IB Economics - 2.7

Why governments intervene

Earn revenue

Provide support to firms

Provide support to low income households

To influence the levels of production and consumption

To correct market failure

To promote equality

Price Controls

Setting to the minimum or maximum prices by the government so that prices are unable to adjust to their equilibrium level determined by demand and supply.

Price Ceiling

A maximum price set below the equilibrium price, in order to make goods more affordable to people on low incomes

Consequences of price ceilings on markets

Shortages: As QD > QS

Non-price rationing: Goods are not distributed according to who is willing and able to afford the good.

Underground/Parallel Markets: As some consumers purchase the good, consumers who have sell it at higher prices in the parallel markets.

Allocative Inefficiency: As the price is not at equilibrium. CS > PS.

Consequences of price ceilings on stakeholders

Consumers: Mixed, as those who get it get it at a lower price. However, some people may not get it at all.

Producers: Worse off, since they face revenue and welfare losses.

Workers: Not benefitted, as firms may face losses and thus may be fired.

Government: No gains or loss in budget.

Examples of price ceilings

Rent control: Maximum legal rent on housing below the equilibrium price.

- Housing becomes more affordable for low-income earners

- Shortage of housing and long waiting lists

- Market for rented units above the legal maximum

- Unprofitable landlords poorly maintain their houses.

Food price controls: Maximum price on food

- Food becomes more affordable for low-income earners

- Shortage of food

- Market for food above legal maximum arises

- Unprofitable farmers may fire workers, leading to unemployment.

Price Floors

A minimum price set above the equilibrium price in order to provide support to farmers or to increase the wages of low skilled workers.

Consequences of price floors on markets

Surpluses: As QS > QD

Government measures to dispose of surpluses: Governments may have to purchase, store, subsidise and export the excess supply.

Firm Inefficiency: Firms are not incentivised to be efficient.

Allocative Inefficiency: As price is not at equilibrium. PS > QS.

Consequences of price floors for stakeholders

Consumers: Worse off, since a higher price must be paid and there is welfare loss.

Producers: Better off, as revenues and welfare increase.

Workers: Output will increase, so there will be lesser unemployment

Government: It is a burden on the government to purchase, store, subsidise and export the excess. OppCost arises.

Stakeholders of other countries: Benefitted, as they purchase goods at a lower price than locally available.

Consequences of minimum wages for the economy

Labour surplus

Illegal workers at wages below the minimum wage

Misallocation of product markets

Consequences of minimum wage on stakeholders

Firms: Worse off due to higher CoP

Workers: Some gain as they receive a higher wage. Some lose as they might be fired (unemployment)

Consumers: Lose, since rising CoP might lead to a decrease in supply

Indirect Tax

Tax imposed on spending. They are not paid directly to the government.

Why governments impose indirect taxes

1. Excise taxes are a source of government revenue

2. Excise taxes are a method to discourage consumption of goods that are harmful for the individual

3. Can be used to redistribute income

4. Can be used to improve the allocation of resources and correct -ve externalities.

Specific Tax

Fixed amount imposed per unit of a good (e.g. $5 per unit of cigarettes)

Ad Valorem Tax

Fixed percentage imposed on a good (e.g. 5% VAT on a TV)

Consequences of indirect taxes for various stakeholders

Consumers: Price increases, and QS decreases, They are worse off.

Producers: Revenue decreases, as price and quantity decrease. They are worse off.

Government: More government revenue

Workers: Less workers needed to produce; output falls.

Society: Worse off, as there is dead weight loss.

Subsidies

Assistance by the government to individuals or groups of individuals in the form of direct payments or other forms of financial aid.

Why governments grant subsidies

- To increase revenues & incomes of producers

- To make certain goods affordable to low-income consumers

- To encourage the production and consumption of particular goods and services

- To support the growth of particular industries of an economy

- To encourage the export of certain goods

- To reduce allocative inefficiency.

Impact of subsidies on stakeholders

Consumers: Better off, since P decreases and QS increases.

Producers: Better off, since QS and QD increase, so revenue increases.

The government: The payment places a burden on them. They may have to find other ways to raise money.

Society: Worse off, as there is an overallocation of resources (govt budget) and producers have no incentive to be efficient.

Foreign Producers: If granted on exports, the price is lowered and could and increases competition with foreign producers.