how government might intervene to constrain business activity

External Influences – Economic (Cambridge 9609)

Learning objective

Explain how and why government intervenes in the economy, both to constrain and to help business activity, and evaluate the impact of those interventions on firms, consumers, competitors and the wider economy.

Why governments intervene

• Correct market failures – negative externalities (e.g., pollution), positive externalities (e.g., R&D), information asymmetry.
• Protect consumers, workers and the environment – health & safety, product standards, labour rights.
• Achieve macro‑economic objectives – low unemployment, low inflation, sustainable growth, stable exchange rate.
• Promote fair competition – prevent monopolies, cartel behaviour, encourage entry.
• Realise broader social or political goals – public‑health, regional development, social equity.

Government intervention – Constrain vs. Help

Monetary vs. Fiscal policy

Monetary policy is conducted by the central bank (Bank of England). Main tools:

• Policy interest rate (base rate) – affects borrowing costs for firms and households.
• Open‑market operations / quantitative easing – changes the money supply and long‑term interest rates.
• Reserve requirements – influence banks’ capacity to lend.

Typical macro‑objective links:

• Low inflation – raise rates, reduce money supply.
• Stimulate growth – cut rates, QE.
• Exchange‑rate stability – intervene in FX markets, adjust rates.

Fiscal policy is set by the government (HM Treasury). Main tools:

• Taxation – cuts (e.g., reduced corporation tax) or targeted taxes (e.g., carbon duty).
• Government spending – infrastructure projects, education, health, direct subsidies.
• Public‑investment schemes – Enterprise Investment Scheme (EIS), Regional Growth Funds.

Typical macro‑objective links:

• Low unemployment – increase spending on public works, provide wage subsidies.
• Economic growth – tax incentives for investment, R&D grants.
• Balance of payments – fiscal restraint to avoid excessive deficits that could pressure the exchange rate.

Macro‑economic objectives & the policy mix

How each instrument influences business activity

1. Cost changes – taxes, subsidies, interest rates directly alter unit costs and profit margins.
2. Market access – tariffs, quotas, licences, export‑promotion schemes expand or restrict the size of the market.
3. Operational flexibility – regulations dictate processes; supply‑side measures (deregulation, training, digital infrastructure) broaden capabilities.
4. Price environment – price ceilings, minimum‑wage floors, or tax‑on‑sales reshape revenue and wage structures.
5. Financial environment – monetary policy influences borrowing costs; fiscal policy changes disposable income of consumers and the overall demand for goods.

Case studies (illustrating both constraining and helping tools)

1. UK Plastic‑bag charge (Constraining)

• Instrument: £0.05 specific charge on single‑use carrier bags (tax/fee).
• Rationale: Reduce the negative externality of plastic waste.
• Direct effect on firms: Small administrative cost; price of bags rises.
• Secondary effect: 90 % fall in bag usage; shift to reusable bags; modest impact on overall retailer profit.

2. R&D Tax Credit (Helping)

• Instrument: Additional 12 % tax relief on qualifying R&D expenditure.
• Rationale: Encourage innovation (positive externality) and raise long‑term productivity.
• Direct effect on firms: Lower effective tax rate on R&D spend → higher net return on innovation projects.
• Secondary effect: More new products, increased export potential, spill‑over benefits to suppliers.

3. Minimum‑wage increase (Mixed – both constrain and help)

• Instrument: Statutory rise in the National Living Wage.
• Rationale: Improve living standards and reduce poverty.
• Direct effect on firms: Higher hourly labour cost.
• Secondary effect: Some firms raise prices or invest in productivity; workers have higher disposable income, boosting demand.

4. Quantitative Easing (Monetary – Helping)

• Instrument: Bank of England purchases of government bonds, injecting liquidity.
• Rationale: Lower long‑term interest rates to stimulate investment and consumption.
• Direct effect on firms: Cheaper borrowing, higher asset prices, increased confidence.
• Secondary effect: Potential future inflation; depreciation of the pound can raise import costs.

5. Tariff on imported steel (Constraining)

• Instrument: 25 % duty on steel imports (post‑Brexit trade policy).
• Rationale: Protect domestic steel industry and preserve jobs.
• Direct effect on firms: Higher input cost for manufacturers using steel.
• Secondary effect: Higher final‑product prices for consumers; possible retaliation from trade partners.

Potential unintended consequences

• Black‑market activity – overly restrictive licences or price caps can push trade underground.
• Competitive disadvantage – domestic firms may face higher costs than foreign rivals not subject to the same rules.
• Innovation suppression – heavy compliance burdens can deter R&D investment.
• Fiscal burden – generous subsidies or tax cuts may widen the budget deficit, leading to future tax rises.
• Currency volatility – aggressive monetary easing can depreciate the pound, raising import costs.
• Regulatory “lock‑in” – firms may design processes around a regulation, making later deregulation costly.

Impact on business decision‑making

When evaluating a strategic choice (e.g., launching a new product, expanding abroad, setting prices), firms should consider:

1. Current and anticipated government policies (tax rates, subsidies, regulations, trade measures).
2. How those policies affect costs, revenues, and risk (compliance costs, access to finance, market size).
3. Implications for the macro‑environment – inflation, exchange rates, consumer confidence.
4. Potential secondary effects on competitors, supply chains, and consumer behaviour.
5. Likelihood of unintended consequences and how they could be mitigated.

Summary checklist for exam answers

• Identify the specific government instrument (name, type, and whether it is constraining or helping).
• State the economic rationale (market failure, macro‑objective, social/political goal).
• Explain the direct effect on the firm’s costs, output, market access or pricing.
• Analyse the secondary effects on consumers, competitors and the wider economy.
• Provide a real‑world example (UK or comparable country) to illustrate the point.
• Briefly mention any likely unintended consequences.
• Link the instrument to the relevant macro‑economic objective(s) where appropriate.