4. Government intervention

Why might the government intervene? (8 reasons)

• Government revenue from indirect taxes

• Provide support to firms through subsidies and price floors

• Protect domestic firms from foreign competition through tariffs and quotas

• Provide support to low income earners through subsidies and price ceilings

• Change production levels through taxes and subsidies

• Change consumption levels through subsidies (encourage) and indirect taxes (discourage)

• Correct market failure

• Promote equity/equality by redistributing income (the market does not achieve a fair distribution of wealth)

3 types of government intervention

1. Taxes

2. Subsidies

3. Price controls: price floors/price ceilings

Define tax with examples

Compulsory financial charge imposed on the income of a person or a firm or the consumption/production of certain goods and services
PAYG tax (for households), company tax (for firms), fringe benefits tax (paid by employers on certain benefits provided to their employees), HECS (student loans)

Define indirect tax with examples

Compulsory financial charge imposed on spending to buy goods and services

GST (10% in Australia), tariffs, excise tax, luxury car tax

Why impose indirect tax? (4 reasons)

1. Source of government revenue (lower PED product → higher revenue)

2. Discourage consumption of demerit goods

3. Redistribution of income (excise tax on luxury goods)

4. Improve allocation of resources by correcting negative externalities

2 types of indirect tax with definitions

Specific tax: a fixed amount of tax charged per unit of a good or service

Ad valorem tax: a tax charged as a fixed percentage of the price of a good or service

Draw the impact of an ad valorem tax

Draw the diagram of a specific tax

Define incidence of tax

A measure of who bears the burden of the tax (dependent upon PED and PES)

• PED<PES (demand less elastic): consumer pay higher proportion of tax

• PED>PES (demand more elastic): consumer pay lower proportion of tax

Impacts of indirect tax on market outcomes (5 outcomes)

• Equilibrium price increases, equilibrium quantity decreases

• Fall in producer revenue

• Government tax revenue

• Underallocation of resources 

• Welfare loss

Impact of indirect tax on stakeholders

• Consumers: worse off (increase in price, decrease in quantity)

• Producers: worse off (fall in revenues)

• Government: better off (gains revenue)

• Workers: worse off (lower amount of output → few workers needed → unemployment)

Define subsidy with examples

 a form of assistance provided by the government to individuals or groups

Direct cash payment (specific subsidies), low interest loans, direction provision of G&S, tax relief

Why provide subsidies? (5 reasons)

1. Increase revenue and income of producers

2. Make goods and services more affordable to low-income consumers

3. Encourage production and consumption of merit goods and services

4. Support the growth of particular industries

5. Reduce allocative inefficiencies

Impacts of subsidies on market outcomes (5 impacts)

• Greater production & consumption

• Consumers receive lower price, producers receive higher price

• Government spending

• Overallocation of resources

• Welfare loss

Define welfare loss/dead weight loss

Social surplus that is lost due to inefficient resource allocation

Draw the impact of a subsidy

Impacts of subsidies on stakeholders

• Consumers: better off (lower price, higher quantity) → increase in consumer surplus

• Producers: better off (higher price, larger quantity, higher revenue) → increase in producer surplus

• Government: Worse off (burden on government funds) → loss of government spending

• Workers: better off (more need for workers)

Define price controls

regulation of prices by the government so that prices are unable to return to equilibrium

Define price ceiling

a legal maximum price set by the government for a good/service that is below the equilibrium price

Price ceiling aim

to make certain goods and services more affordable for low income earners

Consequences of price ceiling for the economy (5)

• Constant shortage

• Non-price rationing: first-come-first serve, coupons, favouratism

• Underground markets (inequitable)

• Underallocation of resources to this good/service

• Welfare loss

Draw a diagram for price ceiling

Consequences of price ceiling for stakeholders

Consumers: partly gain and partly lose (some consumers are able to purchase the good at a lower price, but others do not get the good at all due to the shortage)

Producers: worse off (revenues decrease)

Workers: worse off (fall in output makes unemployment more likely)

Government: no gains or losses (but might gain political popularity from consumers who are better off)

2 examples of price ceiling

Rent controls, food price control

Define price floor

a legal minimum price set by the government below which it is illegal to sell that is set above the equilibrium price

Why impose price floors?

• Protect farmers due to price volatility (low PES and low PED)

• Protect low-skilled, low-wage workers by offering a minimum wage above the equilibrium

Consequences of an agricultural price floor

• Persisting surplus (common practice for the government to buy the surplus: rightward shift in demand)

  • If gov does not buy surplus, price levels would drop back to equilibrium

• Government measures to dispose of surplus → additional costs for the government

  • Store it (extra costs)

  • Export it (has to subsidise the industry to create low export prices)

  • Destroy it (waste of resources)

• Firm inefficiency: no incentive → technical efficiency not promoted

• Overallocation of resources → allocative efficiency not achieved (another product may be undersupplied)

• Negative welfare impacts (dead weight loss)

Draw a diagram for an agricultural price floor

Impact of an agricultural price floor on stakeholders

Consumers: worse off (loss of consumer surplus)

Producers: better off (increase in revenue, protected against low-cost competition, less likely to go out of business)

Workers: better off (more employment)

Government: worse off (less government funds, costs of storing the surplus)

Consequences of minimum wage

• Labour surplus and unemployment

  • Unskilled workers most likely to be affected by unemployment

• Illegal workers below the minimum wage

  • Often involves illegal immigrants

• Misallocation of labour resources

  • Industries that require more unskilled labour are most affected and will hire less unskilled labour

• Misallocation in product markets

  • Firms requiring more unskilled labour experience an increase in costs of production, causing a decrease in supply of their product

Draw a diagram for minimum wages

Impact of the minimum wage on stakeholders

Firms/employers: worse off (higher costs of production)

Workers: mixed (some gain due to a higher wage, but some lose as they become unemployed)

Consumers: worse off (decrease in number of workers → decrease in supply of products → higher prices)

Define price fixing

when prices for a product are fixed at a particular level (e.g. concert ticket)

• Quantity supplied is also often fixed

• Surplus if low demand, shortage if high demand

Draw a diagram of price fixed below equilibrium

Draw a diagram of price fixed above equilibrium