Government Intervention

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1 Government Intervention Taxes - Aim of imposing indirect taxes: the government does such spending in order to raise tax revenues and to internalize externalities, to achieve the optimum level of output. - Reduce the consumption of demerit goods - The poor can contribute may not be able to pay direct taxes - Convent and easy to collect no cost for the government - non evadable - parallel market may emerge - However Indirect taxes are regressive and hurt lower income families more this may lead to a further disparity between income groups and reduce economic growth. Lower spending in the market less disposable income. - A specific tax: a fixed amount of tax that is imposed on a product, which shifts the supply curve vertically upwards by the amount of tax. - An ad valorem tax: the tax is a percentage of the selling price and so the supply curve will shift by an increasing amount as the price of the product rises. - When either specific taxes or valorem taxes are imposed, the market will shrink in size (decrease in quantity), thus possibly lower the level of employment in the market, since firms might employ fewer people. (Curve shifts up because it increases costs of production.) - tax burden for consumers + tax burden for producers (Value of tax x quantity) - Producers and consumers suffer: producers incur greater average costs, meaning that they partially pass this onto consumers - Tax reduces output: shifting supply to the left means a lower quantity is supplied, this means that the market size shrinks - Government benefits: taxes increase government revenue 1

2 Can provide merit + public goods. Which increase growth etc.. Tax on inelastic goods are good for raising revenue. - Tax raises prices: tax shifts demand to the left and raises equilibrium, meaning higher prices - If a good with inelastic demand is taxed, the tax burden can be easily passed on to the consumer (PED is less than PES) - This means the tax burden on the consumer (C) is greater than the tax burden on the producer (P). - As shown in this diagram, the producer would like to raise the price to P4, to pass all the tax burden onto consumers. However, this would cause excess supply, so prise falls to a new equilibrium at P2. - If a good with elastic demand is taxed, the tax burden on the consumer (C) is less than the tax burden on the producer (P). (PED is more+ than PES) - In this second scenario, the producer would like to increase the price to P4, to pass all the tax burden on to consumers. However, this would cause excess supply, so price falls to a new equilibrium of P2. This is where enough consumers would continue to buy but not all of the tax burden is taken by the producer. Subsidies Subsidy: an amount of money paid by the government to a firm per unit of output. This causes the supply curve to shift to the right by the amount of subsidy Aims of subsidies : 2

3 - To ensure consumers can afford necessary goods: the price of the product will be lowered so that more consumers are able to buy. For instance in Malaysia millions is being spent in order to subsidise food and fuel to keep prices low. Like sugar which is an essential ingredient in Asian cooking. (July 2012). - Protectionism: subsidies are used to help domestic firms become more competitive in the international markets therefore increasing export revenue. This is in order to address a balance of payment deficit. For example the USA subsidises their steel industry, in order to protect it against countries, such as Brazil, where steel can be produced more cheaply. Maybe be unfair and lead to dumping if there is an excess of supply. Balance of payments but will hurt competition in lower develop countries who cant face the eos. - To ensure consumers buy merit goods: merit goods are goods or services which are provided for the benefit of society. They are usually under-consumed and undersupplied, this is a result of information failure about the private and external benefits the good can have. Therefore, the government subsidises them in order to make more consumers willing and able to consume Examples of merit goods are pensions, healthcare, insurance and education. In Columbia for instance health insurance is subsidised. - Guarantee the supply of products: the government may believe that some industries need to be supported by lowering their average costs of production. This may be in order to ensure them for future times such as war. Also this could be to provide employment For instance the power supply in India is most states is subsidised as the government believes it is necessary for the economy. - When subsidies are provided, the market will expand in size (increase in quantity), thus possibly raise the level of employment in the market, since firms might employ more people. (Curve shifts down because costs of production decrease). - Example Singapore Transport and Housing 3

4 Maximum Prices - Maximum prices: the government sets a price below the equilibrium price to prevent producers from raising the price above it. - Prices are set in order to protect consumers from the high prices of merit and/or necessary goods because these would be underprovided in a free market. - For instance, during food shortages the government may impose a maximum price on the cost of wheat in order to ensure that food prices a low enough for all income levels to afford. Also in London maximum prices have been used in order to keep the rent lower than the market equilibrium in attempt to ensure affordable accommodation is available for those on low incomes. - When a maximum price at Pmax is put emplace by the government, below the equilibrium price of Pe, there is an excess demand of Qs to Qd. This is because at the new price the quantity demanded is Qd, but the quantity supplied is Qs. S1 is the supply of rented housing at the maximum price in the long run. It gets more elastic as people will stop letting houses as they cannot justify the opportunity cost. - The excess demand from maximum price may result in shortages. This could lead to the emergence of a black market or parallel underground market, where the products are sold at a higher price until the demand curve which represents willingness to buy. - Non-price rationing systems may emmerge and involve long queues or reservations if working on a first come first serve basis in order to determine which consumers to serve. - Decreased market size could hurt producers and lead to heavy losses if they cant earn enough from the price to stay open. Lead to unemployment. - Elimination allocative efficiency as MB does not equal MC because there is no equilibrium as a result society is not producing enough and it can be considered instance of market failure. - Welfare: there is a deadweight loss of BCE. This is because consumer surplus has changed from AEPe to ACBPmax whilst producer surplus has decreased from 0EPe to 0BPmax, as a result of the maximum price imposed. It is therefore not allocative efficient as community surplus is not maximised. - Rent control 4

5 - Staple Foods - Education - Housing Minimum Prices - Minimum price: price set above the equilibrium price by the government, which prevents producers from reducing their prices to below it. - Prices are set in order to protect the supply of products that the government believes are important, such as agricultural products. This may be because their products are subject to large price fluctuations or there is a lot of foreign trade. Minimum prices also protect workers as they act as a minimum wage, which ensures that workers earn enough to lead a reasonable existence. Other reasons include for strategic importance and to prevent rural urban migration. - Inefficient firms The higher price provided by the price floor allows firms with high costs of production(inefficient firms) to survive and have no incentive to cut costs. - high costs of production (inefficient firms) to survive and not try to cut costs - When a minimum price at Pmin is put emplace by the government, above the equilibrium price of Pe, there is an excess supply of Qs to Qd. This is because at the new price the quantity demanded is Qd, but the quantity supplied is Qs. - Minimum prices usually result in a supply surplus. The government may therefore deal with it by increasing demand through advertising, restricting the amount of imports, selling the product cheaply abroad (undermines foreign farmers but balances trade deficit. This may hurt relations with other countries dumping) or buying the product up themselves and storing or burning it, which can be very expensive. For instance, some EU countries do this and it is referred to as wine lakes and butter mountains. - Minimum wage - Consumers pay a higher price for a lower quantity. - Producers will gain from higher price and quantity - Employment will rise due to increased quantity supplied and labour would need to be demanded in order for supply to increase. 5

6 - Other methods to deal with the surplus affect the supply of a product. These are usually quotas which limit how much a producer is legally allowed to produce. The EU calls these method a set aside policy. - Lead to emerge of parallel market as firms illegally distribute bellow price ceiling in order to make revenue and deal with excess supply. - Welfare: there is a welfare deadweight loss of BCE. This is because consumer surplus has decreased from AEPe to ACPmin whilst producer surplus has changed from 0EPe to 0ECPmin, as a result of the minimum price imposed. It is therefore not allocative efficient as community surplus is not maximised. 6