How does taxation allow the free market mechanism to continue to function and not distort the price signals? How do government regulations send wrong price signals to producers, leading to inefficient allocation of resources?

Question

Topic: Imposing taxes on motorists and utilising government regulations to solve the problem of negative externalities caused by unlimited use of private transport. How does taxation allow the free market mechanism to continue to function and not distort the price signals? How do government regulations send wrong price signals to producers, leading to inefficient allocation of resources?

Answer

Tax lets the free market to continue to function and not distort the price signals because either consumers or producers may be left with the burden of paying the tax. For example, companies pay the government tax for every item traded – which can be seen as the equivalent of an increase in production costs. Furthermore, a company can choose to pay some or all of an indirect tax increase and receive a lower profit margin, or alternately, pass on the sum of tax increase to the customers by charging higher prices. The effect of tax on price and output largely depends on the Price Elasticity of Demand of the product. The more price inelastic demand, the greater the incidence being on the consumer. Government intervention occurs when the state believes that the markets are not delivering allocative or productive efficiency. Therefore, the purpose of state involvement in the markets is to improve economic efficiency by altering the distribution of resources. The government can intervene through various tools, such as the use regulation, price signals, better information or direct provision to change resource allocation. However, at times government failure can also occur when the intervention causes more inefficient use of resources than formerly realised in the free market. For example, government action can magnify market failure because:

• Imperfect information causes an inefficient allocation of resources.
• Regulatory capture is another reason: after a while, dealings between government officials and monopolies influences regulators to favour the vested interests of producers.
• By increasing taxes or setting strict regulations, it can encourage agents to disregard the law. For instance, a higher tax on cigarettes may encourage illegal importation and black markets.

References

Tutor2u (n.d.) Government intervention. Available at: http://www.tutor2u.net/_legacy/assets/samples/qa-aqaecon1.pdf (accessed on 10/09/2016)