Government Intervention

Free Market:

• A market without any government control or intervention. The price and outputs are determined by the interactions of buyers and sellers

Governments intervene often to influence several variables in markets for particular goods:

• Taxing the good to discourage consumption (demerit goods) or raise revenues

  • Indirect Taxes

    • An indirect tax is one placed by the government on the producers of a particular good.

      • Consumers will pay the tax indirectly through producers

      • An indirect tax will be shared by both consumers and producers

    • A tax reduces the supply of a good and increases the price. The following points should also be observed.

    • If demand is relatively elastic: Producers will bear the larger burden of the tax. Firms will not be able to raise the price by much out of fear of losing all their customers, therefore price will not increase by much, but producers will get to keep less of what consumers pay.

    • If demand is relatively inelastic: Consumes will bear the larger burden of the tax. Firms will be able to pass most of the tax onto consumers, who are not very responsive to the higher price, thus will continue to consume close to what they were before the tax. 

    • Elasticity and government revenue: The implication for government of the above analysis is that if a tax is meant to raise revenue, it is better placed on an inelastic good rather than an elastic good. Taxing elastic goods will reduce the quantity sold and thus not raise much revenue. 

    • Taxing goods with relatively inelastic demand will raise more revenue and lead to a smaller loss of total welfare, while taxing goods with elastic demand will lead to a larger decrease in quantity and a greater loss of total welfare.

• Paying producers of the good to reduce costs or encourage the good’s production

  • Subsidies

    • The price of the good does not increase by the full amount of the tax

    • The producers of the good do not keep the full price paid by consumers, as they must pay the tax

    • There is a loss of total welfare in the market resulting from the tax.

    • A subsidy increases the supply of a good and reduces the price. The following points should also be observed.

    • The price of the good does not decrease by the full amount of the subsidy

    • Pen consumers enjoy some of the benefit of the good, but producers also benefit

    • There is a loss of total welfare in the market resulting from the cost of the subsidy exceeding the benefit

• Reducing the price of the good below its free market equilibrium to benefit consumers

  • Price Ceilings

    • When a government lowers the price of a good to help consumers, there are several effects that we can observe in the market. Assume the government has intervened in the market for gasoline to make transportation more affordable for the nation’s households

    • On consumers:

      • Quantity demanded increases (Qd)

      • The lower price leads to an increase in consumer surplus, which is now the blue area

      • The lower quantity means some consumers who want to will not be able to buy the good

      On Producers:

      • The lower price means less producer surplus (red triangle)

      • The lower quantity means some producers will have to leave the market and output will decline (Qs)

      On the market:

      • Overall, not enough gasoline is produced, and is the market is allocatively inefficient. The gray triangle represents the loss of total welfare resulting from the price ceiling.

• Raising the price of a good above its free market equilibrium to benefit producers

  • Price Floors

    • When a government raises the price of a good to help producers, there are several effects that we can observe in the market. Assume the government has intervened in the market for corn to help farmers sell their crop at a price that allows them to earn a small profit.

    • On consumers:

      • Quantity demanded decreases (Qd)

      • The higher price means there is less consumer surplus (blue area)

      On Producers:

      • Quantity supplied increases (Qs)

      • The higher price means there is more producer surplus, but since consumers only demand Qd, there is an excess supply of unsold corn (Qd-Qs)

      On the market:

      • Overall, the market produces too much corn and is thus allocatively inefficient. The increase in producer surplus is smaller than the decrease in consumer surplus. The total loss of welfare is represented by the gray triangle.

When governments intervene in the free market, the level of output and price that results os may NOT be the allocatively efficent level. In other words, government intervention may lead to a misallocation of society’s resources.

Buffer stock scheme:

A policy that regulates the price of non-perishable agricultural commodities to keep it within a narrow range that is deemed desirable for both producers and consumers.