1.3 - Government Intervention

1.3 - Government Intervention The decisions of governments can influence the price and quantity demanded of a product. They may choose to intervene in the market by creating taxes, subsidies and price controls.

Indirect Taxes Specific Taxes and ad valorem Taxes and Their Impact on Markets These are also known as excise taxes. They are taxes on goods and services, which are passed on to consumers when they purchase a product. There are two main reasons why governments choose to tax certain products. 1. On demerit goods by increasing the price, thereby deterring consumers from purchasing products that are considered harmful or socially undesirable due to their negative externalities. 2. On products with inelastic demand, allowing the government to raise revenue for support public goods and services. Two types of indirect taxes exist: 1. Specific taxes - Also called flat rate taxes. These are set per unit, such as $2 per carton. 2. Ad Valorem taxes - These are set as a percentage of the price of the good. The graph on the left shows the shift that occurs as price increases (from P1 to P2) due to a specific tax. This causes the quantity demanded to decrease (Q1 to Q2). In the case of demerit goods, this would mean that the government achieves their objective of introducing the tax. The government will gain revenue from this tax, which is used for public goods and services. Therefore, although there is a welfare loss (since consumer and producer surplus decrease), there is also a welfare gain, as the government uses the money on things to benefit society.

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HL - Tax Incidence and Price Elasticity of Demand and Supply When a product is demand inelastic (and supply elastic - PED < PES), the consumers often pay the majority of the tax burden, since producers pass on the cost of the tax by increasing the price. On the other hand, when demand for a product is more elastic (PED > PES), producers will have to bear the larger share of the tax burden, as consumers switch to substitute products. Producers will absorb the burden of taxes on pure profits, as it will not affect price or output. Governments use Price Elasticity of Demand to determine the effect of an indirect tax on the quantity demanded. It also determines the impact of any shift in supply due to subsidies. Indirect taxes are placed on suppliers and raise costs by shifting the supply curve: 

Ad Valorem taxes add a percentage to the price (i.e. a 10% Goods and Services Tax)

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Specific or unit taxes add a fixed amount into costs. Deadweight Loss If rent increases by the amount of tax (A to B), there will be excess supply, and rent fall to a new equilibrium at C. The landlord receives the rent R1 but pays tax equal to the difference between R1 and R1-t. The landlord’s burden is the difference between R0 and R1-t while the tenant’s share is the difference between R1 and R0.

Deadweight loss represents the loss in social net benefits that no one receives. It occurs because less is supplied than is socially optimal. If demand were perfectly inelastic, the tenant would bear the whole burden. If demand were perfectly elastic, the landlord would bear the whole burden.

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Subsidies Impact on Markets Subsidies are when the government gives payments to producers to help lower the costs of production and therefore lower the price of the goods. Governments provide subsidies for goods that are deemed to have a benefit for society. These are called merit goods and have positive externalities. The subsidies are used to encourage consumption. When a subsidy is introduced, it has the effect of increasing the equilibrium quantity of the product. As shown on the graph, the price will move from P1 to P2, and consequently the quantity from Q1 to Q2. This leads to an increase in social welfare, since both consumer and producer surplus increases. However, the money to fund the subsidy may have been raised from taxes, which decrease welfare. It is important to weigh up the effect of each action when considering overall welfare. Since a subsidy increases producer surplus, it has positive consequences for the producers. Likewise, subsidies have positive consequences for consumers because they increase consumer surplus. Finally, the increase in quantity of merit goods may be seen as a benefit for governments. Quotas Governments may enforce quantity controls to restrict the quantity below what it would have been in the free market.

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HL Impact on Markets The chart shows that the subsidy leads to a decrease in price from P1 to P2. Consequently, the quantity increases from Q1 to Q2. The total consumption of the product increases. The grey rectangle represents the amount paid by the government for the subsidy. The yellow triangle represents the total surplus increase.

Price Controls These are mechanisms of managing prices. There are two main types: 1. Minimum prices – also called price floors. It is the lowest allowable level to which prices may fall. Often used in the agricultural sector. 2. Maximum prices – also called price ceilings. It is the highest allowable level to which prices may rise. Often used for apartments via rent control. Price Ceilings (Maximum Prices): Rationale, Consequences and Examples These are set through legislation or similar measures. The maximum price is below market equilibrium price, otherwise it would have no effect. Consumer surplus increases whilst producer surplus decreases. Example: Rent control sets a price ceiling on accommodation. Normally when prices are low, the demand will increase and then prices rise. However, maximum prices prevent any price increase, so that there is a supply shortage.

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When there is a supply shortage, black markets or parallel markets are likely to crop up. Black markets will buy at the low price then resell to the highest bidder. The markets exist because some consumers are willing to pay more than the ceiling price for the products in short supply. Black markets are illegal in most economies. In centrally planned economies, it is common for supplies to be exhausted before all the consumers can be served. To cope with the short supply, governments may use rations to limit the amount that each individual can purchase. Rations are most common during wartime and natural disaster. It is a fairer approach than the black market.

Price Floors (Minimum Prices): Rationale, Consequences and Examples A minimum price is generally set in a volatile market. The price is above market equilibrium, otherwise it would have no effect. It increases producer surplus whilst decreasing consumer surplus. The excess supply will mean that inventories build up or the government may buy the surplus, then sell it cheaper on the international market. Example 1: Agricultural products may be given minimum prices in order to encourage local domestic production despite global competition. There has been a downward trend in agriculture over recent years due to technological improvements and increased supply. Further, the income elasticity of demand for food is inelastic. Agriculture also experiences large fluctuations based on harvests and time lags in supply. Subsidies and price minimums keep the agricultural sector alive where it would otherwise fail. Getting paid above market equilibrium makes producers willing to supply more, whilst preventing cheap imports from abroad.

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However, price controls have led to overproduction of local products that are not put to use, which is wasteful and has led to reforms in the European Union. Governments have traditionally bought the surplus and sold it at a loss, moving the cost to taxpayers. Example 2: The minimum wage is used to ensure that labour is adequately rewarded. It may be circumvented if people illegally accept lower wages. The excess supply in this situation means that people will not be able to find work. The government provides welfare support to these people. This is better for unemployed individuals because their income is higher than if they were working without a minimum wage.

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