1.4.1. Part 2 Government intervention – Edexcel Economics A notes

This page contains notes for Edexcel Economics A, covering tradable pollution permits, state provision of public goods, provision of information and regulation.

For part 1 on taxes, subsidies and price controls, see the link here.

Contents

Tradable pollution permits

Tradable pollution permits are one way to intervene to reduce pollution. 

Tradable pollution permits are allowances for firms to pollute a certain amount that firms can buy and sell to other firms. If firms do not buy enough permits to cover their pollution, they could face fines.

The government sets the total number of permits. Hence the permit supply is set at a constant level, which does not depend on the price of permits. However the government could choose to reduce the number of permits over time in order to lower pollution levels.

Examples of tradable pollution permit schemes include:

• The UK Emissions Trading Scheme (UKETS).
• The EU Emissions Trading Scheme (EUETS).
• For more information on these, see the practice question section of this page.

Diagrams for tradable pollution permits

1) The permit market

This diagram below shows the market for tradable pollution permits.

The government is the sole supplier of permits at auction. So the supply of permits is assumed to be perfectly price-inelastic: no matter the price, the supply of permits remains the same. 

Demand for permits is a standard downward-sloping line.

This gives the equilibrium (q,p) for the permit market. 

The government could decide to reduce the total number of permits available, to reduce pollution levels. This shifts permit supply left from S to S1. 

As a result, the equilibrium quantity of permits falls from q to q1. The price of a permit rises from p to p1. 

This increases the cost to firms of polluting, incentivising some firms to invest in energy efficiency and other firms to reduce their output. 

2) Externality diagram 

Consider a negative externality of production diagram, as shown below. This could represent the market for a good whose production causes pollution, such as the steel market.

The free market outcome occurs where MPB = MPC, at (q,p).

The socially optimal outcome occurs where MSB = MSC, at (q1,p1).

How could the government move the free market towards the socially optimal outcome? One way is to force polluting firms to pay for tradable pollution permits. This would increase costs for polluting firms, shifting their MPC leftwards from MPC to MPC + permit cost.

This moves the market outcome to where MPC + permit cost = MPB, at (q1,p1). This decrease in quantity and increase in price increases social welfare by the green area, eliminating the welfare loss from the negative production externality.

In other words, the permit cost forces some firms to “internalise” the external cost.

Other diagram options include:

• Showing the market for green technology. Firms needing to buy permits may instead invest more in green technology to reduce emissions (increasing supply) or demand more green technology to reduce emissions.
• The effect of permit costs on a firm’s costs and profits, using a cost and revenue diagram. This requires theme 3 knowledge.

What are the effects of tradable pollution permits?

Pollution reduction:

• Pollution permits make polluters pay for the amount of pollution they produce. This increases the costs associated with pollution, reducing the incentive to pollute.
• Hence, firms internalise the negative externalities arising from pollution, such as the consequences of climate change and breathing problems.
• Moreover, firms are able to sell their permits if they can reduce pollution.
• This may increase spending by firms on energy efficiency measures or encourage firms to switch to less polluting forms of energy.

Increase in firm costs:

• Particularly if the government initially auctions off the permits to firms, firm costs are likely to increase. This is because firms need to buy enough permits to cover their emissions. 
• This could increase prices of final goods for consumers, if firms pass the higher costs onto consumers. 
• Firms may also seek to move abroad to avoid paying for pollution permits.
  • A firm may choose to move to another country with less environmental regulation. 
  • This could reduce the extent to which pollution falls following the use of tradable pollution permits in one country. 

The success of tradable pollution permits depends on:

• Whether the government sets the right level of permits.
  • Suppose the government releases too many pollution permits. 
  • The supply of permits would be higher, which would reduce the equilibrium price of permits.
  • As a result, firms may not have to reduce emissions as much. 
  • Cheap and abundant permits could make it easier for firms to continue to pollute.
• The extent of any “free” permits given out by the government.
  • Some firms that produce high pollution levels as part of their production process are assigned “free permits”. 
  • This could reduce the extent to which business costs increase under a pollution permit system.
  • However, free permits could make it harder to reduce emissions.
• How the government decides which firms get permits – auctions or “grandfathering”.
  • The government could choose to run an auction, offering the permits to the highest bidder. This would increase firm costs, but it would create a disincentive to pollute and raise government revenue. 
  • Alternatively, the government may choose to base the permit allocation on past emissions, known as “grandfathering”. This could reduce the initial cost burden on firms as they may not need to buy (as many) permits but instead just receive an allocation from the government. 
  • However, grandfathering could create an incentive to increase emissions before the government’s decision on who gets permits, in order to receive more permits.

State provision of public goods

State provision is when the government directly supplies a good or service, funded through taxation. These goods are provided free at the point of use.

Examples include public goods such as national defence or streetlights. Some merit goods are also provided by the state, such as the National Health Service providing healthcare in the UK.

The diagram for state provision

See the diagram below, which could reflect the market for streetlights.

• The supply of the good is set by the government, independent of the market price. Hence the supply is perfectly price-inelastic.

• The good is provided free at the point of use, at price 0, funded by taxation.
• This reduces the price from p, the free market price, to p1 (which is zero) with intervention. 
• However, state provision also creates excess demand for the good of q1-q.

What are the advantages and disadvantages of state provision?

The advantages of state provision are:

• The provision of public goods can increase social welfare.
  • Public goods may suffer from the free-rider problem.
  • Consumers can always consume public goods without paying, because of non-excludability. 
  • This leads to consumers not being willing to pay for the public good. So firms cannot generate revenue from producing the good – complete market failure results. 
  • That said, society may benefit from the good being provided, compared to the good not being provided at all. By providing the public good, social welfare increases.
• [For state provision of merit goods] The provision of merit goods could also increase social welfare.
  • Merit goods are goods that are underconsumed in the free market. 
  • This could be because of positive externalities or information failures.
  • An example of a merit good is healthcare.
  • The government can choose to provide healthcare to increase the quantity of healthcare beyond the free market outcome and closer to the socially optimal outcome.  
  • This could lead to a gain in social welfare.
• Reduced inequality, with those on low incomes having greater access to state provided goods.
  • This is because the goods are provided free at the point of use. 

The disadvantages of state provision are:

• There is a cost to the government from funding state provision.
  • This could lead to higher taxes to cover the cost.
  • The cost of state provision could also generate an opportunity cost. Perhaps the funds spent on state provision could be spent elsewhere on another project with a higher benefit-cost ratio. 
• There could be excess demand if the level of state provision supplied is below the level of demand.
  • This could lead to queues or waiting lists for some goods or services.

The effectiveness of state provision depends on: 

• Whether the government correctly estimates the socially optimal quantity.
  • The government may lack information on costs and benefits required to determine the socially optimal quantity.
  • This could lead to underprovision of the public good if the government underestimates the benefits of the public good.
• The return to the government from providing the good.
  • Sometimes the government stands to benefit from the positive externalities from providing goods. For example, providing healthcare may lead to workers being less likely to be sick, so more people enter the workforce. This could increase income tax revenue for the government.
  • In such cases, there may be a high rate of return from government provision of healthcare. 
  • This could reduce the extent to which the government’s budget deficit rises, following provision of the public good.

Provision of information

The government could run an information campaign to encourage or deter consumption of a good or service. 

Alternatively, the government could require firms to provide information to consumers on buying the product. [This could also be seen as a type of regulation].

Providing information can help solve information gaps.

Examples of information campaigns include:

• The UK Government’s Better Health campaign. The purpose of this was to support parents in improving their children’s diet, providing information on healthier snack alternatives at shops. [External link]
• Covid-19 – information videos about washing hands. 
• Cigarettes – labelling on packages of the health risks from consuming cigarettes.

What are the consequences of information provision?

• Increase in social welfare in cases of lack of consumer information about benefits or harms.
  • Some goods may be underconsumed in the free market if consumers lack information about the private benefits of consuming the good. Examples include healthcare, education or pensions. 
  • An information campaign could make consumers more aware of the private benefits of taking on education or training. This could include the wage benefits from learning new skills. The campaign could increase demand for education or training, reducing the extent of market failure.
  • Other goods may be overconsumed in the free market, if consumers lack information about the private harms from consuming the good. Examples here include cigarettes and alcohol. 
  • Information campaigns could make consumers aware of the health risks from consuming cigarettes. An example is packaging on cigarettes informing users of the health risks to lungs and teeth.
• Increase in social welfare in cases of asymmetric information.
  • An example of adverse selection is the used car market, where sellers may have more information than buyers about the defects in a used car. 
  • Consumers could be provided information about the quality of the used cars. For instance, knowledge of the defects of a used car before purchasing.
  • This could make consumers more willing to buy good quality used cars and less likely to buy poor quality cars, increasing consumer surplus.
• However, the information campaigns may not be effective.
  • Consumers may have limited attention and may miss or skip over the advert.
  • The advertising may be in the wrong place to reach the target group. For example it may be more effective to use social media campaigns than radio advertising to target younger age groups. 
  • Consumers may rebel against any encouragement or pressure from the government to consume a particular good.
• Government failure. 
  • Consumers may already be aware of the benefits and risks of consuming a good. So, government intervention through providing information could lead to over- or underconsumption of a good.
  • Also, if the information campaign does not affect demand as much, the cost of the information campaign to the government could outweigh the benefit of the campaign. 
  • Moreover the money from the campaign may have an opportunity cost. 

Diagram for information provision

The diagram below shows a market failure for a good where consumers lack information about the benefits. This could be the market for fruit. 

The lack of information about the health benefits of eating fruit could lead consumers to consume on the lower demand curve (D imperfect info).

If consumers had full information, they would consume on the higher demand curve (D1 full info). This means in the free market, there is underconsumption of q1-q.

To resolve this market failure, information provision shifts demand right from D to D1, providing consumers with full information about the benefits of consuming healthy food for health. This increases the equilibrium quantity from q to the optimal quantity q1. 

Regulation 

A regulation is a rule that the government puts in place that forces consumers or firms to take or avoid certain actions (with penalties if they do not comply). 

Examples of regulations include:

• Age limits such as a minimum age of 18 for buying alcohol at a supermarket.
• Location-based bans such as a ban on smoking inside pubs.
• Outright bans, such as the ban on new diesel and petrol cars being sold in the UK by 2030.
• Quotas, a limit on the quantity of a good. For example, quotas limiting the number of fish that can be caught.
• Rules to protect workers, consumers or the environment:
  • An example for workers is health and safety paperwork to reduce the risk of worker injury. 
  • Another example for consumers is consumer protections if consumers are missold a good. 
  • Environmental regulations include emissions declarations by firms.

Diagrams for regulations

Some regulations may directly reduce demand, such as age limits:

• An age limit on cigarette purchases could shift cigarette demand to the left from D to D1 in the diagram below.
• This reduces the equilibrium price and quantity.

Other regulations may reduce the quantity supplied by increasing firm costs to comply. 

• If firm costs increase, supply would shift left from S to S1 in the next diagram below. This increases the price and reduces the quantity. 
• For example, health and safety paperwork to avoid accidents in the workplace. 
• Note age limits may also impose costs on firms, with workers spending time checking customer IDs.

A quota diagram (see below) is a variation on the above diagrams. 

• A quotas can move the supply curve from S to S with quota in the diagram below.
• At low quantities below the quota, the supply curve remains the same as the original supply curve. 
• However, at the quota level q1, no more may be supplied, no matter how high the price rises. So, the supply curve becomes perfectly price-inelastic and vertical at the quota outcome. 
• Hence, the quota reduces the equilibrium quantity from q to q1 and increases the price from p to p1. 
• The effect of the quota ends up as a similar outcome to a simple supply shift left.

What are the consequences of regulations?

Correcting market failure for demerit goods:

• Demerit goods are over-consumed in the free market, for instance because of negative externalities or information failures.
• These include alcohol or cigarettes.
• These goods exhibit market failure, leading to a welfare loss without government intervention. 
• Regulations, by reducing demand or supply, can reduce the equilibrium quantity of demerit goods.
• This reduces the extent of overconsumption, increasing social welfare.

Reduced firm profits:

• Regulations can reduce demand and/or increase firm costs, reducing supply.
• This reduces firm profits. 
• This leaves firms with less funds to invest, so investment may fall.
• Firms may be more likely to shut down, which could reduce labour demand and increase unemployment. 
  • However, some regulations may provide opportunities for other firms to increase their profits. A ban on the sale of new petrol and diesel cars could increase consumer demand for electric vehicles (EVs), boosting revenues and profits for EV manufacturers.
• Some regulations could also increase the barriers to entry to an industry, making the market less contestable. [This links with theme 3 on contestability].

Risk of government failure:

• Regulatory capture is when regulators are lobbied by firms to water down the regulation, making it less strict. This could make the regulation less effective.
• There could also be unintended consequences.
  • This includes illegal transactions to circumvent the regulations.
  • A young person wanting to buy alcohol may ask an older friend or relative to buy it for them, making the regulation less effective.

Certainty and confidence effects of regulation:

• Some regulations help to create certainty.
• For example, regulations to protect worker safety could make workers more certain and confident about performing their work. This could contribute to higher worker productivity.
• In the case of firms, regulations such as property rights may encourage investment.
  • Property rights: Regulations could give firms the legal right to own land or property they have purchased and to sue anybody who tries to claim this land.
  • Another example of this is patent rights. Giving firms a right to the returns from a new invention could increase the incentive to create new inventions.
  • Property rights give firms assurances and predictability, which could increase investment.
• Other regulations to ensure the financial stability of banks could also generate higher business confidence and investment. Firms would be less worried about the risk of bank failure, making them more willing to borrow from banks to invest.

Practice question on government intervention 

Here is a practice question written in the style of Edexcel Economics A on government intervention. It features an extract, followed by a practice question.

Extract – The UK and EU Emissions Trading Schemes

Since leaving the European Union, the UK Government has replaced the EU Emissions Trading Scheme with the UK Emissions Trading Scheme (UK ETS). This is a tradable permits scheme. Companies have to buy permits to cover their carbon emissions and such permits can be traded. This covers power generation, industry and aviation, though some sectors do receive free permits. These schemes can incentivise firms to reduce their pollution, so they can sell their permits. Indeed for the UK firms that participated in the EU ETS before the UK left the EU, pollution fell from 236 million tonnes per CO2 equivalent to just under 130 million tonnes per CO2 equivalent.

However, if there are too many permits, the price will be too low and there will be no incentive to reduce emissions. During the Covid-19 pandemic, a slowdown in economic activity contributed to an increase in the supply of permits for the EU ETS, which could undermine efforts to reduce emissions. Nevertheless, expectations that the EU will have tougher pollution targets has pushed permit prices from 25 euros on average in 2020 to over 50 euros per permit as of May 2021.

Question: Referring to the extract, evaluate the effects of introducing tradable pollution permits (15 marks).

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