regulation and deregulation

Government Policies to Achieve Efficient Resource Allocation and Correct Market Failure (Cambridge AS & A‑Level Economics 9708 – Topic 8.1)

1. Why Government Intervention Is Needed

Market failure occurs when the free market does not allocate resources at the socially optimal level (MSB = MSC). The main causes are:

• Externalities (positive or negative)
• Public goods
• Information asymmetry
• Market power (monopolies, oligopolies)
• Equity concerns

When a failure exists, the market outcome creates a dead‑weight loss (DWL):

$$ \text{DWL}= \frac{1}{2}\,(P^{*}-P_{e})\,(Q_{e}-Q^{*}) $$

where P^*, Q^* are the price and quantity after intervention and P_e, Q_e are the free‑market equilibrium values.

2. Regulation – Direct Government Control (Syllabus 8.1)

2.1 Indirect Taxes (Syllabus 8.1.1)

• Specific tax – a fixed amount per unit (e.g., £0.20 per litre of sugary drink). Shifts the supply curve vertically upward by the tax amount.
• Ad‑valorem tax – a percentage of the price (e.g., 20 % fuel duty). Shifts the supply curve upward by a proportion of the price.
• Both aim to internalise negative externalities by raising the marginal private cost (MPC) toward the marginal social cost (MSC).

Tax incidence (economic incidence) – the burden shared between consumers and producers depends on relative elasticities:

$$ \Delta P_{c}=t\;\frac{E_{s}}{E_{s}+E_{d}},\qquad \Delta P_{p}=t\;\frac{E_{d}}{E_{s}+E_{d}} $$

where t is the statutory tax, E_d and E_s are the absolute values of the demand and supply elasticities. The statutory incidence (who legally pays the tax) may differ from the economic incidence.

2.2 Subsidies (Syllabus 8.1.2)

• Demand‑side subsidy – paid to consumers (e.g., education grants, free school meals). Shifts the demand curve upward, encouraging consumption of a good with positive externalities.
• Supply‑side subsidy – paid to producers (e.g., R&D tax credit, agricultural subsidies). Shifts the supply curve downward, reducing marginal private cost (MPC) toward marginal social cost (MSC).
• Buffer‑stock subsidy – government buys (or sells) a commodity to stabilise its market price (e.g., wheat buffer‑stock scheme). The purchase price is set above the market price, creating a price floor for producers and a price ceiling for consumers, reducing price volatility.

2.3 Price Controls (Syllabus 8.1.3)

• Price ceiling – maximum legal price (e.g., rent control). If set below equilibrium it creates a shortage (excess demand).
  Short‑run impact: immediate shortage, rationing, possible queues.
  Long‑run impact: reduced investment, deterioration of quality, emergence of black‑markets.
• Price floor – minimum legal price (e.g., minimum wage). If set above equilibrium it creates a surplus (excess supply).
  Short‑run impact: unemployment or surplus stock.
  Long‑run impact: firms may adopt labour‑saving technology, or the floor may be adjusted.

Diagram placeholders: price‑ceiling shortage; price‑floor surplus of labour.

2.4 Quantity Controls & Tradable Permits (Syllabus 8.1.4)

• Quotas – a fixed limit on the quantity that can be produced or imported (e.g., fishing quotas). Creates a scarcity rent for quota holders.
• Cap‑and‑trade (tradable permits) – government sets an overall cap on a harmful activity (e.g., EU Emissions Trading Scheme for CO₂). Permits are allocated and can be bought/sold, allowing the market to determine the price of the right to emit.
• Buffer‑stock scheme (quantity control) – government holds a reserve of a commodity (e.g., oil‑stockpiling by the IEA). When world prices rise above a preset level, the reserve is released, increasing supply and stabilising price; when prices fall, the reserve is replenished.

Quota vs. Permit comparison

Aspect	Quota (fixed allocation)	Tradable Permit (cap‑and‑trade)
Flexibility	Low – firms cannot adjust quantity beyond the set limit.	High – firms can trade permits, allowing cost‑effective compliance.
Administrative cost	High – monitoring and enforcement of individual quotas.	Moderate – central authority issues permits; market handles allocation.
Price signal	None – quantity fixed, price of the right is undefined.	Clear – permit price reflects marginal abatement cost.
Potential for rent‑seeking	High – scarcity rent captured by quota holders.	Lower – rent is spread across all permit holders, but can still be captured.

2.5 Prohibitions & Licences (Syllabus 8.1.5)

• Prohibitions (bans) – outright removal of a good or activity (e.g., single‑use plastic‑bag ban, asbestos ban). Removes the externality at source but may generate a black market.
• Licencing – legal permission required to enter a profession or market (e.g., medical licence, taxi licence). Reduces information asymmetry, ensures minimum standards, and can limit the number of firms, affecting competition.

2.6 Other Regulatory Instruments

• Standards – minimum quality, safety or environmental requirements (e.g., food‑hygiene standards). Raise production costs but protect consumers.
• Competition (anti‑trust) policy – legislation to prevent monopolistic behaviour, break up dominant firms, or stop collusion.

3. Deregulation – Removing or Reducing Government Controls

Deregulation aims to improve allocative efficiency by allowing market forces to operate with fewer artificial constraints.

• Eliminating price caps or floors that distort the supply‑demand equilibrium.
• Reducing or removing licensing requirements to lower barriers to entry.
• Privatising state‑owned enterprises to introduce competition.
• Relaxing product‑standard requirements where reputation or third‑party certification can ensure quality.
• Repealing prohibitions that have become ineffective or generate large black‑market activity.

4. Comparative Evaluation Framework (AO3)

Criterion	Regulation – Advantages	Regulation – Disadvantages	Deregulation – Advantages	Deregulation – Disadvantages
Efficiency	Corrects specific market failures; moves outcome toward MSB = MSC.	May create new distortions (shortages, surpluses, rent‑seeking); DWL if set incorrectly.	Removes artificial constraints; lowers production costs; can increase output.	Risk of re‑emergence of market failures (pollution, monopoly power).
Equity	Targets distributional goals (minimum wage, subsidies for low‑income groups).	Can be costly to fund; may create dependency or “crowding‑out”.	Allows individuals to benefit from market rewards; may reduce price discrimination.	May widen income/wealth gaps if market outcomes favour higher‑skill or capital‑rich groups.
Administrative & Compliance Cost	High monitoring, enforcement, and bureaucracy (e.g., licensing boards).	Potential for rent‑seeking and regulatory capture.	Lower ongoing administrative burden.	Initial restructuring costs; possible need for new monitoring of emerging failures.
Risk of Government Failure	Policy may be poorly designed, mis‑targeted, or subject to lobbying.	Regulatory capture, information gaps.	Less scope for capture in the regulatory sphere.	Government may be too slow to intervene if new failures appear.
Impact on Innovation	Prescriptive standards can stifle creative solutions.	Over‑regulation may deter investment.	Competitive pressure encourages product and process innovation.	Absence of standards may lead to unsafe or low‑quality outcomes.

5. Practical Examples (Illustrative Cases)

5.1 Price Ceiling – Rent Control

Maximum rent set below equilibrium → shortage of rental units, black‑market “key‑money”, and long‑run deterioration of housing stock.

5.2 Minimum Wage (Price Floor)

Legal wage set above equilibrium → surplus of labour (unemployment) in the short run; possible wage‑compression and increased automation in the long run.

5.3 Specific Tax – Sugar Tax

£0.30 per litre of sugary drink raises price, reduces consumption, and internalises health externalities. Tax incidence depends on the relative price elasticities of demand (relatively elastic) and supply (relatively inelastic), so consumers bear most of the burden.

5.4 Ad‑Valorem Tax – Fuel Duty

20 % tax on petrol price shifts the supply curve upward proportionally, discouraging excessive use, raising revenue for road maintenance, and generating a larger fiscal windfall when demand is price‑inelastic.

5.5 Subsidy – R&D Tax Credit (Supply‑side)

Firms receive a tax credit for each £1 spent on qualifying research, shifting the supply curve for innovative products downward, encouraging positive spill‑overs.

5.6 Subsidy – Buffer‑Stock Wheat Scheme (Demand‑side)

Government purchases wheat when market price falls below a preset floor and sells when price rises above a ceiling, stabilising farmer incomes and consumer prices.

5.7 Tradable Permit – EU Emissions Trading Scheme (Cap‑and‑Trade)

The EU sets a cap on total CO₂ emissions, allocates permits, and allows firms to trade them. The market determines the permit price, achieving the environmental target at the lowest possible cost.

5.8 Quota vs. Permit – Fisheries Management

Traditional quota: each fishing firm receives a fixed share of total allowable catch – leads to high administrative monitoring and static allocation.
Cap‑and‑trade: total catch is capped, permits are tradable – firms with low marginal abatement cost (e.g., more efficient vessels) can sell permits, reducing overall compliance cost.

5.9 Prohibition – Single‑Use Plastic‑Bag Ban

Ban removes the source of plastic waste, reducing environmental damage. Enforcement costs are modest, but a small illegal market for plastic bags can develop.

5.10 Deregulation – UK Airline Industry (1980s)

Removal of route licences and price controls increased competition, lowered fares, and expanded consumer choice. Later consolidation raised competition concerns, illustrating the need for selective re‑regulation.

6. Summary

Governments possess a rich toolkit of regulatory instruments—specific and ad‑valorem taxes, subsidies (including buffer‑stock schemes), price controls, quotas, tradable permits, prohibitions, licences, standards, and competition policy—to correct market failures and achieve equity. Each tool can improve efficiency in the targeted area but may also generate new distortions, impose administrative costs, and be vulnerable to government failure. Deregulation removes or relaxes these controls, often boosting efficiency and innovation, but can allow externalities or monopolistic behaviour to re‑appear. The most effective policy mix typically combines targeted regulation where market failures are severe with selective deregulation to minimise unnecessary bureaucracy and promote competition, while continually monitoring for unintended consequences.