1.4.1a Taxation, subsidies and price controls

Correcting Market Failure

1. The purpose of intervention is to correct market failure and move output closer to the social optimum.
2. The main price-based tools are indirect taxes, subsidies, and maximum and minimum prices.

Indirect Taxation

1. An indirect tax raises the price and lowers the quantity, so consumers face more of the external cost and output moves toward the social optimum.
2. The government raises tax revenue equal to the tax per unit multiplied by the quantity sold.
3. The more inelastic demand is, the more of the tax burden falls on consumers rather than producers.

Subsidies

1. A subsidy lowers price and raises quantity, encouraging consumption of goods with external benefits or merit goods.
2. The cost to the government equals the subsidy per unit multiplied by the quantity.
   1. How far the price falls for consumers depends on the elasticity of demand.

Maximum and Minimum Prices

1. A maximum price set below equilibrium makes demand exceed supply, causing a shortage.
   1. Shortages can lead to queues, rationing and black markets.
2. A minimum price set above equilibrium makes supply exceed demand, causing a surplus.
   1. The government or another buyer may have to purchase the surplus, as seen with the minimum unit price on alcohol and the National Living Wage.

Do indirect taxes solve market failure?

1. It holds because a well-set tax internalises the external cost, raises price towards the social optimum and cuts the harmful quantity, while raising revenue that can fund further correction.
2. But if demand is price-inelastic, as with cigarettes or fuel, quantity barely falls, so the tax mainly raises revenue rather than curing the failure.
3. But governments struggle to value the externality precisely, so the tax may be set too high or too low, and it can be regressive, hitting poorer households hardest.
4. On balance, whether an indirect tax solves the failure depends on the elasticity of demand, the accuracy of the valuation and whether it is combined with measures such as information or regulation.

1.4.1b Other methods of intervention

Tradable Pollution Permits

1. A tradable pollution permit scheme caps total emissions and issues permits that firms can buy and sell.
2. Firms that cut emissions cheaply can sell spare permits, while heavy polluters must buy more.
   1. This puts a price on pollution and gives every firm an incentive to produce more cleanly.

State Provision

1. The government provides public goods directly, funded by taxation, because the free-rider problem otherwise leaves a missing market.
2. It can also provide merit goods to raise their consumption toward the social optimum.

Provision of Information

1. The government provides information to close information gaps and help people judge the true costs and benefits.
   1. Better-informed consumers are more likely to reach the socially optimal level of consumption.

Regulation

1. Regulation sets rules that require or ban behaviour, backed by penalties for breaking them.
2. It can force output toward the social optimum, but needs monitoring and enforcement to work.
   1. Examples include emissions limits, minimum age laws for alcohol and bans on harmful products.

Is regulation better than market-based tools for cutting pollution?

1. It holds because regulation sets a firm limit that is simple to understand and, when properly enforced, guarantees a change in behaviour.
2. But it needs costly monitoring and enforcement, and a uniform rule ignores that firms can cut pollution at very different costs, so it can be inefficient.
3. But market-based tools such as permits or a carbon tax let cuts happen where they are cheapest and keep giving firms an incentive to go greener, provided the price or cap is set accurately.
4. On balance, the best choice depends on how measurable the pollution is, the cost of enforcement and the risk of government failure in setting the rule, tax or cap.