IB Economics SL4 - Government Intervention

ECONOMICS SL chapter four - government intervention

4.1 Indirect taxes INDIRECT TAXES • Indirect taxes are placed on spending to buy goods and services. • Indirect because they are paid to gov’t by producers but the consumers also pay part. • Excise tax - taxes imposed on a specific good or service • Expenditure - taxes on all spending, like GST. • Taxes can change allocation of resources because they raise the price paid by consumers and lower the price received by producers. P • Causes consumers to buy less and producers to produce less. S 2

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For • A firm pays the government when a tax is imposed on aSgood. 1 every level of output, the firm needs to make more than the original price. This causes a upward (leftward) shift of the supply curve.

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TYPES P • Specific taxes - fixed amount of tax per unit • Ad valorem taxes - fixed percentage of price of good

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REASONS FOR INDIRECT TAXES • Source of government revenue. • Used to discourage use of harmful goods (i.e. cigarettes) • Redistribution of income • Taxing goods that can be afforded by high-income earners • Improve allocation of resources

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Q IMPACTS ON STAKEHOLDERS specific tax ad valorem tax • Consumers are worse off. • There is a price increase but less quantity. Consumers pay more for less of the good. • Producers are worse off. • Producers receive less and sell less. There is a revenue decrease. • The government gains. • They earn revenue. • Workers are worse off. • Fewer workers are needed to produce less output. This may lead to unemployment. 1 GOVERNMENT INTERVENTION

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• Society is worse off. • There is an underallocation of resources. P

ON DIAGRAM ➤ • Equilibrium Q decreases from Q* to Qt. • Equilibrium P increases from P* to Pc (price paid by consm.). • Consumer expenditure decreases from P* x Q* to Pc * Qt. PcP • Price received by firm falls from P* to Pp (Pc – tax per unit) P*P* • Firm revenue decreases from P* x Q* to Pp to Qt. PpP • Government receives tax revenue (shaded), (Pc – Pt) x Qt.

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4.2 Indirect taxes: HL topic

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4.3 Subsidies SUBSIDIES • Subsidy - assistance by the government to individuals or firms • Specific subsidy - a cash payment subsidy of a fixed amount per unit • Subsidies change the allocation of resources by decreasing the price paid by consumers and increasing the price earned by producers. REASONS FOR SUBSIDIES • Increase revenues and incomes of producers. • Make certain goods affordable to low-income consumers. • Encourage production and use of desirable goods. • Support growth of specific industries. • Encourage exports. • Improve allocation of resources. IMPACTS ON STAKEHOLDERS • Consumers are better off. • Consumers pay less and receive more! • Producers are better off. • Producers receive a higher price and can produce more. Increased revenue. • The government is worse off. • The gov’t budget is used to pay for the subsidy. 2 GOVERNMENT INTERVENTION

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• Workers are better off. • Firms may hire more workers to produce more. • Society is worse off. • Overallocation of resources to subsidized product. • It depends for foreign producers. • If subsidy granted on export, price of export decreases and quantity of it increases. This is good for domestic producers, but bad for foreign producers because they can’t keep up with the subsidized price. P S1 Pp

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ON DIAGRAM ➤ • Equilibrium Q increases from Q* to Qsb. • Equilibrium P (paid by consm.) falls from P* to Pc. • Price received by producers rises from P* to Pp. • Government pays for (shaded) subsidy (Pp – Pc) x Qsb. • Overallocation: Qsb > Q*

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4.4 Subsidies: HL topic

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4.5 Price controls INTRO! • Price controls - setting of minimum/maximum prices by government so prices can’t adjust to equilibrium. This causes excess demand or excess supply because there is disequilibrium. PRICE CEILINGS • A price ceiling is a maximum legal price for a good. It needs to be set below the equilibrium price for it to work. • At the price ceiling Pc, the firms supply Qs, but there is a demand at Qd. • The market cannot clear. There is a shortage (excess demand) of Qd – Qs.

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D Q Qe Qd CONSEQUENCES (ECONOMY) QQss Qe Q d • Rationing - method of dividing something among users. In a free market, the price system helps by letting those who are willing and able to pay for a good get the good.

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• There is a shortage, so the price mechanism cannot help with rationing. • Non-price rationing methods are used to distribute the quantity among all buyers. • “first-come-first-serve” • distribution of coupons • favoritism • Underground (parallel) markets involve buying/selling that are unrecorded and usually illegal. They involve buying a good at the legal price and selling it at the equilibrium price. • Underallocation of resources - A price lower than the equilibrium results in a smaller Qs. There are too few resources allocated to the production of this good. Society is worse off. • Negative welfare impacts: • Consumer surplus is the region of (a + b) • Producer surplus is the region of (c + d + e) • When there is allocative efficiency MB = MC, CS P S=MC and PS is maximum (a + b + c + d + e). • If price ceiling Pc is imposed, we move from Qe a to Qs. CS is now (a + c), and PS is (e). b • The social surplus is now the region of (a + c + Pe e). d c • The shaded section, (b + d), is welfare (deadweight) loss. These benefits are lost due P c to misallocation. e We can see that MB > MC at Q . The benefit of • s D=MB an extra good purchase is greater than the cost Q Qs Qe Qd of producing it. CONSEQUENCES (STAKEHOLDERS) • Consumers gain and lose. • Consumers gain area c, but lose region b. Consumers that can buy it are better off. • Producers are worse off. • Producers can only sell a smaller quantity and have a loss in revenue. • The government is not affected. • The government is not affected economically, but may gain popularity. • Workers are worse off. • Fewer workers are needed to produce less output. This may lead to unemployment.

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RENT CONTROLS • Rent controls limit the maximum rent on housing so low-income earners can get housing. • Housing is now more affordable. • There is a shortage of housing. • There is a smaller quantity of housing. • There are long waiting lists for people to get a house/apartment. • Underground markets may appear. • Poor house maintenance because of unprofitable. FOOD PRICE CONTROLS • Food price controls can be used to make food more affordable during times when food prices are rising. • Lower food prices. • Food shortages • Non-price rationing • Underground markets • Falling farmer incomes and unemployment. PRICE FLOORS • A price floor is a legally set minimum price set by the government. It needs to be above the equilibrium price for it to be effective. • At the price floor Pf, firms supply Qs, but the demand is at P Qd. The market cannot clear. There is a surplus of Qs – S Qd. PPff • The government imposes price floors to: • provide income support for farmers • protect low-wage workers

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D PRICE FLOORS (AGRICULTURAL) Q • Farmers’ incomes are usually unstable because of the low Qe Qd QQds Q Q e s elasticities. • Governments place price floors called price supports to raise agricultural products above the equilibrium price. • This causes a surplus because the market cannot clear. Usually, the government buys the excess supply so the floor can be maintained.

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AGRICULTURAL PRICE FLOOR CONSEQUENCES • There is an excess supply (surplus) of Qs – Qd. • Government needs to decide what to do with the surplus. • Store it - there are additional costs to store it • Export it - requires a subsidy because the price floor increased the price • Send as aid - extra problems for the countries that are intended to benefit from it • Inefficient production because they have no incentive to use efficient production methods because they have the price floor protection. • Overallocation of resources to produce the P good. Society is getting too much! S=MC a • Negative welfare impacts P • At equilibrium, CS is (a + b + c); PS is (d + e). f f b • After a price floor is imposed, CS falls to (a), c and PS becomes (d + e + b + c + f) Pe D+ gov't purchases The government needs to pay P x (Q Q ) • f s d e to buy the excess. d

CONSEQUENCES (STAKEHOLDERS) D=MB • Consumers lose. • Consumers must pay more and receive less. Q Qd Qe Qs • Producers gain. • Producers increase revenue from Pe x Qe to Pf x Qs. • Producers are also protected and don’t have to be as efficient. • The government loses. • The government has the burden of buying all the surplus • Workers gain. • Employment increases • Stakeholders in other countries: • Developed countries have price floors to support farmers. The surplus is then exported, which decreases the overall price. These countries without price floors will have to decrease their prices to compete, which signals the farmers there to cut down on production. MINIMUM WAGE • Determines minimum price of labor an employer must pay. Similar to the effect of a price floor, the market does not clear if one is imposed. 6 GOVERNMENT INTERVENTION

CONSEQUENCES (ECONOMY) • Labor surplus and unemployment • There is a surplus of labor (or unemployment). • Illegal workers • Workers may be employed at wages below the minimum. Usually involves illegal immigrants. • Misallocation • Firms relying on unskilled workers will have increased production costs, resulting in less quantities produced. CONSEQUENCES (STAKEHOLDERS) • Firms lose. • Firms have now a higher cost of production. • It depends for workers. • Some gain and receive a higher wage. Others lose job. • Consumers lose. • An increase in labor cost will lead to supply decrease. REAL LIFE SITUATIONS • Inefficient system, but used because farmers claim they need income support. • There may be positive effects: • Workers work harder • Increased labor productivity • Firms cutting bonuses instead of workers.

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