7/27/2019 Lecture Outline- 8 - Govt Intervention

1/4

Lecture outline- 8- Government Intervention in the market

- We examined the behavior of the market in the absence of the government intervention

The main reasons for policy intervention are:

To correct for market failure To achieve a more equitable distribution of income and wealth To improve the performance of the economy

Source:

Government Legislation and Regulation Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban

smoking in the workplace. The laws ofcompetition policy

impose price controls in most of the main utilities such as telecommunications, electricity, gasand rail transport.

Direct State Provision of Goods and Services Fiscal Policy Intervention

(a) Indirect taxes(b) Subsidies to consumers

(c) Tax relief: The government may offer financial assistance such as tax credits for business

investment in research and development

(d) A reduction in corporation tax (a tax on company profits) designed to promote new capital

investment and extra employment

1. In a free market system government takes part in producing only Public GoodsPublic goods: Some ones Consumption will not deprive some one elses consumption.

Private good: Some ones Consumption will deprive some one elses consumption.

2. In a mixed economic system government interferes in the economy in:a. participating in productionb. Generating government revenue through imposing direct and indirect taxes.c. Providing subsidies to consumers and producersd. Protecting producers and consumers imposing price ceilings

Free

Market

System

Govt.

Market

System

Govt.

7/27/2019 Lecture Outline- 8 - Govt Intervention

2/4

- Effects of direct tax on the market is minimal- Effects of indirect tax on the market are substantial depending upon the elasticity of demand and

supply.

Case of Inelastic demand for the product:

- Price will go up equivalent to tax rate--------------

Consumer surplus and Producer surplus

Consumer surplus or consumers' surplus is the monetary gain obtained by consumers

because they are able to purchase a product for a price that is less than the highest price

that they would be willing to pay. Producer surplus or producers' surplus is the amount

P0

S0S2

P0

S

D S1

P1 t

t

D

P0

S

D

S1

P1 t

P0

S

D

S1

P1 t

7/27/2019 Lecture Outline- 8 - Govt Intervention

3/4

that producers benefit by selling at a market price that is higher than the least that they

would be willing to sell for.

A subsidy is a payment by the government to suppliers that reduce their costs of production and

encourages them to increase output. The effect of a government subsidy is to increase supply and

(ceteris paribus) reduce the market equilibrium price. The subsidy causes the firm's supply curve to

shift to the right. The amount spent on the subsidy is equal to the subsidy per unit multiplied by total

output. Occasionally the government can offer a direct subsidy to the consumer which has the effect

of boosting demand in a market.

Demand elasticity and producer subsidy

Government intervention leads to worsen distribution of resources.

1.

Distortion of the Market: Subsidies distort market prices - this can lead to a misallocation ofresources many economists believe that the free-market mechanism works best.

2. Financial Cost: Subsidies can become expensive note the opportunity cost!3. Who pays and who benefits?: The final cost of a subsidy usually falls on consumers (tax-payers)

who themselves may have derived no benefit from the subsidy

4. Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need torestructure i.e. it delays much needed economic reforms

5. Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments

P0

S1

D

S

P1 S

P1

S1

D

S

P0 s

7/27/2019 Lecture Outline- 8 - Govt Intervention

4/4

6. There are alternatives: It may be possible to achieve the objectives of subsidies by alternativemeans which have less distorting effects, for example by direct income support through the tax

and benefit system

Price ceilings

When market price is too high and when it affects the majority of people in the system the

government intervenes and set a ceiling price.

Gasoline prices, milk food prices medical drugs etc.

It leads to create queues. If there is a queue discipline then first come first serve system works.

This also leads to black markets. Black market price will retain at P2.

Price floor

Because of this sense of inequity, or because of political pressure from farm groups, the government

has had programs to aid farmers since the mid-1930s. One of these, called the price support

program, is an example of a price floor. This is the farmers problem.

Minimum wages.

P0

D1

S

Price Floor P1

D

Wm

S

Price Floor W1

D

D

Ceiling Price