Economics (9708) | Methods and effects of government intervention in markets

Government Intervention: Methods and Effects (AS Level Economics 9708)

Hello future economists! This chapter is crucial because it takes the pure theory of demand and supply (the free market) and adds a dose of reality: what happens when the government steps in? Governments intervene to fix market failures (like pollution or under-provided public goods, covered in the previous section). Here, we look at HOW they intervene and what the consequences are.

Don't worry if the diagrams seem tricky at first. We will break down the effects step-by-step, focusing on how different policies affect equilibrium price and quantity.

Key Concept Checklist (Syllabus 3.2)

• Impact and incidence of specific indirect taxes.
• Impact and incidence of subsidies.
• Direct provision of goods and services.
• Maximum and minimum prices (price controls).
• Buffer stock schemes.
• Provision of information.

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1. Indirect Taxes and Subsidies (The Shifting Curves)

These two policies are often called 'market-based' interventions because they use price changes (incentives) to influence consumer and producer behaviour.

1.1 Specific Indirect Taxes (3.2.1)

A specific indirect tax is a fixed amount added to the price of a good, regardless of its value (e.g., \$1.00 tax per liter of petrol).

Impact and Incidence of Taxes

When a government imposes an indirect tax, it is usually levied on the producer (the firm).

• Impact: Refers to the agent (buyer or seller) upon whom the tax is initially imposed. (Usually the producer).
• Incidence: Refers to the final distribution of the tax burden between consumers and producers. This is the crucial part!

The Effect on the Market:

A tax increases the cost of production for firms. This causes the Supply curve to shift vertically upwards (or leftwards) by the exact amount of the tax.

The new equilibrium price (P\(_1\)) will be higher than the old equilibrium (P\(_e\)), and the quantity (Q\(_1\)) will be lower than Q\(_e\).

The Burden (Incidence) Depends on Elasticity (PED):

1. Inelastic Demand (Consumers don't have many alternatives, PED < 1):
   • Consumers bear most of the tax burden because they continue buying the good even if the price rises significantly.
   • Example: Cigarettes or basic necessities. The producer passes almost all of the tax onto the consumer.
2. Elastic Demand (Consumers have many alternatives, PED > 1):
   • Producers bear most of the tax incidence. If the producer tries to pass the tax onto the consumer, consumers will switch to substitutes, causing a massive drop in quantity demanded.
   • The producer must absorb much of the tax to keep sales up.

Mnemonic Alert: Think of a Tax as a Tower or a mountain that pushes the supply curve UP. Who falls down the least? The person who has no choice but to stand there (the consumer with inelastic demand).

1.2 Subsidies (3.2.2)

A subsidy is a payment made by the government to firms to encourage production or consumption of a good (often a merit good). It is essentially a "negative tax."

The Effect on the Market:

A subsidy reduces the firm’s cost of production. This causes the Supply curve to shift vertically downwards (or rightwards) by the exact amount of the subsidy.

The new equilibrium price (P\(_1\)) will be lower than P\(_e\), and the quantity (Q\(_1\)) will be higher than Q\(_e\). The policy achieves its goal of increasing consumption.

The Benefit (Incidence) Depends on Elasticity (PED):

Just like taxes, the distribution of the subsidy benefit (the incidence) depends on price elasticity of demand (PED).

1. Inelastic Demand: Consumers receive most of the benefit (the price falls by almost the full amount of the subsidy).
   • Example: Subsidies on public transport tickets. Since commuters have few good alternatives, the price drops significantly for them.
2. Elastic Demand: Producers receive most of the benefit. The price falls only slightly, but the massive increase in quantity sold means producers receive a much larger total revenue.

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2. Price Controls: Maximum and Minimum Prices (3.2.4)

Price controls are direct interventions where the government sets specific limits on how high or low a price can go.

2.1 Maximum Price (Price Ceiling)

A maximum price (or price ceiling) is a legal limit on how high a price can be set. It is only effective if set below the original market equilibrium price (P\(_e\)).

Reason for Intervention: To protect consumers, usually on essential goods like basic food staples or rents, ensuring they remain affordable.

Effects of a Maximum Price (P\(_max\)):

• The price mechanism is disrupted. The market cannot reach equilibrium.
• Because the set price is low, quantity demanded (Q\(_d\)) will be greater than quantity supplied (Q\(_s\)).
• This creates a shortage (excess demand).
• Consequences:
  • Non-price rationing mechanisms emerge (e.g., queues, waiting lists, black markets).
  • Producers have less incentive to supply or maintain quality, leading to under-investment.

Real-world Example: Historically, rent control laws in major cities have been set as maximum prices to help low-income tenants, often leading to housing shortages and reduced maintenance quality by landlords.

Common Mistake to Avoid: A maximum price is designed to protect buyers, so it MUST be set *below* the normal price (otherwise it wouldn't constrain the market).

2.2 Minimum Price (Price Floor)

A minimum price (or price floor) is a legal limit on how low a price can be set. It is only effective if set above the original market equilibrium price (P\(_e\)).

Reason for Intervention: To protect producers (ensuring they earn a fair income) or to discourage the consumption of certain goods.

Effects of a Minimum Price (P\(_min\)):

• The price mechanism is disrupted. The market cannot reach equilibrium.
• Because the set price is high, quantity supplied (Q\(_s\)) will be greater than quantity demanded (Q\(_d\)).
• This creates a surplus (excess supply).
• Consequences:
  • The government often has to buy the surplus (which is costly).
  • Storage and disposal of the surplus (e.g., agricultural produce) becomes a problem.
  • Higher prices hurt consumers.

Real-world Example: The National Minimum Wage is the most common example. It is a price floor for labour (the price of labour is the wage rate). If set above the equilibrium wage, it creates a surplus of labour (unemployment).

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3. Buffer Stock Schemes (3.2.5)

A buffer stock scheme involves a central agency buying and selling stocks of a commodity to stabilize its price within a predetermined range (a price ceiling and a price floor). They are typically used for volatile primary products (like wheat, coffee, or tin) where supply is highly unpredictable (due to weather) and demand/supply are relatively inelastic.

How the Scheme Works (The Mechanism)

1. The government (or agency) announces an intervention price range: P\(_min\) (floor) and P\(_max\) (ceiling).
2. When Supply is High (Good Harvest): Market price drops towards P\(_min\). To prevent the price falling below P\(_min\), the agency buys the excess supply, creating a government stockpile.
3. When Supply is Low (Bad Harvest): Market price rises towards P\(_max\). To prevent the price exceeding P\(_max\), the agency sells stocks from its stockpile back into the market.

Advantages of Buffer Stocks

• Price stability provides certainty for producers and consumers (encouraging investment).
• Can help maintain farmer income.

Disadvantages of Buffer Stocks

• Costly: Buying up surplus requires significant funds, and storage costs (including maintaining perishable goods) can be high.
• Information Challenge: Setting the 'correct' P\(_min\) and P\(_max\) is difficult; if P\(_min\) is set too high, the government will constantly be buying and eventually run out of storage space or money.
• If the government runs out of stocks during a prolonged shortage, the price ceiling breaks, and the price will soar unpredictably.

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4. Non-Price Intervention Methods

Not all government intervention relies on manipulating price through taxes or controls. These methods often target specific market failures related to provision or information.

4.1 Direct Provision of Goods and Services (3.2.3)

This occurs when the government directly uses state resources to produce or offer a good/service, bypassing the private market entirely.

• Purpose: Essential for goods the market won't provide (Public Goods, e.g., national defense) or for goods the market under-provides (essential Merit Goods, e.g., primary education, basic healthcare).
• Benefit: Ensures universal access, improves equity, and achieves social objectives, not just profit.
• Drawbacks: Can be inefficient (lack of competition), high cost to the taxpayer, and potential misallocation of resources (Government Failure).

4.2 Provision of Information (3.2.6)

Sometimes, market failure occurs because consumers or producers have imperfect information—they don't know the true costs or benefits of a decision.

• Target: Often used to encourage consumption of Merit Goods (e.g., campaigns promoting the benefits of vaccinations or higher education) or discourage Demerit Goods.
• Mechanism: The government supplies accurate information (e.g., required health warnings on alcohol/tobacco, nutritional labels on food, or public health campaigns).
• Benefit: Helps consumers make rational choices, leading to consumption closer to the socially optimal level. It is generally less intrusive than taxes or bans.

Did you know? Many economists prefer the provision of information for minor imperfections over direct price intervention because it maintains consumer choice while correcting the knowledge gap.

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Key Takeaway: Evaluating Intervention

The effectiveness of any government intervention method hinges on its ability to move the market closer to the socially optimum level of output. However, remember that every policy has trade-offs and potential drawbacks (like high costs, shortages/surpluses, or administrative inefficiency). When analyzing these policies in an essay, always discuss both the intended positive effects and the potential unintended negative consequences or practical limitations.