Instruments of Government Policy

Instruments of government policy To correct market failures, the state uses various instruments. Each has its own advantages and disadvantages. Taxes and Subsidies Pigouvian instruments: alter prices to reflect social costs/benefits. Advantages: Flexibility — agents themselves decide how to respond Efficiency — resources flow to where the costs are lower Revenue for the budget (taxes) Disadvantages: Difficulty in determining the proper rate Political resistance Direct Regulation Command-and-control: standards, limits, prohibitions. Examples: Emission standards for cars Ban on hazardous substances Safety requirements Advantages: certainty, simplicity of understanding. Disadvantages: inflexibility, does not account for differences in compliance costs. Tradable Permits Cap-and-trade: a limit is set, permits are traded. Advantages: Certainty of quantity (unlike taxes) Flexibility: reductions occur where it is cheaper Price is determined by the market Examples: EU ETS, SO2 trading in the USA. Informational Instruments Disclosure requirements: mandatory disclosure of information. Labeling: labeling (energy efficiency, organic products). Public information: ratings, warnings. Government Failure Government failures: intervention may be worse than the problem. Regulatory capture — regulator serves the interests of the industry Rent-seeking — resources spent on lobbying Unintended consequences Political distortions For the investor Regulatory environment: understanding probable regulatory changes. Carbon markets: investment opportunities and risks. Policy analysis: how regulations affect costs and competitiveness.