UNIT 3.

GOVERNMENT
MICROECONOMICS
INTERVENTION

ECONOMICS
AS/A LEVEL
Questions to answer:
1. Mention an example of the market failure situation identified as
bellow:

• Lack of public good:

• Underproduction and underconsumption of merit goods:

• Overproduction and overconsumption of demerit goods:

• Information failure:
Questions to answer:
2. What are the forms of government intervention and give
brief explanation/example of them.

3. What are the 4 components of “Canons of Taxation”?

4. What are the differences between direct and indirect taxes?

Reason for Government Intervention in Markets

• Markets do not always operate in the way that is set down by

economic theory (market/price mechanism). When this happened,
there is market failure.
• Market failure is an inefficient allocation of goods and services in the
market or when the free market mechanism does not make the best
use of scarce resources.
• Example of market failure:
• Lack of public goods
• Underproduction of merit goods
• Overconsumption of demerit goods
• Information failure
 How Governments Intervene in Markets
Addressing the non-provision of public goods
• Public goods include the police force, national defence, fire protection, street light, non-toll
roads and flood control system.
• Public goods have to be funded by the government out of tax revenue and provided free of
charge for the public.
Addressing the overconsumption of demerit goods
• Demerit goods are the ones that are considered underible for consumers and tend to be
overprovided, such as cigarettes and liquor.
• Government sets regulation banning the demerit goods to protect the well-being of the
population
Addressing the underconsumption of merit goods
• Merit goods are more beneficial to consumers than they may realise, for example healthcare
and education.
• The problem from information failure on the part of consumers, and market failure that
when provided by private sector, the quantity supplied is less than what is required
Forms of Government Intervention

Regulation Financial Intervention Government Provision

• Government use • Financial tools such as • Gov. take over the

different methods of tax and subsidies used to production of a good or
regulations as a means influence production service, either in whole
of control the free and the prices of a wide or in part.
market. range of goods and • Example: State and
• Example: regulation to services in the market private hospital, school
control pollution, • Example: demerit goods
minimum wages, subject to high indirect
maximum price taxes, public transport
subsidies
 Methods and effects of government intervention in markets

Taxation
Taxes are charges that are imposed by governments on people and businesses
• Their main purpose is to raise finance for government spending.
• This spending is typically on public goods, merit goods, administration, welfare
benefits and subsidies.
• Revenue from taxation is also used to reduce inequalities in the distribution of
income.
Taxation was introduced in the UK at the end of 18th century by Adam Smith, called
“Cannons of Taxation”. This stated the “good tax” is one that:
Equitable • Those who can afford to should pay more
Economic • The revenue should be greater than the costs of collection
Transparent • Tax payers should know exactly what they are paying
Convenient • It should be easy to pay
 Methods and effects of government intervention in markets

Taxation

Direct Taxes Indirect Taxes

Direct taxes are taxes on income
and wealth. They are paid directly Ad-Valorem
to the government by tax payers Special taxes
Taxes
from their incomes.
E.g. income tax, corporation tax Ad-Valorem Taxes are a Specific taxes are in the
proportion or percentage of the form of a fixed amount
price charged by the retailer. per unit purchased.
E.g. Value-Added Tax (VAT) and E.g. Fuel taxes
General Sales Tax (GST)
• Indirect taxes are collected for the government by retailers and local government bodies.
• Indirect taxes are widely used to discourage the production and consumption of demerit goods
such as cigarettes and high-sugar sports drinks.
• These taxes tend to be passed on to consumers through increased prices in the market,
although technically they are imposed on the producer.
Methods and effects of government intervention in markets

Taxation
• In collecting taxes and in the development of taxation systems,
governments should be very aware of the impact a tax has on the various
income groups in the economy.
• This is entirely consistent with the equity aspect of the canons of taxation
referred to earlier.
Fixed Taxes Proportional Progressive Regressive Taxes
Taxes Taxes

• Fixed amount • Percentage • A tax that • A tax that

of tax ($) rate of tax takes a higher takes greater
charged to (%) charged is percentage percentage
product is the the same or from those from those
same constant with higher on lower
• e.g. Sales tax • e.g. income income.
Corporate Tax • e.g. Personal • e.g. Value
Income Tax Added Tax
Questions to answer:
1. What are the purposes of the government give subsidies to the
producers?
2. Explain the effect of the tax and subsidy to the price and quantity of
the product! Support your answer with diagrams!
3. Explain the meaning and purpose of maximum price!
4. How the government set the minimum price?
5. Explain the mechanism of buffer stock scheme!
 Methods and effects of government intervention in markets

Subsidies
Subsidies are direct payments made by governments to the producers of goods and services.
The purposes of government pay money to producers are:
To keep down the market prices of essential goods
To encourage greater consumption of merit goods
To contribute to a more equitable distribution of income
To provide services that would not be provided by the free market
To raise producers’ income
To provide an opportunity for exporters to sell more goods
To reduce dependence on imports by paying subsidies to domestic producers
Subsidies are controversial issues: opportunity cost implication, blanket or lump sum
payments which can not easily be link to incomes and the ability to pay.
Example of subsidies: staple foods like rice, cooking oil, mass/public transport.
Methods and effects of government intervention in markets

Effects on Taxation and Subsidies

The effects of imposing an indirect tax The effects of introducing a subsidy

Methods and effects of government intervention in markets

Direct provision

Governments provide certain important services free of charge at the point of use or
consumption.
The two most common instances of direct provision are merit goods and public goods.

Merit goods, such as healthcare The characteristics of public goods mean that they will not
and education, are provided be provided by the market mechanism. Neither will
free in some but not all consumers be willing to pay for them. The only way in
economies. which they can be provided is directly by the government
and paid for out of tax revenue

The direct provision of goods and services is a controversial issue.

The main criticism is that the market overprovides, especially where no direct charge is
made. Resources are not allocated efficiently.
Methods and effects of government intervention in markets

Maximum and Minimum Prices

Maximum Prices Minimum Prices

(Ceiling Price) (Floor Price)

Maximum prices means sellers of the good Minimum prices means sellers of the good
cannot sell it legally at any price above the cannot sell it legally at any price bellow
price ceiling. the price floor.
The purpose is to protect those on low The purpose is to protect the income of
incomes by providing heavily subsidised the seller and can be more certain about
items that were used daily the security of future supplies.
To be effective the maximum price must be To be effective the minimum price must be
below the equilibrium price above the equilibrium price.
E.g. Oil price E.g. Agricultural products
Methods and effects of government intervention in markets

Maximum and Minimum Prices

Maximum Prices or “Price Ceiling”

Market failure can occur where the price of a good in the free
market is too high.
The purposes of government are:
• This is seen as a way of assisting families on low incomes
• Reducing inequalities in income

Governments use legislation to enforce maximum prices for:

• staple food items such as rice and cooking oil
• petrol and diesel fuel
• rents in certain types of housing
• services provided by utilities, such as water, gas and
electricity
• transport fares, especially where a subsidy is being paid
Methods and effects of government intervention in markets

Maximum and Minimum Prices

Minimum Prices or “Price Floor”

Market failure can occur where the price of a good in the free
market is too low.

Governments use legislation to enforce minimum prices for:

• demerit goods such as high-sugar sports drinks
• agricultural products, particularly in middle and in high-
income countries
• wages in certain occupations, usually low skilled, to avoid
employers exploiting their employees
• certain types of imported goods where close substitutes
produced by domestic producers are available
Methods and effects of government intervention in markets

Buffer Stocks Schemes

A buffer stock scheme is designed to smooth price rises and falls by buying and selling
stocks of products depending on market conditions.
In general terms, buffer stock schemes combine the principles of minimum and
maximum price controls.

If market price
Set Minimum Government will Stored in a
fall bellow
Prices buy the product warehouse
Minimum Price

If market price Government

Set Maximum Release from
increase above will sell the
Prices the warehouse
maximum price product

The negative impact will be the cost of warehouse burdened to the government.
Methods and effects of government intervention in markets

Provision of information

The government itself uses information provision as a form of direct

intervention.

A few examples are:

• compulsory information on cigarette packets warning of the dangers of
smoking
• public health announcements and campaigns
• advice on non-prescription medicines
• nutrition and allergy information on food packaging
Methods and effects of government intervention in markets

Nationalisation and Privatisation

A government could decide to provide a particular good or service itself by
providing it through a state-owned/nationalized industry or private sector.

Nationalisation
• the process by which a government takes over a private firm or
industry into the public sector – in other words, ownership of the firm
or industry is transferred form the private sector to the public sector

Privatisation
• The process by which a government decide to privatise an industry by
transferring ownership from public to the private sector.
• The reason: a nationalized industry may not always be as efficient as
one operating in the private sector.
Questions to answer:
1. Find an example of nationalisation and privatisation!

2. Mention the advantages and disadvantages of nationalisation and

privatisation
Addressing Income and Wealth Inequality
Difference between income and wealth

Income Wealth

Income is the reward for the services of a Wealth describes the stock of assets that
factor of production. someone has built up over time.
• FoP labour, income is paid in wages,
salaries and bonuses. For example: savings, businesses, property,
• For other factors of production, income shares, gold and antiques.
takes the form of rent, interest and profits.
Income is a flow concept. These assets are there to provide security
This is because the returns to the various and in some cases, an income stream for
factors of production are variable over any the future.
given period of time.

Income and wealth usually measured by Gini coefficient.

If the income distribution in an economy is equal, the Gini coefficient will have a value of 0.
At the other extreme, if all income accrues to just one person, then the Gini coefficient will be 1.
Addressing Income and Wealth Inequality
Economic reasons for inequality of income and wealth

Economists agree that inequality of income and wealth acts as a barrier to economic
growth and development.

Below are some economic reasons for inequality:

• a lack of formal employment opportunities, particularly for young people, but also for
those with professional skills
• poor vocational training, which means that local industries cannot obtain the labour
needed to maintain a viable operation in national and international markets
• a lack of investment in the education and health sectors, which holds back human
capital needed to promote economic growth
• poor infrastructure such as roads, railways, power and water supplies
• a low rate of savings, which holds back private and public sector investment
• the inability of many people to obtain credit to fund small businesses and improved
personal education
Policies to redistribute income and wealth
Minimum wage rate

A minimum wage rate is a legal requirement of what employers must pay an employee per
hour. It is a rate before tax and any social security deductions are made. Employers who do
not pay the legal minimum wage rate can be fined or face other forms of penalty.

Introducing a minimum wage can reduce poverty in all economies.

Problems occurred on minimum wage rates:

• minimum wage rate has no relevance where
workers are self-employed or run small
businesses staffed by family members
• Its introduction leads to unemployment.
Those who are employed will get more pay
but at the cost of fewer jobs being available
Policies to redistribute income and wealth
Transfer Payment

A transfer payment is a payment from tax revenue that is received by certain members
of the community.
Their function is to provide a more equitable distribution of income and less poverty.
The main recipients are vulnerable groups such as the elderly, the disabled, the
unemployed and those on the lowest incomes.

Examples of transfer payments Critics for transfer payments include:

include: • Pension and social security coverage is limited
• old age pensions to the formal sector and therefore only covers a
• unemployment benefits small percentage of the population
• housing allowances • Unemployment benefits and benefits to those
• food coupons on the lowest incomes can act as a disincentive
• child benefits to accepting work, so increasing the
unemployment rate
Policies to redistribute income and wealth
Progressive income taxes, inheritance and capital taxes

The tax system can be used in order to reduce inequalities in income and wealth.
This is specifically through the use of progressive taxes.

The best example is a progressive income tax whereby those earning higher
incomes are taxed a higher rate or percentage of their income than those on
lower incomes.

Other example is inheritance tax. Individuals who inherit more than a certain
amount of wealth have to pay some of the value of that wealth in tax to the
government.

Another example is capital tax, whereby a tax is payable on the financial gain a
person may have made in the time that an asset, such as property or a financial
portfolio, has been owned
Policies to redistribute income and wealth
State provision of essential goods and services

A further way of reducing inequalities in society is for the government to

provide certain important goods and services, often free of charge to the
user. Such services are financed through the tax system.

The two main examples of free provision in many economies are

healthcare and junior and secondary education.
Governments also provide goods to support those on low incomes. This
provision could consist of food and other essentials items, water and in
some cases, housing.
Like health and education, the justification is on equity grounds.