government intervention

indirect taxes uses

provides the government with revenues needed to carry out their many responsibilities

discourages the consumption of certain goods → undesirable goods (demerit)

effects of indirect taxes

raises the firm’s costs and shifts the supply curve to the left negatively (up)

• because of this shift, less of the product will be supplied at every price

types of indirect taxes

• specific taxes

• ad valorem taxes

specific tax

fixed amount of tax that is imposed upon a product

• shifts the supply curve negatively to the left by the exact amount

• vertical distance is specific tax

• draw the graph

ad valorem tax

percentage tax

• tax is a percentage of the selling price and so the supply curve will shift

• the gap between S and S1 will get larger as the price of the product rises

diagrams showing

• producer revenue before vs after

• government revenue

• tax burden on consumer and producer

…

elastic demand + tax

since PED is elastic, consumers are highly responsive to prices

• larger tax burden on producers than consumers

draw graph

inelastic demand

higher consumer burden as consumers are highly unresponsiveness to higher price levels

• producers pass burden onto the consumers

• gov tend to place indirect taxes of relatively inelastic demand leading to higher gov revenue because demand changes by a proportionately smaller amount than the change in price

draw graph

subsidy

payment from the government to firms, per unit of output, to reduce their cost of production

reasons for subsidies

1. lowers the price of essential goods to consumers → encourages by the lower price

2. guarantee the supply of products that the government thinks are necessary also creates employment

3. to enable producers to compete with overseas trade, thus protecting the home industry

diagram

• draw diagram (shift from S to S+subsidy)

• supply curve shifts positively to the right because subsidies reduce the cost of production for the firm and therefore more will be supplied at every price

disadvantages of subsides

1. gov opportunity cost in terms of expenditure → less resources allocated to healthcare and education

2. firms are not incentivised to gain efficiency if they do not have to compete against foreign producers

3. consumer are taxpayers

4. may lead to overproduction → implications for sustainability such as dumping

price ceilings

where the government sets a maximum price, below the equilibrium price which prevents producers from raising the price above it

why are price ceilings set

to help consumers and are imposed in markets where the product is a necessity and/or a merit good

merit good

a good that would be under provided if the market were allowed to operate freely

• agricultural products during food shortages/ rented accommodations

price ceiling diagram

• w/o gov interference, market operates at Pe and Qe

• at Pmax, Q2 is demanded whereas only Q1 is supplied leads to excess demand (shortage)

• if gov does not intervene further, consumption will fall from Qe to Q1, despite the lower price

  • leads to black market (illegal market) where the product is sold at a higher price

resolve price ceiling

gov can attempt to shift the supply curve to the right until the equilibrium price is reached

• offer subsidies to encourage production

• direct provision → gov produces the product themselves → increases supply

• gov could use previously stored goods (only non-perishable so not bread)

price floors

situation where gov sets minimum price above the equilibrium price which prevents producers from reducing it

why are price floors set

• attempts to raise incomes for producers of goods and services that the gov believes are important

• may be subjected to large price fluctuations - low equilibrium prices harm the economic well-being of producers

• to protect workers by setting a minimum wage, to ensure that workers earn equitable wages

price ceiling diagram

• w/o gov inference, the market producers at Qe and Pe

• gov imposes minimum price to increase the revenue of producers

• at Pmin, only Q1 is demanded as price has risen, however Q2 will now be supplied → excess supply also known as surplus

• if gov doesn’t interfere further, consumption will fall to Q1

resolve price floor

gov can eliminate excess supply by buying the surplus at Pmin and shifting the demand curve, then storing it

• expensive and destroying is unsustainable

• selling abroad leads to dumping accusations

• opportunity cost to gov expenditure

limit producers using quotas which restrict the supply so that it does not exceed Q1

• keeps prices at Pmin but would only affect a limited number of producers