Chapter 10

reasons for government intervention in markets

support firms

promote equity

Earn government revenue

Influence the level of consumption

support households on low income

influence the level of production

correct market failure

Govt revenue comes from

1. tax revenue

2. the sale of goods and services

3. Privatisation proceeds

4. Sovereign wealth funds

5. public sector

govt support firms through

1. subsidizing

2. tax concession

3. protecting domestic infant industries

4. business development loan

5. research and development funding

6. financial bailout

to support households on low income

there are huge inequalities and unfair distribution of income, therefore, government help to improve their living standard. example: provision of essential infrastructure

to influence the level of production

government uses methods such as tax or regulation policies to increase or decrease consumption of goods and services. competitive policy can also be used to stimulate competition.

Influence the level of consumption

regulation and indirect tax are used to reduce consumption of demerit goods etc.

Government expenditure can also allow more socially desirable goods and services to be consumed, such as healthcare, education etc. they might do this by directly providing the service or subsidising the output or consumption.

public goods

collective consumption goods provided by the government that are non-rivalrous and non-excludable

street lighting, public parks etc.

merit goods

products that create positive externalities when they are produced or consumed that is MSB>MPB

MSB

Marginal Social Benefit in IB Economics, representing the total benefit to society from consuming one extra unit of a good, calculated as .

MPB

Marginal Private Benefit (MPB) is the additional benefit or utility a consumer receives from consuming one extra unit of a good or service

Negative externalities (for external costs)

expenses incurred by third parties in an economic transaction for which no compensation is paid

etc. pollution from factories, water contamination, construction noises etc.

to correct market failure

markets are not always efficient in allocating resources —> government intervene to help

non excludable

non-payers can benefit directly

non-rivalrous

one person’s consumption of a good or service does not reduce the amount available to other people

to promote equity

the free market economy does not alwyas promote equity. the extent to which government should intervene in markets to promote greater equity remains a debate among economists.

main forms of government intervention

price ceiling, price floor, indirect taxes, subsidies, direct provision, command and control and consumer nudges

price controls are

government regulations establishing a maximum or minimum price to be charged for a certain goods or service

price ceiling (maximum price)

occurs when the government sets a price below the market equilibrium price to encourage output and consumption. causing a shortage

welfare loss (deadweight loss)

refers to a reduction in social surplus (consumer surplus + producer surplus) due to the inefficient allocation of resources.

price floor (minimum price)

a form of price control that imposes a price guarantee set above the market equilibrium price to encourage supply of a certain good or service. this result in a surplus which is either exported or stored.

indirect tax

a payment taken indirectly from the consumer’s income, through their expenditure on goods and services

a specific tax

also known as per unit tax imposes a fixed amount of tax on each product sold

Ad valorem

tax imposes a percentage tax on the value of a good or service that is sold.

who carries more tax burden if PED is low? (price inelastic)

it falls on consumers since there is a lack of substitutes

who carries more tax burden if PED is high (price elastic)

producers. this is because they are unable to pass on most of the indirect tax to the consumer because customers are highly responsive to price changes

who pays more for the tax if PES is high?

consumer pays a greater proportion of the incidence tax. this is because suppliers are less willing and able to supply if the cost of production increases.

who pays more for the tax if PES is low?

producer pays a greater proportion of the incidence tax. When supply is inelastic, producers have little ability to reduce the quantity they supply in response to a tax. They can't easily exit the market or cut back production, so they're "stuck" absorbing most of the tax rather than passing it on to consumers.

who pays more when PES=PED

both pays 50/50

subsidy

a form of financial assistance from the government to encourage output (such as the sale of good for exporting) to reduce the cost of producing or supplying certain merit goods or to keep down the cost of living for its citizens.

direct provision

occurs when the government directly provides or supplies goods and services deemed to be in the best interest of the public. they do not always mean that the good or service is necessarily provided for free but charged at a much lower price.

command and control (CAC) regulation and legislation

refers to the direct rules or laws governing an activity or industry, stating what is permitted and what is illegal

some limitations of CAC regulation and legislation

expensive and time consuming

do not offer incentive for firms to improve the quality of their production

inflexible

Goverment failure

arises when the cost of attempting to prevent or correct free market imperfections or distortions turn out to be greater than the social costs of the original market failure itself.

positive consequences of government intervention

promoting general economic wellbeing and fairness

maximising social welfare

creating greater economic opportunities

What effect does a price ceiling have on market price?

It sets the price lower than the free market equilibrium.

What market outcome does a price ceiling create?

Excess demand (shortage).

How does a price ceiling affect consumers and firms?

Consumers gain (increase in consumer surplus); firms lose (decrease in producer surplus).

What effect does a price floor have on output?

It creates excess supply (surplus).

What is the government's response to a price floor surplus?

The government buys goods and services to eliminate the surplus.

How does indirect taxation affect price and quantity?

Price rises above free market equilibrium; quantity demanded decreases.

What determines the tax incidence between consumers and firms?

The value of PED (Price Elasticity of Demand).

What happens to price and quantity when a subsidy is introduced?

Price falls below free market equilibrium; quantity demanded increases.

How do subsidies affect firms?

Producer surplus increases and profitability is higher.

What is the cost to the government of providing subsidies?

Government spending increases to finance the subsidies.

What must the government do in response to a price ceiling shortage?

Supply goods and services to match the shortage.

How does a price floor affect consumers?

Consumer surplus decreases.

How does indirect taxation affect firms specifically?

Producer surplus decreases and profitability is lower.

What is the government's gain from indirect taxation?

Tax revenues increase, depending on the value of PED.

How does a subsidy affect consumers?

Consumer surplus increases; subsidy incidence depends on PED.