CH.

3 GOVERNMENT MICROECONOMIC INTERVENTION

Government intervention

 Government only intervenes when there is market failure

 It is a situation where the market fails to make the best use of
scarce resources, prompting government intervention.

Regulation

 These are the various means by which the government controls

production and consumption

Financial intervention

 Taxes – charges imposed by the government on incomes, profits,

consumer spending to fund their expenditure
 Subsidies – they are direct payments made to the supplier by the
government to lower price of a good or service

Government provision

 Governments can either take over the entire production of a good

or service or a part of it
 These are known as ‘nationalised industries’

Maximum price

 A maximum price is a ceiling on the price a firm can charge, to

enable access of the goods to the poor.
 The main reasons to impose a maximum price is:
 Make it affordable for the poor
 Encourage consumption
 Counterbalance the monopolies

 For this to be effective, it must be BELOW the equilibrium price,

which will cause a shortage of the good as producers will cut
supply. This will lead to shortage.
  This strategy is usually imposed on necessities like staple foods,
water, gas, etc.
 Governments use allocation methods like rationing, queuing and
lottery to prevent illegal markets
 Lottery is the drawing of tickets to decide who will get the product
 Rationing is imposing a limit on the amount that can be consumed
of a particular good per individual
 There is a danger of occurrence of informal and illegal markets.
 Maximum prices can lead to excess demand and huge waiting lists
 It may in turn lead to corruption and bribery.

Price

D S It shows maximum price

below the equilibrium price
and now people can
P E
purchase it at a lower
Px Maximum price
price. This will create a
shortage as QD will exceed
QS.

0 QS QD Quantity

Minimum price

 To encourage production, governments set a minimum price.

 It is the price floor and no producers are allowed to charge below
the price.
 It is done to:
 Discourage consumption of a product
 Act as an incentive for producers
 For it to be successful in having an impact on producers, it must be
set ABOVE the equilibrium price.
  This causes a surplus, as producers are allocating more resources
towards these goods, due to the higher profits.
 This is usually done for demerit goods like cigarettes, tobacco,
alcohol, etc.
 This may lead to inefficiencies and will reduce the firm’s want to
lower their costs.
Price

D S
Px Minimum price It shows minimum price above the
equilibrium price. It shows the price
P below which producer cannot sell. This
will create a surplus as QS will exceed
QD.

0 QD QS Quantity

Taxes

 Taxes are charges imposed by governments on people and

businesses.
 Main purpose is to fund government expenditure
 It also used to reduce inequalities in the distribution of income
 Adam Smith criteria for a good tax – Cannon of taxation
 Equitable – higher income earners should pay more
 Economic –
 Cost – revenue should be greater than costs of
collection. It should not to lead disincentive to work.
 Efficiency – tax system shouldn’t lead to disincentives
to work. It should not cause a poverty trap (losing out
on government benefits by earning money and paying
taxes is more expensive)
  Transparent – tax payers should know what they are paying
for
 Convenient – easy to pay
 Types of taxes –
 Direct taxes – taxes charged on income. Ex. income tax,
corporation tax. They are paid directly to the government.
These create disincentives to work.
 Indirect taxes – taxes on expenditure. Ex. VAT, excise duties.
They are collected by government bodies. Collection of
indirect is easier, cheaper and less viable to evasion and
corruption but it falls heavily on the poor as they are
regressive and widens income inequality.
 Impact and incidence of taxes –
 Incidence of tax refers to the burden of taxation divided
amongst consumers and producers.
 Impact of tax is the person whom it was actually charged to.
 If direct taxes are high, it will reduce incentive to work and
invest. It will also lower consumption.
 If indirect taxes are high, inflation will occur due to wage-rise
spiral
 It will encourage tax evasion
 Both impact and incidence of direct tax is to the same person
 The impact of indirect tax is towards producers but it is
shared with consumers depending on the PED of the product.
 If a product has inelastic PED, consumers will bear most of
the tax, because a huge rise in price will also cause only a
small fall in demand.

D
Producer share Consumer share
Price S1

As a tax is introduced, supply shifts S

to the left (S-S1). As demand is P1

price inelastic, producers passed a
larger amount of the tax to P
Z
 Q1 Q Quantity

 If a product has elastic PED, producers will bear most of the

tax, because even a small rise in price will cause a huge fall in
demand

Producer share Consumer share

Price S1

As a tax is introduced, supply shifts S

to the left (S-S1). As demand is P1
price elastic, producers pass only a P
small amount of the tax to D
Z
consumers (P-P1) and they retained
(P-Z) a larger part. But this caused
demand to fall by a very large
quantity (Q-Q1). The total amount
0 Q1 Q Quantity
of tax is P1-Z.

 If a product has perfectly inelastic PED or perfectly elastic

PES, consumers will bear the entire tax.

Price S1 Price
D
D
S
P2
P2 S1
 P1
P1 S

0
Q1 Quantity
0 Q2 Q1 Quantity

 Ad valorem taxes –
 Proportion or percentage of the price charged to the retailer.
 The final price paid by consumers includes this amount.
 An ad valorem tax is a tax based on the assessed value of an
item, such as real estate or personal property.
 The Latin phrase ad valorem means "according to value." So,
all ad valorem taxes are based on the assessed value of the
item being taxed.
 It is a charge based on a fixed percentage of the product
Price
value
S1
An ad valorem tax is based on the
percentage, so as the quantity of
S
P1 goods/services traded rises, so does
the tax paid. This is shown by the
P
pivotal shift (not-parallel) shift in
the curve.
D

0 Q1 Q Quantity

 Specific taxes –
 Fixed amount on per unit purchased
 Tax based on a measurable quantity
 It is also known as per unit tax because it is a fixed amount for
each unit of a good or service sold. It is thus proportional to the
particular quantity of a product sold, regardless of its price.
  Mostly charged on demerit goods to discourage consumption.

Price S1
A specific tax is a fixed amount per
S unit, therefore doesn’t change as
quantity traded increases.
P1
Therefore, it is a parallel shift to the
P
left.

0 Q1 Q Quantity

 Proportional tax –
 As income rises, the tax rate remains the same, but tax paid
increases. The proportion of income spent on taxes is constant.
 Average and marginal taxes are always the same
Tax rate

Irrespective of the income

level, the tax rate paid
(20%) is constant.
20

0 Income level

 Progressive tax –
 As income rises, both tax paid and tax rate rises.
 As people earn more, they spend a greater proportion of their
income in taxes.
 Average tax rate is always lower than marginal tax rates.
 Ex. income tax, but this type of tax creates disincentive to
work
 Tax rate
As income level rises
from Y to Y1, tax
T1
rate also rises from
T to T1
T

Y Y1 Income
level

 Regressive tax –
 As income rises, the proportion of amount spent falls.
 Both average and marginal tax rates are falling
 Ex. indirect taxes like VAT, GST
 Fall heavily on the poor, widens income inequality

Tax
rate
With a specific amount of tax, high
income earners (Y1) pay a smaller
proportion of tax (T1) than low
T
income earners (Y) at T.
T1

Y Y1 Income level

 Marginal tax –
 It is tax paid on incremental income. Income tax is paid
according to different slabs/tiers.
 Average tax –
 Total tax paid/total income * 1oo
  It is a measure of a household’s tax burden that is how taxes
affect the household’s ability to consume today or in future.

Subsidies

o They are direct payments made by the government to producers to

encourage production of those goods and services.
o It causes a fall in costs of production and therefore a fall in price.
o Subsidies lead to interference in the workings of price mechanism
o Subsidy can be ad valorem or specific
o Have opportunity cost implications
o A lump sum amount cannot be linked with income and ability to
pay directly
o May lead to complacency
o Main reasons for giving a subsidy:
 Keep market prices down
 Encourage consumption
 Raise producer’s income
 Ensure a more equitable distribution of income
 Provide goods and services not provided by free market –
public goods
 Opportunity for exporters
 Reduce dependence on imports
 Protect from foreign competition – protectionism measure

Price
D S

Government giving a subsidy

S1
cause a rise in supply,
P
indicated by a rightward
P1 shift (S-S1). This in turn
caused price to fall from P
to P1 which lead to an
0 Q Q1 Quantity

Subsidy when demand is elastic –

Consumer share Producer share

Price S
As a subsidy is introduced, supply
S1
shifts to the right (S-S1). As
P
demand is price elastic, producers
P1
pass only a small amount of the
D
subsidy to consumers (P-P1) and Z
they retained (P-Z) a larger part.
But this caused demand to rise by a
0 Q Q1 Quantity
very large quantity (Q-Q1). The
total amount of tax is P1-Z.

Subsidy when demand is inelastic –

Consumer share Producer share

Price S
As a subsidy is introduced, supply
S1
shifts to the right (S-S1). As
P
demand is price inelastic, producers
passed a larger amount of the
P1
subsidy to consumers (P-P1) and Z
they retained (P-Z) a small part.
But this caused demand to rise by a
very small quantity (Q-Q1). The
Transfer payments
total amount of tax is P1-Z. Q Q1 Quantity
o They are payments from the tax revenue that are received by
certain members of the economy
 o They main function is to have a more equitable distribution of
income so that average living standards are maintained across.
o They are payments made to transfer money from those who are
able to work and pay taxes to those who are unable to work or are
in need of assistance.
o For example – unemployment benefits, pensions, state pensions
o The extent of payment made depends on how much tax is collected
and the number of people paid taxes.
o It is necessary to offer transfer payments to reduce poverty and
protect the most vulnerable groups
o But it may act as a disincentive to work, increasing unemployment
o It has an opportunity cost
o It maybe seen as form of inefficiency as not all scarce resources are
being used.

Direct provision of goods and services

o The government may provide a certain important goods and

services free of charge to the user
o This also helps reduce income inequality and gaps
o It may lead to excessive demand as it is free of cost, lead to
overproduction and shortages
o Resources are not allocated efficiently
o Disrupts the working of the price mechanism
o If a charge is introduced, demand may fall
o Also, consumers who can afford to pay may use these services,
reducing their tax burden

Nationalisation

It is the process by which governments take a private business into public

ownership
 o Reasons for nationalisation –
 Certain strategic industries must be in the public sector
 Public sector looks at social benefit (public benefit) rather
than profits
 Little sense in duplicating certain services
 Any profits made will be reinvested in public benefit
 Employees have job security and ensures financial viability for
them
 Will continue providing loss making services
o Benefits of nationalisation –
 It will be a monopoly so may enjoy economies of scale
 Reduces income inequality
 Includes externalities in their decision-making process (cost
benefit analysis)
 Avoids wastage and duplication of resources
o Problems of nationalisation –
 Maybe managed inefficiently
 No competition, no innovation
 May lead to complacency
 Decisions may be influenced for political reasons
 Limited scope to increase long term investment and grow

Privatisation

o It refers to a change in ownership of an activity from the public

sector to the private sector
o Types –
 Direct sale – it is when the public sector sells shares to the
private sector. There is a transfer of ownership
 Deregulation – it is removal of barriers of entry and exit
allowing private sector firms to enter and increase
competition
  Contracting out – it is allowing the private sector to provide
services which were, before, supplied by the government. No
transfer of ownership
o Benefits –
 Reduces government intervention, process towards a market
economy
 Widening the extent of share ownership
 Increasing efficiency
 Higher competition, lower prices
 Wider choice
 More innovation
 Increases government revenue
o Problems –
 May lead to monopoly, exploiting suppliers, customer and
employees
 Income from sale maybe ‘one-off’
 May not operate in public benefit (won’t take into account
externalities)
 May lead to duplication and waste of scarce resources