Micro Economics

Government intervention
(Unit 3)

 Why government intervene the market mechanism

 Methods of Government intervention
 Impact of intervention on Market price

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Government intervention in the market
Often the incentives that consumers and producers have can be changed by government intervention in
markets. For example, a change in relative prices brought about by the introduction of government
subsidies and taxation.

Why Government intervene?

 To collect revenue so that public goods and merit goods can be financed
 To discourage production and consumption of de-merit goods
 To encourage production and consumption of merit goods
 To redistribute income from rich to poor ( form have ones to have not ones )
 To achieve set macro-economic objectives

How Government might intervene?

 By imposing taxes, to collect revenue and to discourage demerit goods

 By providing subsidies to encourage merit goods
 By passing laws and regulations to implement controls
 By redistributing income / by reducing disparity between different segments of the society

Taxation

Direct taxes

 Direct taxes are imposed on income, property and wealth individuals or on profits of the corporate
business.
 Direct taxes are normally progressive in their nature, means higher the income, higher will be the
tax rate.
 Incidence/burden of the direct taxes cannot be shifted to the third party
 In case I progressive direct taxes, it is helpful for the government to redistribute income from rich
to poor so these are helpful in reducing disparity

 Examples: income tax, property tax, wealth tax. Inherence tax, capital gain tax and corporate tax

Indirect taxes

 Indirect tax are imposed on goods or services / production and consumption

 Indirect taxes are considered regressive in their nature, means higher the income , lower will be the
tax rate ( rich is paying lower proportion of income as tax than the poor )
 Incidence/ burden of tax can be shifted to final consumer by adding it to the price.
 It causes disparity between different segments of the society so indirect taxes are considered unfair

 Examples: VAT, GST, duties.

Note

Impact of indirect taxes: increase in indirect taxes increase the cost of production so supply curve
shifts to left due to indirect taxes

Impact if direct taxes: increase in direct taxes reduces the personal disposable income (PDI) for the
individual or distributable profit for the businesses so demand for goods shits left wards

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Indirect taxes

Specific indirect taxes: this is one unit or one-time tax imposed on the goods or services irrespective of
their value, means any change in price is not going to change the tax imposed on the product. Specific tax
cause parallel shift the supply curve to left.

Ad-valorem indirect tax: this is imposed as a percentage of prices of the product so whenever there is
change in price, amount or indirect tax is going to change though % rate will remain same. Ad-valorem
tax cause the pivotal shift in supply curve to left.

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Elasticity of demand and indirect taxation (incidence of tax)

Many products are subject to indirect taxation imposed by the government. Good examples include the
excise duty on cigarettes, alcohol and fuels. Here we consider the effects of indirect taxes on a producers
costs and the importance of price elasticity of demand in determining the effects of a tax on market price
and quantity.

Indirect tax imposed by the government, who will pay?

If PED> 1 or PES<1, greater incidence will be for the producer

If PED <1 or PES> 1, greater tax incidence will be for the consumers

If PED=1 and PES= 1, tax burden will be shared equally between producers and consumers

If PED=0 or PES is infinity, whole tax burden will be for the consumers

If PED is infinity or PES= 0 , whole burden will be for the producers

How it works

Tax revenue = tax per unit * Q after imposition tax

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A tax increases the costs of a business causing an inward shift in the supply curve. The vertical distance
between the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the supplier
may be able to pass on some or all of this tax onto the consumer through a higher price. This is known as
shifting the burden of the tax and the ability of businesses to do this depends on the price elasticity of
demand and supply.

Government Subsidy

Subsidy refers to financial assistance provided by the Government to encourage producers to produce
more at the same or even lower prices, without compromising their profits. Government provides subsidy
in form of aid, grant, tax holiday, tax free zone, withdrawals of duties. Producers may share benefits of the
subsidy with the consumers considering the PED.

Provision of subsidy reduces cost of input for the producers so supply curve shifts to right, increasing
quantity of goods available in the market so market price reduces and to get benefits of lower prices
consumers start buying more ( extension in demand).

Consumer’s surplus and producer’s surplus increases with provision of subsidy and over all social welfare
improves.
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Advantages of providing subsidies

To keep prices down and control inflation – in the last couple of years several countries have been
offering fuel subsidies to consumers and businesses in the wake of the steep increase in world crude oil
prices.

To encourage consumption of merit goods and services which are said to generate positive
externalities (increased social benefits). Examples might include subsidies for investment in
environmental goods and services.

Reduce the cost of capital investment projects – which might help to stimulate economic growth by
increasing long-run aggregate supply.

Subsidies to slow-down the process of long term decline in an industry e.g. fishing or mining

Subsidies to boost demand for industries during a recession e.g. the car scrappage scheme

Disadvantages of providing Subsidies

Government subsidies inevitably carry an opportunity cost and in the long run there might be
better ways of providing financial support to producers and workers in specific industries.

Free market economists argue that subsidies distort the working of the free market mechanism
and can lead to government failure where intervention leads to a worse distribution of resources.

Distortion of the Market: Subsidies distort market prices – for example, export subsidies distort
the trade in goods and services and can curtail the ability of ELDCs to compete in the markets of
rich nations.

Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary, based on political
aims

Who pays and who benefits? The final cost of a subsidy usually falls on consumers (or tax-
payers) who themselves may have derived no benefit from the subsidy.

Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure
– i.e. it delays much needed reforms.

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MINIMUM PRICES

A minimum price is a price floor set by the government where the price is not allowed to fall below this
set level (although it is allowed to rise above it).

Reasons for setting a price floor:

 To protect the earnings of producers – in certain industries prices are subject to great fluctuations.
Minimum prices will guarantee producers income in periods when prices would otherwise have
been very low. Examples include certain agricultural products.

 To create a surplus – in periods of glut surpluses can be stored in preparation for possible future
shortages.

 To guarantee a certain level of earnings – workers can be given a minimum wage so that their
earnings don’t fall below a certain (unacceptable) level.

The diagram below shows the effects of a minimum price:

The minimum price has created a surplus (excess supply) of Qs – Qd. There are three ways in which the
government can deal with this surplus:

The government purchases all the surplus to store it, destroy it or sell it in other markets. If the
government seeks to do this then it has to buy up the excess (Qs – Qd) at the current minimum price. This
means the cost to the government and therefore taxpayer is the shaded area QdabQs.

The government could artificially lower supply to Qd by issuing quotas which limit production. Demand
could be raised by advertising, finding alternative uses or by taxing substitutes.

MAXIMUM PRICES

A maximum price is a price ceiling set by the government where the price is not allowed to rise above this
set level (although it is allowed to fall below).

The reason for setting a maximum price is so that the prices of necessities don’t rise too much in times of
shortage. Such a situation is common in times of war and/or famine.

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The maximum price has caused a shortage (excess demand) equal to Q2 – Q1.

The government can deal with this in two ways:

 First come first serve – this is the situation in most of the countries operated under command
economy and means that huge queues are common.
 Rationing – Purchases are limited by the number of coupons or vouchers issued.
 Encouraging more homegrown production.
 Drawing on stores from previous surpluses.

Problems with maximum prices include:

 Black markets – Selling of rationed goods illegally at very high prices to consumers who feel that
they are not able to purchase enough legally.
 Reduces the supply of already scarce products.

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PUB LIC GO O DS - PRO VIDED BY TH E STATE

One key area of government spending is on public goods. These differ from private goods, which are
normally left to be provided through the price mechanism.

A private good has three main characteristics:

 Excludability: Consumers can be excluded from consuming the product if they are not willing to pay for
it (for example - a ticket to the theatre or a meal in a restaurant)
 Rivalry: One person's consumption reduces the amount that it available for other people to consume -
because scarce resources are used up in producing and supplying the good or service
 Reject ability: private goods and services are reject able - if you don't like the look of the soup on the
restaurant menu, you can reject the chance to consume it and use your money to buy something else.

THE NATURE OF PUBLIC GOODS

Public goods are services which are clearly in demand, but which must be provided collectively by the
Government for two main reasons;

 Non excludability - the goods cannot be confined to those who have paid for it. It means benefits are
extended to every member of the society without any discrimination and no one can be excluded from
getting benefits.
 Non rivalry in consumption - the consumption of one individual does not reduce the availability of
goods to others there is no competition between the different consumers as everyone will be able to
enjoy the benefit without making some one worse off.
Examples of public goods include flood control systems, street lighting, roads, roads lights, traffic signals,
the police and national defence.

Public goods (in fact most of them are services!) are not normally provided by the private sector in an
economy. Partly this is because of the free-ride principle. The “free rider” principle says that you cannot
charge an individual a price for the provision of a non-excludable good because somebody else would gain
the benefit from consumption without paying anything. Consider the case of the provision of traffic wardens
and safety signs on roads. One person's benefit from these services is not unique - other motorists benefit
from the service as well - but they cannot be stopped and asked to pay for the benefits they derive. The
solution is collective provision.

Merit Goods

Positive externalities exist when the marginal social benefit of production and or consumption exceeds the
marginal private benefit i.e. production and/or consumption generate external benefits that may go under-
valued by the market.

Merit goods are goods and services where the social benefits exceed the private benefits. Merit goods are
underprovided by the market mechanism, as individuals don’t take into account the positive externalities
that arise from consumption. This will lead to the market equilibrium quantity being lower than the social
optimum.

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One reason for the under provision is that individuals find it difficult to make rational choices when the
costs arise today and the benefits are only received in the future. Healthcare and pensions are two examples
of merit goods where money has to be spent (or saved) today, but the benefits aren’t reaped for a number of
years.

If it is left to market forces, young people wouldn’t make the necessary provisions for sickness or
unemployment (retirement) in old age. Young people tend to be healthy and in work therefore they find it
difficult to appreciate that on day they will be ill and out of work. The cost of healthcare and pensions are so
great that you could only afford them if you start saving at a young age. It therefore makes sense for the
government to intervene and force individuals to make contributions that will safeguard them against illness
and retirement.

The beneficiary of the education will often not be the person who has to pay for it. This could lead to a
conflict of interests as parents may wish to minimize their expenditure on education, whilst it would be in the
child’s best interests to receive the highest quality of education available. In addition to the external benefits
the child/student will gain society as a whole will also be better off. Somebody who is unable to read or write
could be deemed as a burden on society as they would more than likely need supporting, whereas an
educated individual would contribute to the welfare of the nation.

This leads to the case for some form of government intervention to encourage increased consumption of
merit goods. It might take the form of an explicit government subsidy to reduce the private costs of
consumption and cause an expansion of demand. Higher government spending on these merit goods should
yield a positive social rate of return which leads to an improvement in total economic welfare.

There are plenty of examples of economic activities that can generate positive externalities:

 Industrial training by firms: This can reduce the costs faced by other firms and has important
effects on labour productivity. A faster growth of productivity allows more output to be produced
from a given amount of resources and helps improve living standards throughout the economy,
thereby shifting the production possibility frontier outwards.
 Research into new technologies which can then be disseminated for use by other producers. These
technology spill-over effects help to reduce the costs of other producers and cost savings might be
passed onto consumers through lower prices
 Education: A well-educated labour force can increase efficiency and produce other important social
benefits. Increasingly policy-makers are coming to realize the increased returns that might be
exploited from investment in human capital at all ages.

 Health provision: Improved health provision and health care reduces absenteeism and creates a
better quality of life and higher living standards.
 Employment creation by new small firms
 Flood protection system and spending on improved fire protection in schools and public arenas
 Arts and sporting participation and enjoyment derived from historic buildings

De-Merit Goods

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De-merit goods are those goods or services that create negative externalities when the product is consumed.
This reduces the social marginal benefit of consumption and also leads to potential market failure through
over-consumption.

The government normally chooses to tax those products that generate negative consumption externalities
e.g.: Cigarettes. Alcohol

Or it may choose some form of regulation as an alternative strategy, e.g.: Pollution. Noise

Finally it may choose to ban the good or service all together, e.g.: Drugs.

Direct provision of goods and services by the government

The existence of externalities provides an important argument for the common ownership, or nationalization
of a number of key industries.

The argument is that privately owned firms, in order to survive in a competitive world, necessarily have to
put their own interests before those of society at large, for to do otherwise might be inconsistent with the
goal of long run profit maximization, or even survival. This harsh reality of the market is likely to manifest
itself in the generation of negative externalities such as pollution, as the control of these externalities would
involve higher costs and an adverse impact on profits; conversely, production activity which conferred net
positive externalities on society might not be undertaken in sufficient quantities if the criterion of private
profitability could not be met.

Nationalized industries, on the other hand, which, on account of being commonly owned, could be operated
according to broad social criteria, rather than the narrow commercial one of private profitability, and this
allows for the possibility of externalities to be fully incorporated into production decisions. Thus, for
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example, questions of workers' safety standards and atmospheric pollution could be accorded priority status,
rather than being ignored on the grounds that to do otherwise would adversely affect profits and
competitiveness; and activities such as the keeping open of 'uneconomic' pits and the provision of postal and
transport services to remote outlying areas, could all be maintained on the grounds that they provide
substantial positive externalities to society at large, although not necessarily being profitable in the sense that
the private revenues from such activities exceed the private costs.

Similarly, an important argument for merit goods such as education and health being directly provided by the
government rather than through the market, is that they not only confer private benefits on individuals but
also significant positive externalities on society as a whole which individuals would tend to ignore when
making their consumption decisions. As a result, left to the market, under-provision is likely to occur; for
example, individuals would be prepared to buy education through the market if they had to, as substantial
private benefits, such as higher life-time earnings, are likely to result; however, a case for a higher level of
government provision can be made on the grounds that not all the benefits accrue solely to the individual -
society gains from a more efficient and adaptable labour force and perhaps a more tolerant and more aware
population. The issue of merit goods is considered in the rest of this unit.

The above arguments for direct government provision would of course be strongly contested by free market
economists who would argue the case for privatization, the desirability of using markets to provide merit
goods and the extremely poor record of pollution control of the formerly centrally planned economies.

Privatization: It is an act of transferring property previously owned and controlled by the state into the
ownership of private individuals or other legal entities. Government can sell the state owned industries
directly to private businesses or can use stock market floatation option.

Reasons for Privatizon

Create or Increase Competition: Competition is the driving force of innovation and efficiency.
Government ownership of an industry inhibits or precludes competition. This is particularly so if the
government owned industry enjoys a monopoly but occurs even where competition is permitted. This is
because the government owned industry does not have to make a profit to stay in business and even if
nominally in competition with private competitors enjoys various advantages which the private
competitor cannot match, such as access to cheaper finance

Less Political infamy: over time the popular expectations of nationalized industries become unrealistic
with people expecting more and more for less and less. Shortfalls in income can require increased taxes
to pay for them. Poor performance and price increases cause political opprobrium which can be more
easily deflected onto new private owners. Politically it is easier to make reductions in staff numbers if
such reductions are effected by private employers.

COMPARISONS

Comparisons are frequently made as to whether there has been an improvement in changes made by
nationalization or privatization. Regardless such comparisons are often of limited or no value since the
comparisons are made from an enthusiast viewpoint or are based on different criteria. Whilst it may be

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easy to determine if one’s own position has improved or worsened, such viewpoints often fail to consider
what likely would have been the result if the change had not been made.

Nationalization and Privatization

Nationalization refers to an act of taking property previously established, owned and controlled by
private individuals or other legal entities such as companies into the ownership of the state.

Reasons for Nationalization

Reduce Inequality: Major wealth producing assets, such as the ownership of vast landholdings, mineral
deposits or water rights are capable of creating great inequalities of wealth. This is particularly so if the
asset can be seen as a natural monopoly. Nationalization enables this wealth to be earned and distributed
for the good of all.

Stability and Security: Industries and services considered essential such as utilities, hospitals and
education should be exempt from commercial changes and their continued ongoing existence and
operation ensured. Since governments do not have to make a profit they are less likely to go out of
business at short notice.

Economic Size & Efficiency: By combining small private enterprises into a large, possibly monopolistic
organization, economies of scale can be achieved and a more competitive organization can be created and
it can survive and exploit the international completion.

Government Power & Control: nationalization or the threat of nationalization prevents non-government
organizations becoming large or powerful enough to dominate or threaten governments. Control of
certain key industries such as post and communications, policing, defense and the media can be crucial in
ensuring governments are unchallenged or remain in power.

Commanding the Heights of the Economy: Keynesian economists, considering the great depression of
1930s, propagated the idea that the major or dominant industries of an economy should be in the hands of
the government the better to enable it to direct, manage and control the macro economy

Substitute for Welfare: When major industries particularly those employing large numbers become
bankrupt there is often a demand that the industry concerned should be taken over by the government.
Effectively this can be seen as an alternative to government welfare.

Nationalism: Decolonization of many former colonies left their major industries in many instances in the
control of nationals of the former colonial power or other foreigners. National pride demanded in many
instances that this should cease as part of the assumption of local sovereignty.

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