules to increase competition and cut costs (but may reduce protection), and behavioural insights ("nudge" theory) change choices without banning them: default options (automatic pension enrolment), placing healthy food at eye level and clear labels work with how people actually behave (not always rationally). These are often cheap, but their effects can be small and hard to measure.

8.2 Equity and redistribution of income and wealth

Equity is fairness; horizontal equity is equal treatment of equals, vertical equity is unequal treatment of unequals (taxing those with more ability to pay).

Taxation

Direct taxes (income, corporation, wealth, inheritance) are usually progressive (corporation tax is often a flat rate) and help redistribute; indirect taxes (VAT, excise) are often regressive. Principles of a good tax: equity, certainty, convenience, efficiency, flexibility.

Effects of taxes

• Incentives: a high marginal rate may reduce work effort and risk-taking; a lower rate may raise revenue if incentive effects are strong (Laffer curve idea).
• Tax burden between consumers and producers depends on elasticity.

Redistribution policies

Transfer payments (benefits, pensions), subsidised or free public services, minimum wage, progressive tax, wealth taxes, education and training to raise earning power. Means-tested benefits target the poor but create a poverty trap (higher earnings reduce benefits); universal benefits cost more but are simple and carry no stigma.

Poverty: absolute (below a basic needs line) and relative (below a share of median income). Measurement: Lorenz curve and Gini coefficient.

Trade-off between equity and efficiency: high taxes and generous benefits may reduce incentives and growth, but extreme inequality wastes human potential and harms stability; choices depend on values.

A negative income tax (see AS notes) is one policy toward equity and equality; others include progressive taxes, state provision, a minimum wage and targeted benefits.

8.3 Labour market forces and government intervention

Demand for labour

The demand for labour is derived: it depends on the demand for the product and labour productivity. The marginal revenue product (MRP) of labour is the extra revenue from employing one more worker (marginal physical product × marginal revenue); the MRP curve is the demand curve for labour. Firms hire until MRP = wage (marginal cost of labour).

Shifts in demand: product demand, productivity, prices of other factors (capital), technology.

Supply of labour

The supply curve slopes up: higher wages attract more workers. Determinants: wage rates, non-wage benefits, population and migration, education and skills, taxes and benefits, labour market flexibility, hours and leisure preferences. Elasticity of labour supply is greater for unskilled work and in the long run; mobility of labour (occupational and geographical) matters.

Wage determination

Competitive labour market: wage where demand equals supply. Differences in wages reflect skills, risk, productivity, compensating differentials (unpleasant jobs paying more), bargaining power and discrimination.

Trade unions and the minimum wage

Trade unions raise wages by collective bargaining; union power can raise wages above the equilibrium but may reduce employment. A monopsony (a single buyer of labour) pays below the competitive wage and employs fewer workers; a minimum wage in a monopsony can raise both wages and employment.

A minimum wage set above equilibrium in a competitive market creates excess supply of labour (unemployment) but raises the incomes of those in work. Evaluation: effects depend on the elasticity of demand for labour, the size of the minimum relative to the average wage and market structure; also reduced poverty, motivation and inflation effects.

Other interventions: anti-discrimination law, education and training subsidies, benefits (affecting the incentive to work), limits on working hours, flexibility measures.

Transfer earnings are the minimum payment needed to keep a factor in its current use (what it could earn in its next best use). Economic rent is the payment above transfer earnings: for a very talented footballer paid $500,000 who could earn $50,000 in the next best job, the transfer earnings are $50,000 and the economic rent is $450,000. Factors with inelastic supply earn high economic rent; with perfectly inelastic supply (such as a unique piece of land), all earnings are economic rent.