Economics | Government intervention in markets

Welcome to Government Intervention in Markets!

Hello Economists! This chapter is crucial because it takes everything we learned about supply and demand and asks a fundamental question: What happens when the government steps in?

In the "Markets in Action" section, we learned that free markets allocate resources through price signals. However, markets don't always get it right (we call this Market Failure). When this happens, governments often intervene to correct inefficiencies, change behaviour, or improve fairness.

Don't worry if diagrams seem tricky at first. We will break down each intervention step-by-step to show exactly how it affects producers, consumers, and resource allocation!

Section 1: The Rationale for Intervention

Why Governments Get Involved

When we talk about intervention, we are talking about measures taken by the government to influence the outcomes of markets. The main objective is usually to fix a perceived flaw.

• Correcting Market Failure: This is the primary reason. If markets fail to achieve economic efficiency (e.g., monopolies, externalities, public goods), intervention aims to move the economy closer to the optimal allocation of resources.
• Improving Equity (Fairness): Governments may intervene to redistribute income or ensure access to basic necessities (like setting maximum prices on essential goods).
• Influencing Consumption: They may want to discourage the consumption of demerit goods (like cigarettes) or encourage the consumption of merit goods (like education).

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Section 2: Intervention using Indirect Taxes

One of the most common forms of intervention is the use of taxes on spending. These are called indirect taxes because the burden can be passed on from the producer to the consumer.

What is an Indirect Tax?

An indirect tax is a tax imposed by the government on expenditure, which raises the firm’s costs of production.

When firms have higher costs, they are willing to supply less at every given price, causing the supply curve to shift.

Types of Indirect Taxes

There are two main types you need to know:

1. Specific Tax (Unit Tax): A fixed amount of tax per unit of the good sold.
   Example: A tax of \(£0.50\) on every litre of petrol sold.
2. Ad Valorem Tax (Percentage Tax): A tax levied as a percentage of the price of the good.
   Example: Value Added Tax (VAT) at 20% on the selling price. The absolute amount of tax increases as the price of the good increases.

Diagrammatic Effect of a Specific Tax

Since a specific tax is a fixed amount per unit, the supply curve shifts upwards and parallel by the amount of the tax (T).

Step-by-step process:

1. The market is initially at equilibrium E1 (\(P_1, Q_1\)).
2. Government introduces a specific tax (T).
3. The supply curve shifts up from \(S_1\) to \(S_2\). The vertical distance between \(S_1\) and \(S_2\) is the amount of the tax (T).
4. The new equilibrium is E2 (\(P_2, Q_2\)). The price consumers pay rises to \(P_2\), and the quantity transacted falls to \(Q_2\).
5. The price producers actually receive (after paying the tax) is \(P_3\). This point (\(P_3\)) is found by dropping down from the new quantity \(Q_2\) to the original supply curve \(S_1\).

Tax Revenue and Incidence

The total tax revenue collected by the government is given by:
Tax Revenue \( = T \times Q_2 \) (The tax per unit multiplied by the new quantity sold).

Tax Incidence refers to the distribution of the tax burden between consumers and producers.

• Consumer Burden: The amount by which the consumer price rises (\(P_2 - P_1\)).
• Producer Burden: The amount by which the price received by the producer falls (\(P_1 - P_3\)).

Did you know? The tax burden is determined by elasticity.

• If Demand is Inelastic (steep D curve), consumers pay most of the tax (because they have few alternatives and must buy the good regardless of the price rise).
• If Demand is Elastic (flat D curve), producers pay most of the tax (because consumers will easily switch to alternatives if the price rises).

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Section 3: Intervention using Subsidies

A subsidy is the opposite of a tax. It is a payment made by the government to a producer (or consumer) to lower the costs of production.

What is a Subsidy?

Subsidies are typically used to encourage the production and consumption of merit goods (like education, healthcare, or renewable energy) or to support key industries.

Since a subsidy effectively reduces the firm’s cost of production, the firm is willing to supply more at every given price. This shifts the supply curve.

Diagrammatic Effect of a Subsidy

The supply curve shifts downwards and parallel by the amount of the subsidy (S).

Mnemonic Trick: Think Subsidy shifts Supply South-East.

Step-by-step process:

1. The market is initially at equilibrium E1 (\(P_1, Q_1\)).
2. Government introduces a specific subsidy (S).
3. The supply curve shifts down from \(S_1\) to \(S_2\). The vertical distance between \(S_1\) and \(S_2\) is the amount of the subsidy (S).
4. The new equilibrium is E2 (\(P_2, Q_2\)). The price consumers pay falls to \(P_2\), and the quantity transacted rises to \(Q_2\).
5. The price producers receive (including the subsidy) is \(P_3\). This point (\(P_3\)) is found by moving up from the new quantity \(Q_2\) to the original supply curve \(S_1\) plus the subsidy. The vertical distance between \(P_3\) and \(P_2\) is the total subsidy.

Cost and Benefit of Subsidies

The total cost to the government for the subsidy is:
Total Subsidy Cost \( = S \times Q_2 \) (Subsidy per unit multiplied by the new quantity sold).

Just like tax incidence, the benefit of a subsidy is shared between consumers and producers, depending 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 (they keep a larger portion of the subsidy while only slightly lowering the consumer price).

Common Misconception: Students sometimes assume the consumer price falls by the full amount of the subsidy. This is only true if demand is perfectly elastic. Usually, the benefit is shared!

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Section 4: Intervention using Price Controls

Price controls are government restrictions on the movement of prices. Unlike taxes and subsidies, which influence supply, price controls directly manipulate the price mechanism.

Don't worry if this seems tricky at first—just remember that price controls prevent the market from reaching its natural equilibrium.

1. Maximum Prices (Price Ceilings)

A maximum price (or price ceiling) is a legal limit on how high a price can be set. To be effective (or "binding"), the maximum price must be set below the free market equilibrium price (\(P_E\)).

Objective: To protect consumers, especially low-income households, by keeping prices of essential goods (like rent or basic food staples) affordable.

Consequences of a Binding Maximum Price

When the price is held below equilibrium, the quantity demanded exceeds the quantity supplied. This results in a shortage (excess demand).

• Shortage: \(Q_D > Q_S\). Consumers cannot buy as much as they want.
• Non-Price Rationing: Since price cannot ration the limited supply, other rationing methods appear (queuing, waiting lists, favouritism).
• Black Markets: Goods may be illegally resold at prices higher than the legal maximum, defeating the purpose of the control.
• Reduced Quality: Producers have less incentive to maintain or improve quality since they cannot raise prices to cover costs.

Analogy: Imagine a popular concert. If the government sets ticket prices artificially low (a price ceiling), more people will want tickets than are available, leading to huge queues and unofficial ticket scalping (black market).

2. Minimum Prices (Price Floors)

A minimum price (or price floor) is a legal limit on how low a price can be set. To be effective, the minimum price must be set above the free market equilibrium price (\(P_E\)).

Objective: To protect producers or workers by guaranteeing a minimum income or wage (e.g., agricultural products or the Minimum Wage).

Consequences of a Binding Minimum Price

When the price is held above equilibrium, the quantity supplied exceeds the quantity demanded. This results in a surplus (excess supply).

• Surplus: \(Q_S > Q_D\). Producers cannot sell all the goods they produce.
• Government Stockpiles: For agricultural products, the government often has to buy up the surplus to maintain the floor price, incurring significant cost.
• Inefficiency: Resources are wasted producing goods that consumers do not value enough to buy at that high price.
• In the case of Minimum Wage: The price floor for labour leads to a surplus of workers (unemployment), as firms demand less labour at the higher wage rate.

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Section 5: Evaluating Government Intervention

Economists must not only describe how interventions work but also evaluate whether they are successful. Every intervention involves trade-offs.

Challenges and Limitations of Intervention

1. Unintended Consequences

Intervention often creates new problems.

• Example: A maximum price designed to help tenants may lead landlords to sell properties or stop maintaining them, worsening the housing shortage overall.
• Example: High indirect taxes on cigarettes may encourage smuggling and illicit trade, rather than stopping consumption.

2. Information Failure and Poor Design

Governments need perfect information to set the optimal tax, subsidy, or price control.

• Setting the Level: If a tax is too low, it fails to discourage consumption; if it's too high, it might cause massive unemployment or black market activity.
• Cost of Intervention: Administrative costs (e.g., enforcing tax collection or administering subsidy applications) can be very high.

3. Opportunity Cost

The money spent on subsidies or buying up surpluses could have been spent elsewhere (e.g., building schools or hospitals). This is the opportunity cost of the intervention.

4. Elasticity Matters

The success of taxes and subsidies heavily depends on the price elasticity of demand (PED).

• If the goal is to cut consumption (e.g., taxing petrol), the intervention will be ineffective if demand is highly inelastic.

In conclusion, while government intervention aims to improve outcomes and correct market failures, the effectiveness is always dependent on the design of the policy, the responsiveness of consumers and producers (elasticity), and the presence of unintended consequences. A good economist always weighs the costs and benefits!