AS Level Economics: Government Intervention in Markets PDF

Compiled by Celeste Teo Level AS Chapter 3.1 Reasons for government intervention in markets Topics 3.1.1 Addressing the non-provision of public goods 3.1.2 Addressing the over-consumption of demerit goods and the under-consumption of...

Compiled by Celeste Teo Level AS Chapter 3.1 Reasons for government intervention in markets Topics 3.1.1 Addressing the non-provision of public goods 3.1.2 Addressing the over-consumption of demerit goods and the under-consumption of merit goods 3.1.3 Controlling prices in markets Addressing the non-provision of public goods Goods that are non-excludable and non-rivalrous Free rider problem exists Will not be provided by the free market as it is not possible to charge a price ➔ Solution: direct provision of goods and services Question: It would not be feasible for street lighting to be supplied by private companies and sold directly to consumers because a. There are economies of scale in public provision by a single authority b. Variable costs are high relative to overhead costs so that it would be impossible to know what prices to charge c. It would be difficult to prevent those who would not be prepared to pay from benefiting d. Individuals do not set a sufficiently high value on public benefits of this kind Addressing the over-consumption of demerit goods Due to imperfect information People underestimate the potential harm caused by consumption of the good (or overestimate the benefit) Governments will attempt to discourage consumption ➔ Solution: indirect taxes, minimum prices, regulatory controls, provision of information Addressing the under-consumption of merit goods Due to imperfect information People underestimate the potential benefits of consuming the good Governments will attempt to encourage consumption ➔ Solution: direct provision, subsidies, provision of information Compiled by Celeste Teo Controlling prices Situations that require intervention High prices Low prices Unstable prices Example: Example: Example: Essential goods Agricultural products Agricultural products Lower income groups would be If prices fall too low, producers Due to variation in supply over a unable to afford therefore, leading could go out of business* period of time to decline in standard of living & ➔ E.g. SS of crops are subject health to weather conditions Solution: maximum price Solution: minimum price Solution: buffer stock schemes *Note: ➔ Farmers viewed as disadvantaged ➔ Rural communities lack infrastructure compared to urban areas ➔ Labour productivity lower, wages are lower ➔ Technological change increases production > consumption → reducing prices ➔ Prices drop → consumers gain but farmers lose their income Compiled by Celeste Teo Level AS Chapter 3.2 Methods and effects of government intervention in markets Topics 3.2.1 Impact and incidence of specific indirect taxes 3.2.2 Impact and incidence of subsidies 3.2.3 Direct provision of goods and services 3.2.4 Maximum and minimum prices 3.2.5 Buffer stock schemes 3.2.6 Provision of information Indirect taxes ➔ Paid to the government by an intermediary (e.g. firm) ➔ Purpose: o Increase market equilibrium price o Decrease market equilibrium quantity o Collect tax revenue for government spending o Reduce overconsumption/production Specific indirect tax Ad valorem indirect tax A tax levied on the manufacturing or sale, of goods A tax levied on the manufacturing or sale of goods or and services, whereby it is imposed as a fixed services, whereby it is imposed as a percentage on amount per unit the pre-tax price Diagram: Diagram: Example: Example: €1.80/cigarette pack (EU) VAT (UK): 20% SST (Malaysia): 6% GST (Australia): 10% Advantages: Advantages: If prices fall, then a specific tax would yield the same Commonly used as add to govt revenue automatically tax revenue, whatever the price as price rises Compiled by Celeste Teo Can be based on total volume – (e.g. tax of £1/litre) - Does not need to be regularly updated once it is set, or on harmful content only – (e.g. 50p/unit of and may not need to be adjusted so frequently alcohol) Can be better targeted as a policy tool Automatically adjusts for inflation as it is tied to the price of the good Relatively predictable govt tax revenue Tax not sensitive to price changes Higher profit margin is taxed Govt tax revenue protected against price Reduces industry profit margin since part of wars the price is taxed Easier to plan the budget Generates the most revenue from indirect sources Relatively easier to determine Specific taxes are only levied on a small range Charged per quantity of often harmful products Calculation only requires a precise definition of what constitutes as “one unit” or quantity Disadvantages: Disadvantages: Less common than ad valorem taxes as they do not If prices fall, then revenue will also fall generate more revenue for the govt when prices rises Less predictable govt tax revenue stream over time Changes to specific taxes need to be made in the annual budget, whereas percentage (ad valorem) Difficult to determine the amount of tax taxes once set (say at 20%) may not need to be Requires more effort to calculate, adjusted so frequently manufacturers can easily manipulate their product prices to avoid higher tax payments Inflation erodes its value Tax is not tied to price, and so does not automatically adjust to inflation Therefore must be regularly reviewed to adjust for inflation Solution to mitigate disadvantages of both types of indirect tax: Have both a specific and an ad valorem component e.g. cigarettes (EU) Specific tax: €1.80 per cigarette pack Ad valorem: 60% of an EU country’s average retail selling price 20% VAT Compiled by Celeste Teo Impact of indirect taxes (using specific indirect tax) Diagram: Producers only receive: (P1-tax) Imposed on producers May choose to pass on the tax to consumers by raising prices Cost of production rises Supply decreases Impact on consumers Impact on producers Change in consumer expenditure Change in producer revenue ➔ Depends on PED Before tax, producer revenue = consumer expenditure ➔ Depends on PED After tax, producer revenue falls Revenue before tax: O(P0)C(Q0) Revenue after tax: O(P1-tax)F(Q1) Change in consumer surplus Change in producer surplus Original CS: (P0)AC Original PS: O(P0)C CS after tax: (P1)AB PS after tax: O(P1-tax)F Where (P0)AC > (P1)AB Where G(P1-tax)F < G(P0)C Consumer surplus falls Producer surplus falls Tax revenue received by the government: (P1-tax)(P1)BF Overall net loss: FBC → Deadweight loss (a net cost to society) Compiled by Celeste Teo Incidence of specific tax Tax incidence: who is actually paying the tax Tax incidence on either the consumer/producer depends on the relative PED & PES values Diagram: Total tax collected by the government = A+B Area A: Paid by consumers → tax burden on consumers Area B: Paid by producers → tax burden on producers PED < 1 PED > 1 Consumer burden > Producer burden Consumer burden < Producer burden PES < 1 PES > 1 Consumer burden < Producer burden Consumer burden > Producer burden Compiled by Celeste Teo Question: An excise duty falls entirely upon the consumer is the a. Supply curve is perfectly inelastic b. Demand curve is perfectly inelastic c. Demand curve is perfectly elastic d. Supply curve is of unitary elasticity Subsidies ➔ A form of spending by the government provided to different economic agents ➔ A grant given by the government to producers to encourage production of a good or service ➔ 2 types: direct & indirect Direct: Provided directly to an economic agent E.g. unemployment benefits Indirect: Indirectly provided for the manufacturing/sales of goods and services Paid for by the government to an intermediary (e.g. firms) Purpose To lower market price To increase market equilibrium quantity To increase the production and consumption of a good or service (underconsumption/production) Impact of subsidies New market equilibrium price decreases from P0 to P1 New market equilibrium quantity increases from Q0 to Q1 BUT producers receive (P1 + sub) Compiled by Celeste Teo Impact on consumers Impact on producers Change in consumer expenditure Change in producer revenue ➔ Depends on PED Before subsidy: Producer revenue = Consumer expenditure ➔ Depends on PED After subsidy, producer revenue rises Revenue before subsidy: 0(P0)B(Q0) Revenue after subsidy: 0(P1+sub)F(Q1) Subsidy increase the actual price received by the producer AND output sold Change in consumer surplus Change in producer surplus Original CS: (P0)AB Original PS: E(P0)B CS after subsidy: (P1)AC PS after subsidy: E(P1+sub)F Where (P1)AC > (P0)AB Where E(P1+sub)F > E(P0)B CS increases PS increases Government spending on subsidy: (P1)(P1+sub)FC Overall net loss: BFC → Deadweight loss (a net cost to society) Incidence of subsidy Diagram: Subsidy spending by government = A + B Area A → benefit to producers Area B → benefit to consumers Compiled by Celeste Teo PED < 1 PED > 1 Producer benefit < Consumer benefit Producer benefit > Consumer benefit PES < 1 PES > 1 Producer benefit > Consumer benefit Producer benefit < Consumer benefit Drawbacks of government subsidies reduces motivation Expensive o The government would have to raise a significant amount of tax revenue. There is an argument that when government subsidises firms, it reduces incentives for firms to cut costs. For this reason, it is argued that a government should avoid subsidising firms unless there is a clear social benefit to subsidising firms. Producers can become “subsidy dependent” 越依靠subsidy Can distort resource allocation Can lead to excess production Environmental risks from excessive production Subsidies and agriculture Historically, countries with large agricultural sectors and less developed economies tend to have a higher percentage of GDP coming from farming. For example, in sub-Saharan Africa, many countries have over 30% of their GDP coming from agriculture. In some countries, such as Malawi, Burkina Faso, and Sierra Leone, the figure is over 50%. Similarly, in Asia, countries like Nepal and Laos have a large share of GDP coming from agriculture. In the Americas, Haiti is one example of a country where farming represents a high percentage of GDP. Compiled by Celeste Teo Arguments for agricultural subsidies 1. Improving food security a. Subsidies can help smallholder farmers increase their production, which can improve food security for the country. b. Evaluation: how likely will agricultural subsidies solve global food shortages? i. Shortage due to rapid population growth 1. If the rate of population growth is greater than the rate of growth of food production, subsidies may encourage producers to increase production as cost of production falls ii. Lack of investment 1. Subsidies may lower prices but may not be effective in controlling prices 2. Prices of agricultural goods tend to be very volatile as they are subject to environmental conditions 3. Price instability leads to unpredictable income for primary sector workers, making it hard to plan for future investment 4. May lead to unsatisfactory growth, slow growth in productive capacityy iii. Accessibility 1. Even if production of such goods increase, there is the issue of accessibility 2. Governments have to determine a suitable methods of distribution, especially to the relatively poorer population, where the may reside in rural areas where distribution is more difficult iv. PES of agricultural goods 1. Agricultural goods tend to be relatively price inelastic 2. The rise in quantity supplied is less than proportion to the increase in price 3. Provision of subsidies may not have a significant effect on increase of production 2. Higher per capita incomes can reduce extreme poverty in rural areas and prevent high levels of rural - urban migration 3. Encouraging sustainable farming practices a. Subsidies can be used to encourage farmers to adopt environmentally-friendly practices, such as reducing the use of pesticides and fertilizers. 4. Supporting farmers facing economic difficulties a. Subsidies can help farmers facing economic difficulties as a result of market fluctuations or changes in government policies. Arguments against agricultural subsidies 1. Distorting markets a. Subsidies can artificially lower the price of agricultural products, making it difficult for farmers in other countries to compete. This can be seen as a form of trade protectionism. 2. Encouraging overproduction a. Subsidies can lead to overproduction, which can then result in surplus and lower prices, which in turn might hurt farmers incomes. b. Over-production can lead to negative externalities from production which threatens sustainable growth and development 3. Limited public resources a. Subsidies can be a significant expense for the government in a developing country, and may then divert fiscal resources away from other important public services such as access to basic education, health care and infrastructure. 4. Limited to certain farmers a. Subsidies can be targeted to certain farmers, such as large-scale producers, leaving small farmers with fewer resources. In many lower-income countries, small-holder farms are unable to fully reap the benefits of government subsidy. Compiled by Celeste Teo Direct provision of goods and services Where the government provides certain goods and services free of charge to the consumer Financed by tax revenue (tax collected) Lowest income group would gain the most, as a percentage of their income, decreasing inequality Assuming good/service is provided to all consumers Arguments for direct provision Arguments against direct provision Ensures equity The market overprovides especially where no direct charge is made Where goods & services are provided universally free, they are the material equivalent of monetary Resources may not be allocated efficiently universal benefits If a charge is introduced, demand would likely State provision redistributes income and wealth decrease which helps lessen inequality Increases consumption of merit/public goods However, many consumers may be able to afford to because state provision is usually free or largely free pay a charge, which could decrease the tax burden instead, allowing the funding saved this way could be put to alternative uses Absence of market forces The government provides the goods/services without acting on information it receives from market forces The government is not under threat of going out of business, so they can get away with not understanding the customer's needs Leads to misallocation of resources and not satisfying needs and wants Compiled by Celeste Teo Price controls Maximum price A price that is fixed by the government, the market price cannot be higher than this price Price ceiling Only valid if the price is set BELOW the equilibrium price (as determined by the market) Sellers cannot charger higher than the maximum price set Generally used for: o Rent (for certain types of housing) o Utilities (e.g. water, electricity, gas) o Transport fares (especially where a subsidy is given to the producer) Diagram: Price ceiling = P1 DD > SS Shortage Production is insufficient to satisfy the level of demand Impact on consumer and producer surplus: A maximum price will result in an overall deadweight loss Too few resources are allocated May lead to formation of a black market consumers will then pay inflated prices well above the maximum price Arises due to unsatisfied customers who are not able to purchase the product Compiled by Celeste Teo Due to shortage, the good is allocated by queuing or rationing Queuing Rationing Potential buyers must wait in a queue, generally a Potential buyers are limiting in the total quantity of first-come-first-serve queue an item they can purchase Could be a physical queue (e.g. shoppers waiting in Limit may be imposed per unit time (e.g. 1 loaf of line outside a store in order to enter & claim bread per day) items/pay) Unused rations are usually not tradable, though it If a good is sold out by the time a buyer gets to the may be possible to roll them over front of the queue, the buyer is out of luck A buyer can have only one position in a queue at a time Effectiveness of maximum price The most effective way to implement maximum prices would be to also try and deal with the supply. If housing is too expensive, a long-term solution is to build more affordable housing – and not just rely on maximum prices. Maximum prices may be most useful in the case of a monopoly who is both restricting supply and inflating prices. An alternative may be to reduce the power of monopolies; though, in some industries, this is not possible – so maximum prices will be the most effective. Compiled by Celeste Teo Minimum price Price floor A price that is fixed by the government whereby the market price cannot be lower than the set minimum price Only valid if it is set above the equilibrium price Generally used on: o Demerit goods o Wages o Certain type of imported goods (where there are domestically produced substitutes) Diagram: Price floor = Pe SS > DD Surplus will occur DD will only reach Q1 (< equilibrium quantity & at equilibrium price) Impact on consumer and producer surplus: A minimum price will result in an overall deadweight loss Producers may also be inefficient Firms with high costs have low incentive to reduce cost of production due to minimum price Protects them from lower-cost competitors May lead to formation of black market Consumers will pay prices LOWER than the regulated minimum price Arises from consumers who are not able to afford the good at minimum price Question: Which one of the following might explain a simultaneous increase in both price and quantity traded in the market for a normal good? a. The removal of a price ceiling on the good b. Technological progress in the production of the good c. The imposition of a tax on the good d. The granting of a subsidy to producers of the good Compiled by Celeste Teo Evaluation of price controls Short-Term vs Long-Term Impact Analysis Immediate Effects: These include quick relief for consumers or immediate support for producers. Long-Term Market Distortions: Prolonged implementation can lead to significant market inefficiencies and escalate the need for further government interventions. Elasticity and Its Implications Impact on Elastic Demand: Highly elastic demand coupled with price ceilings can lead to substantial shortages. Inelastic Supply Considerations: In cases of inelastic supply, price floors can result in significant surplus production. Comparative Statics: A Theoretical Approach Utilising comparative statics to demonstrate the shifts in supply and demand curves due to price controls. Detailed analysis of how these shifts affect market equilibrium and economic welfare. Behavioural Adjustments Examining how consumer and producer behaviours adapt to price controls, often exacerbating the issues the controls were meant to address. Instances of hoarding during shortages and reluctance to invest in industries under strict price controls. Government Intervention: Costs and Implications Discussing the financial and administrative burden of implementing and enforcing price controls. The potential need for government intervention to purchase surplus goods or provide subsidies to producers affected by minimum prices. Exploring Alternatives Discussing less intrusive alternatives like direct subsidies. Market-based solutions such as issuing vouchers or providing targeted, means-tested assistance. Regulation and equity Price controls interfere with the unregulated market mechanism usually for the purpose of social equity E.g. prices of essential goods are capped (to aid low income groups) May lead to more equal distribution of income Trade off? → free market is distorted → may not bring the full benefits expected Compiled by Celeste Teo Buffer stock schemes Intended to stabilise the price of a commodity by buying excess supply in periods when supply is high & selling when supply is low Due to high volatility, producers face uncertainty and therefore have no incentive to invest to increase productivity An amount is held to limit fluctuations in price Stabilises at a given range Government fixes price at P1 When supply is high (S3 – good harvest), government buys up excess supply (BC) at P1 When supply is low (S2 – bad harvest), government sells buffer stock (AB) to remove the excess demand at P1 Without intervention of the BSS, the price would fall to P3 when supply is high, and rise to P2 when supply is low Compiled by Celeste Teo Advantages and disadvantages of using buffer stock schemes Advantages Disadvantages Overcomes the problem of wide fluctuations in May not be easy to determine the price level to prices from one year to another maintain More stability in the incomes that producers receive Producers want the highest possible price Stability in incomes will encourage producer to make Consumers want the lowest possible price long-term plans Cost of scheme needs to be funded by someone E.g. investment in capital for better productivity Debatable Some believe the government should pay for the scheme Some believe a proportion of producers should contribute to the cost Unsustainable Problem with successive good harvest Buying excess > releasing stocks Build up of stocks Storage costs Issues with perishable goods If agreed price is too high relative to the actual average equilibrium price Buffer stock will buy more in the ‘good year’ than it sells in a ‘bad year’ Should the pattern repeat → size of stocks will rise over time Costly and unsustainable Compiled by Celeste Teo Provision of information Information asymmetry The situation in which one economic agent involved in an economic transaction has more information than another economic agent Imperfect information Refers to consumers misestimating the marginal utility of consuming a good Carried out by the government to remedy under- & over-allocation of resources by: Public education o By providing the public with more information Improving information flow o Can reduce market failure due to asymmetric information o Since the problem lies with one economic agent having more information than another, regulation can be imposed to reveal the ‘concealed’ information to correct market failure