3.13 - methods and effects of government intervention in markets

7 ways the government can intervene in markets

1. Indirect taxes

2. Subsidies

3. Direct provision of goods and services

4. Maximum prices

5. Minimum prices

6. Buffer stock schemes

7. Provision of information

1. Indirect tax

a tax levied on goods and services (e.g. VAT) 

• regressive in nature

• 2 main types of indirect taxes:

  • Specific taxes - taxes that are charged as a set amount per unit 

    • e.g. tax per litre of fuel

  • Ad valorem taxes - a tax that is charged as a given percentage of the price 

    • e.g. VAT

 WHY?

•   Indirect taxes are often used to discourage production and consumption of demerit goods e.g. cigarettes and high-sugar drinks

• These taxes are imposed on the producer, although they are passed on to the consumer in the form of higher prices

• A specific indirect tax will cause a shift of the supply curve to the left by the amount of the tax

  • The market price is now higher (at P1) than the original equilibrium price (P)

  • The quantity traded is lower at Q1     

  

Specific taxes

• taxes that are charged as a set amount per unit 

  • e.g. $10 per item whatever the price

• Shifts the supply curve parallel leftwards

Ad valorem taxes

• a tax that is charged as a given percentage of the price 

  • e.g. VAT

  • 10% of the price

• Shifts the supply curve leftwards but not parallel

Incidence of tax

the extent to which the tax burden is borne by the producer or the consumer or both

• In the diagram, the producer bears a slightly higher burden than the consumer - shown as area B is greater than area A

• The producer now receives a lower price at P2

• The consumer now pays a higher price at P1

• The overall tax revenue to the government is the area A+B

What does the incidence of tax depend on?

The extent to which the producer is able to pass the tax on to the consumer depends on the price elasticity of demand and supply

Price inelastic demand

• it is easier for the producer to pass on the tax to the consumer in the form of higher prices

  • e.g. essential products such as petrol

  • The consumer bears the greater burden of the tax

Price elastic demand

it is more difficult for the producer to pass on the tax to the consumer in the form of higher prices

• The increase in price leads to a larger percentage fall in quantity demanded

• The producer bears the greater burden of the tax

Why do many low-income market economies struggle to collect taxes?

• One reason is that many people in the working population are paid in cash and do not submit a tax return

• Forcing businesses to adopt a more digital means of receiving payments can help avoid this

• In emerging market economies, government therefore feel more confident about collecting indirect rather than direct taxes

2. Subsidy

a direct payment made by the government to producers of goods and services

• Reasons for subsidies include:

  • To keep down market price of essential goods e.g. bread

  • To encourage greater consumption of merit goods e.g. education

  • To contribute to a more equitable distribution of income

  • To provide services that would not be provided by the free market e.g. postal services

  • To raise producers’ income, especially in the case of farmers

  • To provide an opportunity for exporters to sell more goods

  • To reduce dependence on imports by paying subsidies to domestic producers of close substitutes

Incidence of subsidy

the extent to which the benefit of the subsidy is shared between the producer and the consumer

• Consumers benefit from a lower price (P1) rather than the free market price (P)

• Producer benefit through receiving a higher price (a) than they would selling an increased supply

• The overall cost of the subsidy to the government is the area abdp1

What does the incidence of subsidies depend on?

The extent to which the subsidy benefits the producer and the consumer depends on the price elasticity of demand and supply

Why is the allocation of subsidies from a limited government revenue a controversial issue?

• Subsidies interfere with the price mechanism and also create an opportunity costs since this funding could have been used elsewhere in the economy

• Estimating the size of a subsidy required is difficult

• Subsidies are ‘blanket’ or lump sum payments - both high-income and low-income earners pay the same amount per unit consumed

Examples of subsidised goods and services and why they are subsidised

• Staple foods such as rice, bread and cooking oil

  • This is to support the lowest income earners in the economy

  • High income earners pay the same amount for the good as low income earners, though they could afford to pay more

  • Shortages may be created since demand is greater than supply

  • There is no incentive for inefficient producers to improve

  • There is no certainty that the money received as a subsidy will be used for its intended purpose

• Public transport

  • This is to give low-income earners access to employment opportunities, to provide social mobility for elderly, to reduce road congestion and environmental problems associated with traffic

  • The benefits are to individuals and to the community as a whole

 

3. The direct provision of goods and services

• Governments provide certain important services free of charge at the point of use or consumption e.g. public goods and merit goods

  • The funding for these services will come from tax revenue

  • It may lower inequality as those on lower incomes will benefit more as a percentage of their income

  • Merit goods e.g. education and healthcare are sometimes provided for free

    • However, many economies provide these partly free of charge (government provision) and partly by charging a price at the point of use (private sector provision)

    • The main view is that everyone should have an equal access to a certain level of education and healthcare, regardless of income

  • Public goods e.g. streetlights are provided by the government and paid for out of tax revenue

    • These goods will not be provided for by the free market and consumers will not be willing to pay for them

    • An argument is that this leads to inefficiency as the costs are higher than would be if it were provided by a competitive market

 

Differences between economies’ healthcare provision (UK and USA)

• UK - free healthcare

• USA - free healthcare is limited with those who can afford to pay having to take out medical insurance

• Most low-income countries - a charge is usually made for healthcare provision

  • Only a basic system of healthcare may be provided free of charge

Why is provision of goods and services is controversial issue?

• It is argued that it leads to over provision (inefficient allocation of resources), especially if there is no direct charge

• If consumers were charged, demand would fall

  • It would also reduce the tax burden allowing for government spending on alternative uses

4. Maximum prices (price ceiling) -

a price that is fixed and the market price must not exceed this price

• May be imposed by the government if the price of a good is too high in the free market

• It is a way of assisting those on low incomes, reducing income inequality, or when the benefits of consuming a product are not fully appreciated

• To have any effect, the maximum price must be set below the equilibrium price of the free market

  • It is not legally possible for sellers to charge a price higher than the maximum price

•  Governments use legislation to enforce maximum prices for:

  • Staple food items e.g. rice, cooking oil, flour

  • Petrol and diesel fuel

  • Rents in certain types of housing

  • Services provided by utilities e.g. water, gas and electricity

  • Transport fares, especially where a subsidy is being paid

Example: maximum price for cooking oil

• Price is forced down from P-P1

• This creates a shortage (Q2-Q1) because producers are only willing to supply Q1 but consumers demand Q2

  • Production is not sufficient to satisfy everyone - there is an excess demand

  • Some consumers will benefit - those who are able to buy the product (Q1) at a lower price

  • Other consumers will lose out as the product is no longer available

• The available supply of the product may have to be allocated by queuing or rationing

  • Rationing restricts demand but this may create an informal or underground market for the product - consumers will then have to pay high prices well above the maximum price

Minimum price (price floor)

a price that is fixed and the market price must not go below this price

• To have any effect, the minimum price must be set above the equilibrium price of the free market

• Governments use legislation to enforce minimum prices for:

  • Demerit goods e.g. high-sugar sports drinks

  • Agricultural products, particularly in middle and in high-income countries

  • Wages in certain occupations, usually low skilled, to avoid employers exploiting their employees

  • Certain types of imported goods where close substitutes produced by domestic producers are available

 

  

Example: minimum price for high-sugar sports drinks

• Price is forced up from P-P1

• This creates a surplus (Q2-Q1) because producers are willing to supply Q2 but consumers only demand Q1

  • There is an excess supply

  • Only those consumers who can afford the higher price will purchase the product

    • A lower quantity (Q1) is traded

Limitations of minimum prices

• Producers are likely to be inefficient - firms with high costs have little incentive to reduce costs since they are protected by the high minimum price from lower-cost competitors

• An informal market may develop e.g. cigarettes

  • If there is a high rate of indirect tax and a high minimum price, consumers may be happy to buy these goods from dealers offering them at a lower price than the minimum price

• Agricultural markets - the minimum price tends to be set at a level that provides a living income for producers

  • The excess supply will usually be bought by the government at the minimum price

6. Buffer stock scheme

a type of commodity agreement designed to limit price fluctuations

• The government will hold stocks and these will be bought or sold to stabilise prices if there is a disequilibrium (shortage or surplus)

  • The government will buy stocks when there is a surplus so that price does not fall drastically

  • The government will sell stocks it has held when there is a shortage so that price does not rise drastically

• It combines the principles of a minimum and maximum price control

• This is especially useful in agricultural markets because prices are unpredictable due to changes in supply

 

  

Example: agricultural products

• If supply decreases from S-S1, this will create a shortage at the initial price P - this will put upward pressure on the price to rise to P1

  • The government will then sell stocks (increasing supply on the market) so that price will fall and be stabilised in the target price range

• If supply increases from S-S2, this will create a surplus at the initial price P - this will put downward pressure on the price to fall to P2

  • The government will then buy stocks (decreasing supply on the market) so that price will rise and be stabilised in the target price range

7. Provision of information

• Information failure can result in under consumption of merit goods and over consumption of demerit goods

• The government can therefore use information provision as a form of direct intervention: 

  • Examples:

    • Compulsory information on cigarette packets warning of the dangers of smoking

    • Public health announcements and campaigns

    • Advice on non-prescription medicines

    • Nutrition and allergy information on food packaging