Economics | Role of government in microeconomics

📚 The Role of Government in Microeconomics: Study Notes 📚

Hello future economists! Get ready to explore one of the most practical and crucial topics in Microeconomics: the government's role. We've learned that markets are powerful, but they aren't perfect. Sometimes, they need a little help—or intervention—to achieve outcomes that are efficient, fair, or sustainable.

This chapter examines the powerful tools governments use to influence consumer and producer decisions, and why these interventions often lead to both success and unintended consequences. Understanding this is key to evaluating real-world policy!

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1. Why Governments Intervene in Markets

In a perfectly competitive market, the equilibrium price and quantity maximize total welfare (allocative efficiency). However, governments step in when they believe the market outcome is undesirable. This intervention is driven by several major goals:

Goals of Government Intervention

• Correcting Market Failure: This is the biggest reason. If a market produces too much pollution (a negative externality) or too few vaccinations (a positive externality), the government intervenes to shift output toward the socially optimal level.
• Achieving Equity (Fairness): The market is efficient but may be very unequal. Governments intervene to redistribute income or ensure everyone can afford necessities (like housing or staple foods).
• Generating Revenue: Governments impose taxes primarily to raise funds necessary to provide Public Goods (like defense and street lighting) and public services (like education and healthcare).
• Influencing Behavior: Encouraging the consumption of Merit Goods (e.g., education) and discouraging Demerit Goods (e.g., tobacco or sugar).

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2. Intervention Tool: Indirect Taxes

A tax is a compulsory payment to the government. An Indirect Tax is a tax on spending (on goods and services), collected by the producers but ultimately paid partly by the consumer.

Types of Indirect Taxes

1. Specific Tax (Fixed Amount):
   • A fixed amount of tax imposed per unit of the good.
   • Example: A government charges $0.50 tax on every liter of fuel sold.
   • Effect on Supply: Shifts the supply curve vertically upwards by the exact amount of the tax (a parallel shift).
2. Ad Valorem Tax (Percentage Amount):
   • A tax charged as a fixed percentage of the price of the good.
   • Example: A 15% Goods and Services Tax (GST) or Value Added Tax (VAT).
   • Effect on Supply: Shifts the supply curve upwards, but the shift is non-parallel (it gets steeper) because the tax amount increases as the price increases.

Analysis of Taxes (Incidence and Effects)

When a tax is imposed, the supply curve shifts left (or up). The key analysis involves determining tax incidence—who bears the burden of the tax.

Don't worry if the term "incidence" sounds complicated! It just means: Who actually pays the tax bill—the buyer or the seller?

Step-by-Step Effects of a Specific Tax:

1. Initial equilibrium is at \(P_e\) and \(Q_e\).
2. Tax is imposed; Supply shifts from \(S_1\) to \(S_2\).
3. New equilibrium quantity falls to \(Q_{tax}\).
4. The price consumers pay increases to \(P_c\).
5. The price producers actually receive (after paying the tax) falls to \(P_p\).

Crucial Insight: Elasticity and Tax Burden

The share of the tax paid by consumers versus producers depends entirely on price elasticity of demand (PED) and price elasticity of supply (PES):

• If Demand is Inelastic (consumers don't change their quantity much, like for cigarettes), consumers bear most of the tax burden. \(P_c\) rises significantly.
• If Demand is Elastic (consumers are sensitive to price changes), producers bear most of the tax burden. \(P_c\) barely rises, but \(P_p\) falls significantly.

Total Government Revenue: This is calculated as the tax per unit multiplied by the new quantity traded: \((\text{Tax per Unit}) \times Q_{tax}\).

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3. Intervention Tool: Subsidies

A Subsidy is a payment made by the government to firms per unit of output.

Goals of Subsidies

Subsidies are the opposite of taxes—they are designed to encourage production and consumption, usually for merit goods or to support specific industries.

• To lower the price of essential goods for consumers (improving equity).
• To guarantee the supply of goods the government deems necessary (e.g., public transport or staple crops).
• To encourage the production of goods with positive externalities (e.g., electric vehicles).
• To increase the revenue/profits of specific producers, helping them compete internationally.

Analysis of Subsidies

When a subsidy is given, it effectively lowers the cost of production. Therefore, the supply curve shifts right (or down).

Step-by-Step Effects of a Subsidy:

1. Initial equilibrium is at \(P_e\) and \(Q_e\).
2. Subsidy is granted; Supply shifts from \(S_1\) to \(S_2\).
3. New equilibrium quantity increases to \(Q_{sub}\).
4. The price consumers pay decreases to \(P_c\).
5. The price producers receive (including the subsidy) increases to \(P_p\).

Crucial Insight: Subsidy Cost and Benefit Sharing

The total cost to the government is the subsidy per unit multiplied by the new quantity traded: \((\text{Subsidy per Unit}) \times Q_{sub}\).

Just like taxes, the benefits of the subsidy (the extent to which the price falls for consumers vs. the extent to which revenue rises for producers) depend on elasticity:

• If Demand is Inelastic, consumers receive most of the benefit (price falls significantly).
• If Demand is Elastic, producers receive most of the benefit (the increase in the price they receive is large).

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4. Intervention Tool: Price Controls

Price controls are direct government actions to set specific maximum or minimum limits on prices, preventing the market from reaching its natural equilibrium.

A. Price Ceiling (Maximum Price)

A Price Ceiling sets the highest price at which a good or service can be sold.

• Goal: To protect consumers, especially low-income ones, and ensure necessities remain affordable (e.g., rent control, staple food prices).
• Condition for Effect: The price ceiling must be set below the market equilibrium price (\(P_{max} < P_e\)). If it is set above \(P_e\), it has no effect.

Consequences of an Effective Price Ceiling:

1. Shortage: At the low controlled price, Quantity Demanded (\(Q_d\)) exceeds Quantity Supplied (\(Q_s\)). This is a welfare loss.
2. Non-Price Rationing: Since price can't ration the scarce supply, other methods emerge: queuing (waiting in line), distribution based on government preference, or coupons.
3. Black Markets: Goods are illegally sold at a price higher than the ceiling, often closer to the true equilibrium price.
4. Reduced Quality: Producers have less incentive to maintain or improve quality, as they can sell all their stock anyway.

B. Price Floor (Minimum Price)

A Price Floor sets the lowest price at which a good or service can be sold.

• Goal: To protect producers (e.g., guaranteeing minimum income for farmers) or to protect workers (e.g., minimum wage laws).
• Condition for Effect: The price floor must be set above the market equilibrium price (\(P_{min} > P_e\)).

Consequences of an Effective Price Floor:

1. Surplus: At the high controlled price, Quantity Supplied (\(Q_s\)) exceeds Quantity Demanded (\(Q_d\)).
2. Government Buy-Up: If the floor is for agricultural goods, the government often has to buy the surplus to keep the price stable, leading to high storage and administration costs.
3. Inefficiency: Resources (labor, capital) are wasted producing goods that consumers do not want at that price.
4. Minimun Wage (HL Extension Context): When the price floor is applied to the labor market, the price is the wage, and the surplus is unemployment (Qs of labor > Qd of labor).

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5. Evaluation: The Concept of Government Failure

While intervention aims to solve market failures, the irony is that government action itself can lead to a new form of inefficiency called Government Failure.

Government Failure occurs when government intervention leads to a misallocation of resources and a net welfare loss (i.e., the costs of the intervention outweigh the benefits).

Reasons for Government Failure (Why intervention goes wrong)

• Information Failure: Governments rarely have perfect information about supply and demand conditions, optimal tax rates, or the true costs of externalities. Setting the "right" price floor or tax is almost impossible.
• Unintended Consequences: Policies often have unforeseen side effects (e.g., taxes lead to smuggling; subsidies lead to dependency; price ceilings lead to black markets).
• Administrative Costs: Implementing and policing interventions (collecting taxes, storing surpluses) can be expensive, diverting resources away from productive uses.
• Political Factors: Decisions may be made based on political self-interest (e.g., lobbying by powerful firms) rather than economic efficiency or social welfare.