Lectureoutline8GovernmentInterventioninthemarket

Weexaminedthebehaviorofthemarketintheabsenceofthegovernmentintervention

Themainreasonsforpolicyinterventionare:
Tocorrectformarketfailure
Toachieveamoreequitabledistributionofincomeandwealth
Toimprovetheperformanceoftheeconomy
Source:
GovernmentLegislationandRegulation
Parliament can pass laws that for exampleprohibitthe sale of cigarettes to children, or ban
smokingintheworkplace.Thelawsofcompetitionpolicy
imposeprice controlsin most of the main utilities such as telecommunications, electricity, gas
andrailtransport.
DirectStateProvisionofGoodsandServices
FiscalPolicyIntervention
(a) Indirecttaxes
(b)Subsidiestoconsumers
(c)Taxrelief:Thegovernmentmayofferfinancialassistancesuchastaxcreditsforbusiness
investmentinresearchanddevelopment
(d)Areductionincorporationtax(ataxoncompanyprofits)designedtopromotenewcapital
investmentandextraemployment

1. InafreemarketsystemgovernmenttakespartinproducingonlyPublicGoods
Publicgoods:SomeonesConsumptionwillnotdeprivesomeoneelsesconsumption.
Privategood:SomeonesConsumptionwilldeprivesomeoneelsesconsumption.

2. Inamixedeconomicsystemgovernmentinterferesintheeconomyin:
a. participatinginproduction
b. Generatinggovernmentrevenuethroughimposingdirectandindirecttaxes.
c. Providingsubsidiestoconsumersandproducers
d. Protectingproducersandconsumersimposingpriceceilings
Free
Market
System
Govt.
Market
System
Govt.
Effectsofdirecttaxonthemarketisminimal
Effectsofindirecttaxonthemarketaresubstantialdependingupontheelasticityofdemandand
supply.
CaseofInelasticdemandfortheproduct:
Pricewillgoupequivalenttotaxrate

ConsumersurplusandProducersurplus

Consumersurplusorconsumers'surplusisthemonetarygainobtainedbyconsumers
becausetheyareabletopurchaseaproductforapricethatislessthanthehighestprice
thattheywouldbewillingtopay.Producersurplusorproducers'surplusistheamount
P
0

S0
S2
P0
S
D S1
P1
t
t
D
P0
S
D
S1
P1
t
P0
S
D
S1
P1
t
thatproducersbenefitbysellingatamarketpricethatishigherthantheleastthatthey
wouldbewillingtosellfor.

Asubsidyisapaymentbythegovernmenttosuppliersthatreducetheircostsofproductionand
encouragesthemtoincreaseoutput.Theeffectofagovernmentsubsidyistoincreasesupplyand
(ceterisparibus)reducethemarketequilibriumprice.Thesubsidycausesthefirm'ssupplycurveto
shifttotheright.Theamountspentonthesubsidyisequaltothesubsidyperunitmultipliedbytotal
output.Occasionallythegovernmentcanofferadirectsubsidytotheconsumerwhichhastheeffect
ofboostingdemandinamarket.
Demandelasticityandproducersubsidy

Governmentinterventionleadstoworsendistributionofresources.
1. Distortion of the Market:Subsidies distort market prices this can lead to a misallocation of
resourcesmanyeconomistsbelievethatthefreemarketmechanismworksbest.
2. FinancialCost:Subsidiescanbecomeexpensivenotetheopportunitycost!
3. Whopaysandwhobenefits?:Thefinalcostofasubsidyusuallyfallsonconsumers(taxpayers)
whothemselvesmayhavederivednobenefitfromthesubsidy
4. Encouraging inefficiency:Subsidy can artificially protect inefficient firms who need to
restructurei.e.itdelaysmuchneededeconomicreforms
5. RiskofFraud:Everpresentriskoffraudwhenallocatingsubsidypayments
P0
S1
D
S
P1
S
P1
S1
D
S
P0
s
6. There are alternatives:It may be possible to achieve the objectives of subsidies by alternative
meanswhichhavelessdistortingeffects,forexamplebydirectincomesupportthroughthetax
andbenefitsystem

Priceceilings

Whenmarketpriceistoohighandwhenitaffectsthemajorityofpeopleinthesystemthe
governmentintervenesandsetaceilingprice.
Gasolineprices,milkfoodpricesmedicaldrugsetc.
Itleadstocreatequeues.Ifthereisaqueuedisciplinethenfirstcomefirstservesystemworks.
Thisalsoleadstoblackmarkets.BlackmarketpricewillretainatP2.
Pricefloor
Becauseofthissenseofinequity,orbecauseofpoliticalpressurefromfarmgroups,thegovernment
hashadprogramstoaidfarmerssincethemid1930s.Oneofthese,calledthepricesupport
program,isanexampleofapricefloor.Thisisthefarmersproblem.

Minimumwages.
P0
D1
S
PriceFloorP1
D
Wm
S
PriceFloorW1
D
P1
D
S
P0
P2
CeilingPrice