Wednesday 11 May 2011

Impact of Subsidies,regulation and indirect taxes as possible solutions to market failure


Indirect taxation can be an effective solution to market failure. Indirect taxation includes VAT and excise duties on goods such as tobacco and alcohol. One issue with indirect taxation is that much of the burden of the tax can be passed onto the consumer if the good has an inelastic PED. They can be an effective instrument in controlling and correcting market failure arising from externalities, governments try to act upon a “polluter pays” principle by internalizing the external costs of production and consumption. One issue with this form of taxation is that in the case of many goods (cigarettes, alcohol) much of the tax is passed onto the consumer as the inelasticity of the product means that the consumer is able to do this without adversely affecting demand.

A subsidy is a payment paid by the government to a producer which aims to reduce their costs and increase output. The effect of a subsidy is to increase supply and drive prices down, if all things remain equal (ceteris paribus). In terms of correcting market failure this should raise demand to the level it should be at if the benefits of consumption were taken into account, this can be seen as a correction of market failure as under consumption of merit goods can lead to a loss of social welfare. One issue with subsidising an industry is that they can become over reliant on the subsidy and therefore become inefficient as a result, leading to a delay of economic reform.

Regulation is often used as an alternative to taxation and subsidy, the government can regulate the level of output and pollution in a market. In theory it can act by a government setting a limit (quota) so that output is set at the social optimum. An issue with this kind of regulation is it requires accurate and up to date information in order for the government to set the quota at the right level.

1 comment:

  1. You have only quoted one issue on each - is that it? Or are there more issues?

    ReplyDelete