Chapter 3

Price System and Government Intervention

Chapter 3
Price System, Market Failure
And
Government Intervention

After reading this chapter you will be able to

What is market failure?

Sources of market failure
Externalities
43
Cost and benefits analysis
Public goods vs. quasi public goods vs. private goods
Merit goods vs. demerit goods
Asymmetric information
Economic power
Role and effectiveness of indirect taxes and subsidies to correct
the market
Market failure and government regulations and effectiveness
Different tax mechanisms and canons of a good tax
Public sector production and transfer payments
Privatization and nationalization
Chapter 3
Price System and Government Intervention

Market failure

Market fails when it does not function well.

Or
An outcome deriving from the self-interested behaviour of individuals in the context of free trade, in
which economic efficiency does not result.

Sources of market failure

1 public goods
2 merit and demerit goods
3 externalities
4 concentration of economic power (imperfect competition)
5 information deficiencies (asymmetric information)

How does government intervene to achieve certain objectives?

1 maximum price
2 minimum price
3 guaranteed price
4 taxes & subsidies
5 direct provision
6 some other government regulations

Externalities
These are spillover effects of an economic activity i.e. production and consumption. It might be
positive or negative. It is positive when third party gains benefits and negative when third party
incurs loss. 44

Private cost
This is the cost which incur by an individual due to some economic activity that is production or
consumption. For instance if a consumer smokes, what cost he incurs will be the private cost.
Similarly cost incur by a firm to produce given quantity of the product will be considered private cost
of the firm. These are internal costs like labour cost, raw material cost capital costs, depreciation
costs etc. Usually these costs are measurable accurately in monetary terms.

External cost
The cost which is incurred by the third party which is not involved in the economic activity will be
considered as external cost. It is the spillover effect of an economic activity. External cost occurs
when social cost exceeds private cost. These are called as negative externalities. So it becomes the
source of market failure because market forces are unable to add these costs during allocation of
resources, therefore, one incurs cost without gaining any benefit. For instance passive smokers
suffer due to smoking or people incur the cost in terms of road congestion or noise pollution due to
traffic. Similarly, factories emit smoke during production which is also a source of negative
externalities.

Social cost
This is the cost which incur by the whole society due to production and consumption. It includes
private cost as well as external cost. For instance, during the process of smoking, social cost includes
not only the cost of buying cigarettes but also the cost incur by the passer by.

Social Cost = Private Cost + External Cost

Chapter 3
Price System and Government Intervention

Private benefits
Benefits drive by an individual due to some economic activities that is production or consumption. It
is an economic gain to an individual due to an economic activity. For example, a consumer uses his
computer and drives some satisfactions or a producer gain profit by selling his products.

External Benefits
These benefits are driven by the third party who is not involved in that economic activity. Once again
it is a spillover effect of an economic activity. It occurs when social benefits exceed private benefits.
These are also called as positive externalities. It is a source of market failure because price
mechanism ignores external benefits during production. For instance, if a person spends money on
his front garden, not only he derives benefits by himself but also people who live around.

Social benefits
Social benefits include private benefits as well as external benefits. It means all benefits which are
driven by the whole society due to an economic activity.

Social Benefits = Private benefits + External benefits

Marginal Private cost (MPC)

It is the change in private cost by producing or consuming an additional unit of a product.
Marginal external cost (MEC)
It is the change in external cost by producing or consuming an additional unit of a product.
Marginal social cost (MSC)
It is the change in social cost by producing or consuming an additional unit of a product.
MSC= MPC+MEC
Marginal private benefit (MPB) 45
It is the change in private benefits by producing or consuming an additional unit of a product.
Marginal external benefit (MEB)
It is the change in external benefits by producing or consuming an additional unit of a product.
Marginal social benefit (MSB)
It is the change in social benefits by producing or consuming an additional unit of a product.
MSB= MPB+MEB

MSB MSC
MPB MPC

Positive MSC
MSB externalities
Negative externalities
MPB MPC

O O
Q Quantity Q Quantity
Chapter 3
Price System and Government Intervention

Cost and benefits analysis (For A2 only)

It is an appraisal of a project where all costs and benefits are weighed up. If costs exceed
benefits, project will be rejected and, if benefits exceed costs or equal to costs, project will be
proceeded with.
For cost and benefit analysis there is a certain framework. In this framework there are four
different stages.
At the first stage, all relevant cost and benefits are identified. It includes private costs,
private benefits, external costs and external benefits. Apparently it looks quite simple but in reality it
requires some serious thoughts. Private costs and private benefits may be identified easily but
spillover effects in terms of external costs and external benefits cannot be identified easily. For
example, in the construction of motor way, labour cost, raw material cost etc. can be identified but
all spillover costs cannot be identified. Same problems will happen with the benefits.
At the second stage monetary values are given to all costs and benefits. It is relatively
straight forward where market prices are given. Once again market prices are not available for
certain cost and benefits, especially for external costs and benefits. At this stage technique of
shadow pricing is used. These are estimated prices which are given to some of the externalities, for
example, valuation of saved time or cost of an accident. These are imputed prices based on
opportunity cost.
Third stage is applied when project is having some future usage. At this stage all future costs
and benefits are identified. Here, economists use some statistical forecasting techniques. This stage
is usually used in mega projects, like, nuclear power station, water dams, motor ways, air ports etc.
At the final stage, all results from the earlier stages are drawn in such a manner that correct
decisions can be taken. If costs exceed benefits, project is rejected but if benefits exceed costs or
equal to the cost, project will be proceeded with.

Limitations of cost and benefits analysis 46

- The first difficulty is the reorganization of all costs and benefits. Private costs and benefits
can be recognized but it is impossible to recognize all of the external costs and benefits.
- Secondly, it is difficult to put monetary values on these costs and befits. Usually shadow
pricing is used which is not a reliable way to give money values to costs and benefits.
- CBA does not always satisfactorily reflect distributional consequences of certain decisions.
For example, during a mega project like water reservoir local people incur more cost where
as benefits are driven by people who live in other part of the country.
- CBA is used in mega projects and there is an involvement of the state in such projects. This is
why these projects are politicized;
therefore, outcome of the analysis is MSB MSC MPC
rejected for political reasons.
MPB
However, importance of CBA cannot be
denied because CBA at least bring out the MSB
issues involve so that a decision can be
taken on the basis of all information MPB
available. CBA is an aid and not a
replacement for decision making.

O
Q Quantity
Chapter 3
Price System and Government Intervention

Public goods
In price mechanism only those goods are produced, which bring some benefits for the
producer. Public goods are not produced under price mechanism. Government thinks every one
ought to have these goods; therefore, it takes the responsibility to produce such goods. These goods
have three important features.
a) None-excludability, which means everyone, can consume the product whether one pays or
does not pay for it. This feature creates the problem of free-rider. It means one drives the
benefits without paying any price and there is no way to exclude a person from access to
such a good if it is produced at all. As no one is willing to contribute then cost cannot be met
and there is no production of public goods. This is the primary reason that public goods are
not produced in the private sector where major objective is to make profit. This, in the
nutshell, the public good dilemma, a form of market failure which requires taxation to
overcome it. It solution lies outside the economic calculus.
b) None-rivalry, which means consumption of one, does not reduce consumption for others.
For example, radio broadcasting can be listened by millions of people even at a time.
c) None-rejectability, which means everyone, will have to accept the good whether one desires
or does not desire for the product.
Another important feature of public good is that its marginal cost is zero. So, the initial cost
remains the same even there is an increase in number of consumers. An interesting situation is
developed in case of public goods i.e. If public goods are not produced there is a market failure but
on the other hand if these goods are produces still there is a possibility of market failure due to ‘free
rider’ problem.
Public goods may be classified in pure public goods and quasi public goods. Pure public goods
have feature of non excludability and non rivalry, whereas, quasi public goods may have features of
public goods and private goods. These goods have partial excludability, partial rivalry, partial
diminishability and even partial rejectability. For examples, roads, parks, tunnels etc. markets for 47
these goods are also be considered as incomplete market and their lack of provision by the free
market determines inefficiencies and a source of market failure.

Private goods
These goods are produced under price mechanism. Unlike public goods these goods have
characteristics like excludability, which means only those can consume who pay the price. In case of
private goods there is a least possibility of free rider problem. Since main objective of all firms is to
make maximum of profit, therefore they are not willing to produce even a single unit of a product
for those who do not pay because it is not readily available for free. The second feature is rivalry,
which means consumption of one, reduces consumption for others. It is because of competition
between individuals to obtain the good and definitely if one consumes the good will prevent
someone else to consume it. Such goods also incur marginal cost i.e., additional cost will be incurred
by the producer if he produces an extra unit of the product. Private goods can be rejected, i.e. if one
does not require the private good, it will not be produced for him under price mechanism. For
example if a community stops smoking, there might not be any production of cigarettes.

Merit goods
Merit goods are the opposite of demerit goods - they are goods which are deemed to be
socially desirable, and which are likely to be under-produced and under-consumed through the
market mechanism due to lack of information about positive externalities. Examples of merit goods
include education, health care, welfare services, housing, fire protection, refuse collection and public
parks. In contrast to pure public goods, merit goods could be, and indeed are, provided through the
market, but not necessarily in sufficient quantities to maximize social welfare. Thus goods such as
education and health care are provided by the state, but there is also a parallel, thriving private
sector provision. Merit goods confer benefits on society in excess of the benefits conferred on
Chapter 3
Price System and Government Intervention

individual consumers; in other words, there is a divergence between private and social costs and
benefits, as the social benefits accruing to society as a whole from the consumption of such goods
tend to be greater than the private benefits to the individual. The problem is that individual
consumers and producers make their
decisions on the basis of their own, internal
costs and benefits, but, from the
standpoint of the welfare of society at
large, externalities must be considered.

In the fig. market is at its equilibrium at

point ‘B’ and produce Qp, but desirable
output is at point ‘C’ where MSB=MSC. It is
assumed that merit goods do not have any
negative externality; therefore, supply
curve only depicts the private marginal cost
(MPC = MSC). If market produces at ‘B’
then there is a welfare loss which is shown
as shaded area.

Demerit goods
Demerit goods are goods which are deemed to be socially undesirable, and which are likely
to be over-produced and over-consumed through the market mechanism. Examples of demerit
goods are cigarettes, alcohol and all other addictive drugs. Government forms certain policies to
discourage consumption and production of
such goods.
The problem arises from the fact that so long as 48
an effective demand is present, such goods are
going to be extremely profitable to produce,
hence price mechanism produces them.
However, the consumption of demerit goods
imposes considerable negative externalities on
society as a whole i.e. the marginal social cost
will exceed the market price and
overproduction and over-consumption will
occur, causing a misallocation of society's
scarce resources.
The diagram illustrates how the market fails in the case of demerit goods. At a market price OQ1
quantity of the demerit good is consumed and produced, where demand (private marginal benefit)
equals supply (private marginal cost). Once again it is assumed that demerit goods do not have any
positive externalities hence private marginal benefits are equal to social marginal benefits. However,
at OQ1 the social marginal cost exceeds social marginal benefits by the vertical distance (shaded
area), which is called as net welfare loss and source of market failure. Social optimality would
require a smaller level of consumption at OQ2, where price = marginal social cost = marginal social
benefit.

Economic Power

Market failure occurs when economic power is concentrated in terms of monopoly, monopsony,
oligopoly etc. For instance it is assumed that monopoly charge high prices to make more profit,
though at the cost of productive and allocative efficiencies. In oligopolies, firms form cartel to avoid
competition and behave like monopolies and even if there is no cartel, since oligopolies are also
Chapter 3
Price System and Government Intervention

productively and allocative inefficient. So, existence of such types of firms becomes source of market
failure.

Asymmetric information
In perfect markets all participants i.e. buyers and sellers have perfect and equal information.
However, in reality these transactions occur under incomplete information which causes market
failure. There is also a possibility of market failure if one party has lesser information as compare to
another participant. For instance, in case of buying and selling of a second hand car, definitely seller
will have more information as compare to buyer and as a result buyer can be overcharged and a
question mark arises on the Pareto optimality i.e. maximum social welfareness of the society.

How to correct market failure

Taxes
There are two types of taxes, direct taxes which are deducted at the source like income tax,
corporate tax or wealth tax. Second type of tax is called as indirect tax, which is usually levied on
spending. Sales tax, VAT, excise duties and tariff are common examples. Taxes are the main source
of government revenue, however, government also use it to discourage consumption and
production of certain goods. Indirect taxes may be specific or ad valorem. Specific tax is per unit tax
and it is levied on the volume of a good, e.g., $5 per unit, whereas, ad valorem tax is levied on the
value of the product, e.g., 5% of the price.
When indirect taxes are imposed, cost of production increases therefore supply curve shift
leftwards, which increases prices and causes a contraction in demand. In case of specific tax there is
a parallel leftwards shift in the supply curve, whereas, in case of ad valorem tax there is a non
parallel shift in the supply curve. The gap between the supply curves is narrowed at low prices but
widened at higher prices.
49

Price S2 S1 Price S2 S1

O O
Quantity Quantity
Specific Tax Ad valorem Tax

Incidence of the tax is borne by producer and

consumer; however, it depends on the relative
price elasticity of demand (PED) and price
elasticity of supply (PES). If PED is higher than the
PES, there will be more burdens on producer;
however, if PES is greater than the PED, consumer
bears the more burdens.
In the diagram, due to the tax, now consumers
will pay more prices, which restrict their buying power, therefore they incur the burden of tax which
can be shown with the help of upper shaded area (P1P2). Similarly, lower shaded area shows the
 Chapter 3
Price System and Government Intervention

burden of tax on producer (P1P3).Usually taxes are imposed to discourage consumption and
production of demerit goods. It is intended that the amount of tax should be equal to the amount of
negative externalities. However, due to lack of
information government is unable to
determine accurate amount of tax. Therefore,
there may be under or over production of
certain good. Secondly, it may have an
adverse affect on the redistribution of income.
Mostly indirect taxes are regressive by nature,
hence, low income group pay relatively bigger
proportion of their income in terms of taxes.
Indirect taxes also increase cost of production;
therefore, cost push inflation occurs. Another
problem which is arisen is the deadweight loss
or net welfare loss which can be shown with
the help of triangle (vertical lines shaded
area). As tax is levied there is a fall in
consumer surplus and producer surplus. A
part of the loss of surpluses is recovered by the state in terms of tax revenue but still triangle
remains unrecovered and considered as dead weight loss. Elasticity is another important factor
which determines effectiveness of taxes. If demand for the product is inelastic then whatever is the
amount of tax, there is no considerable change in demand for the product. However if demand is
elastic then indirect taxes are effective.

Tax mechanism
50
Marginal Tax rate vs. Average Tax rate
Marginal tax rate determines the change in the tax amount as income changes i.e. the tax rate on
addition income, whereas, average tax rate is calculated by dividing total tax amount on total gross
income.

𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑎𝑥 𝑎𝑚𝑜𝑢𝑛𝑡 𝑡𝑜𝑡𝑎𝑙 𝑡𝑎𝑥 𝑎𝑚𝑜𝑢𝑛𝑡

Marginal Tax Rate = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑔𝑟𝑜𝑠𝑠 𝑖𝑛𝑐𝑜𝑚𝑒
Average Tax Rate = 𝑡𝑜𝑡𝑎𝑙 𝑔𝑟𝑜𝑠𝑠 𝑖𝑛𝑐𝑜𝑚𝑒

Illustration:
Income Amount of tax Average Tax Rate
$1000 $100 10%
$2000 $250 12.5%

$250−$100 $150
Marginal Tax = $2000 −$1000 = $150 on additional $1000 and Marginal Tax Rate $1000
x 100 =15%

Progressive Tax
According to this mechanism rate of tax increases as taxable amount rises. Usually direct taxes are of
this nature where the tax rate progresses from low to high, with the result the average tax rate is
less than the person’s marginal tax rate.
Illustration:
Income Rate of Tax Amount
$1000 10% (+) $100
$2000 15% of additional $1000 $ 250 = ($100 for first $1000
And $150 for second $1000)
 Chapter 3
Price System and Government Intervention

Proportional Tax

According to this mechanism rate of tax is fixed, with no change as taxable base amount increases or
decreases. The amount of the tax is in proportion to the amount which is subject to taxation. In this
case there is no difference between average rate of taxation and marginal rate of taxation.
Proportional tax is usually considered as regressive tax by nature and particularly in case of sales tax
which is imposed on mostly all types of goods which are bought by all income groups. Since for low
income groups it makes higher proportion therefore, we call them regressive by nature.
Illustration:
Income Rate of Tax Amount
$1000 10% (+) $100
$2000 10% of additional $1000 $ 200 = ($100 for first $1000
And $100 for second $1000)

Regressive Tax

According to this mechanism rate of tax decreases as taxable amount rises. However, amount
subject to taxation increases. It may take large proportion from low income groups than from high
income groups. In this case average tax rate is more than the marginal tax rate.
Illustration:
Income Rate of Tax Amount
$1000 10% (+) $100
$2000 7% of additional $1000 $ 170 = ($100 for first $1000
And $70 for second $1000)

Progressive Tax Proportional Tax Regressive Tax

51
Rate of tax Rate of tax Rate of tax

O Income O Income O Income

Canons of good tax

Canons of taxation refer to the administrative aspect of a tax. They relate to the amount, rate and
method of levy of a tax as well as collection of taxes. In fact, canons describe features of a good tax,
therefore, it must be noted that canons just describe features of an isolated tax but not the whole
tax system.
Adam Smith identified four canons of good tax these are:
(a) Equality or Equity
According to this feature a good tax should have equality and most appropriately equity i.e.
‘Fairness’. It means a tax should be charged according to the ability to pay and must ensure
justice. For instance, income tax is a good example which is mostly progressive by nature
where rate of tax increases as income rises and the ability to pay tax is also raised.
(b) Canon of Certainty
Taxations must have an element of certainty i.e. the tax which a tax payer is bound to pay
must be certain and not arbitrary. Secondly, the time of payment, the amount of payment,
the manner of payment etc. must be clear and plain for not only to tax payers but to all
Chapter 3
Price System and Government Intervention

individuals. Element of certainty not only make it certain that what will be the amount
generated as tax revenue but also assure the incidence of the tax.
(c) Canon of Economy
This rule suggests that cost of collection of taxes must not be extravagant and excessive. An
expensive machinery of collection of tax cannot be justified because it will take a large chunk
of tax revenue as expenses and bring little into the public treasury of the state.

(d) Canon of Convenience

According to this canon, tax should be collect in convenient manner. For instance, every tax
should be levied at the time or in the manner in which it is most likely to be convenient for
the contributor to pay it.” For example, it is convenient to pay a tax when it is deducted at
source from the salaried classes at the time of paying salaries (Pay as You Earn Policy).
Secondly, tax documentation procedure should be simple and understandable for a layman.

Subsidies
Subsidies are negative of taxes. Usually subsidies are given on merit goods or necessities to
encourage consumption and production of certain goods. In some cases it is given to that industry
(ies) which maintain employment in an economy. As results of subsidy lower prices are charged to
consumers to encourage consumption, whereas, firms are allowed to charge high prices to
encourage production. The differences between the prices are given by the government as
subsidies.
In the following diagram, as subsidy is given, the supply curve shifts from S1 to S2 and new
equilibrium is formed at point E1. Now consumers are charged ‘OPc’ price whereas, producers are
given ‘OPp’ price and the difference which is ‘PcPp’ per unit is given by the state.

52

However it may damage some of the other objectives of the government, like
redistribution of income to reduce inequalities may be ineffective because subsidies are available to
all mostly. It also increases government spending hence government will have to forego many of its
other projects and incurs opportunity cost. As spending increases government will have to increase
taxes which are disincentive for workers and producers and may cause market failure. It may deter
allocation of resources because firms prefer to produce subsidized product so as a result there is a
possibility of over production of certain goods at the cost of other goods which may not be produced
or under produced. In subsidies there is a possibility of dead weight loss which can be shown in the
above diagram with shaded area ‘H’.
Chapter 3
Price System and Government Intervention

Maximum price
It is a kind of regulation of a regulatory authority to control and stabilize prices of
certain goods. Maximum price control is
usually valid on the prices of staple food,
rents on certain type of housing, utilities
like water and gas and on public transport
fares. Maximum prices are set to increase
buying power of consumers to improve
their living standard. Maximum prices are
set below then the equilibrium prices.
However if these prices are above then
the equilibrium prices, they become
ineffective.

In the diagram, at the maximum price

demand is extended to OQ3, because of increase in the buying power of consumers. But this policy
further enlarges the problem of scarcity, because at maximum price producer is willing to produce
up to OQ1 and there is a possible shortage of Q1 to Q3. Now firms may opt different methods to deal
with such problems, like first come first serve policy where who comes first, will be entertained,
Secondly, queuing where a consumer waits for her turn. However, situation will be worsened if firms
start charging ‘black market price’. This price is even above than the equilibrium price. For instance,
in the above diagram OPb price is charged by firms for OQ1 quantity in the black market.

Minimum prices
These prices are charged, usually above
then the equilibrium price. Government 53
thinks market forces are unable to
determine right price for a particular good
or service and it should be relatively
higher. Minimum prices are usually
introduced to protect small scale
producers or workers who earn low
incomes. Minimum prices are also
introduced to discourage consumption of
goods which cause negative externalities
or a kind of demerit goods like alcohol.
In the above diagram, market is
equilibrium at point E, which determines the price OP for OQ quantity. Government sets the price
PMIN; it increases production to OQ3 and reduces demand to OQ1. Therefore Q1 to Q3 will be the
surplus. If minimum price is below than the equilibrium price, it becomes ineffective.

However, this policy is also not out of flaws. For instance, this policy just discourages consumption
but encourage consumption of demerit goods. Usually this policy is used to discourage consumption
of demerit goods like cigarettes or alcohol which demands is very much inelastic. So there is no
considerable change in consumption of such goods. Secondly, demand for these goods is also highly
income inelastic, therefore, low income group suffer more and it cause more inequalities. Another
drawback of this policy is it allows producers and retailers to make excessive profit since these goods
are always consumed even at higher prices. Implementation of this policy also does not make any
revenue for the state.
Chapter 3
Price System and Government Intervention

Guaranteed price
Guaranteed prices are usually introduced in agricultural sector to bring stability in prices and output.
Guaranteed prices work like minimum prices however in guaranteed prices all excess is purchased by
the government whereas, in minimum price policy, there is no such provision. Government usually
set the price which is above than the equilibrium price. Since not only producers get high prices but
at the same time there is least
possibility of excess supply problems
therefore, they are encouraged to
produce more and stable the supply
side.
As guaranteed prices are introduced,
firms increase their production,
where as demand is contracted as a
result there is an excess supply in the
market. This excess supply is held by
the government and release
whenever there is an increase in
demand to bring stability in prices.
However at the end of the year when there is a time for new crops government lower prices to Pc to
clear the existing stocks.
Guaranteed price has its own limitations; for example, in many cases government expenditures rise
as they need to hold stocks for a period of time. Government also incur additional administrative
cost to manage and maintain stocks and if some stocks are left at the time of arrival of new stocks
then government sell at market clearing price and the difference between guaranteed price PG and
market clearing price PC is borne be the government. Guaranteed price also distorts functioning of
free market (price mechanism) and firms then prefer to produce goods where guaranteed price is 54
introduced and it may cause shortage of other goods even in the same industry.

Other Regulations
Permits
It means permission which should be taken by any firm before setting up and conduct the business
within the geographical jurisdiction of a government. Usually permits are given by the local,
provincial or federal authorities depending on size and nature of the firm. The basic idea behind
permits is not only see the overall trend in business but also control activities of firms which operate
under price mechanism.

Quotas
It is a physical limit on production or import of certain goods. Government usually use quotas to
avoid over production of certain goods and more preferably to reduce negative externalities.

License to pollute
According to this license regulatory authorities give legal rights to a firm to pollute a certain amount.
For example a firm can pollute the environment up to 100 units of carbon dioxide per year. Once the
regulatory authority issues the license to pollute, after that it can be bought and sold in the market
so, there is a market for pollution permits. Usually less pollution producing firms sell license to high
pollution producing firms. Price of the permit depends on respective demand for and supply of the
license.
Chapter 3
Price System and Government Intervention

Ban
It is a formal, legal and complete prohibition on production or consumption of certain goods which
are totally undesirable for the society. For instance there is a complete ban on production and
consumption of narcotics.

Public sector production

Under price mechanism merit goods are under produced, where as there is no production of
public goods. Public sector also engaged in production and provision of basic necessities and some
key services. For example in Pakistan many ‘utility stores’ are run by the public sector where grocery
and other daily life goods are sold at subsidized prices. Similarly, in many countries rail service and
power supply services are also provided by the state. The basic reason for public sector provision is
the high initial cost of these mega projects and secondly transportation services are taken as basic
requirements of people who travel to earn their living and the idea behind that to provide them at
low price to reduce their cost of living. These goods must be produced for the welfare of the society,
therefore, government produces them. Such goods are important to reduce inequalities as well as to
improve over all living standards. However public sector production has its own limitations. For
instance, public sector production may crowd out private sector production. Private sector firms are
reluctant to enter in such industries where public sector organizations are already operating.
Secondly, profit is not the motive, therefore, efficiencies are very much low and even these
organizations are run by bureaucrats who do not have special knowledge to run a business. Thirdly,
there is no free lunch, so, to finance public sector production, government levies direct or indirect
taxes which are ultimately paid by consumers.

Transfer payments
These payments are made by the state to individuals through certain programs like social security
benefits or unemployment benefits. These payments are considered as non- exhaustive since they 55
do not directly absorb resources or create output. It is the mean of redistribution of income and
these payments are made in price mechanism to reduce inequalities. Government makes these
payments to reduce poverty and improve living standards. It is also helpful to increase aggregate
demand in an economy to achieve macroeconomics objectives like reduction in unemployment and
to increase economic growth rate. However, it increases government spending, therefore, either
government has to forgo many of other projects (opportunity cost) or levies more taxes to meet the
deficit.

Nationalization and Privatization

Nationalization is an act where ownership of business organization is transferred from individuals
and other legal entities to the state. On contrary, in privatization ownership of business organization
is transferred from the state to individuals and other legal entities of private sector.

Reasons for Nationalization

Reduce inequalities: As money makes money, therefore, those who have resources will become
richer and other remains poor. It increases the gulf between rich and poor. So, to reduce inequalities
state takes the ownership of firms to provide equal opportunities to all income groups.
Stability and security: in private sector main objective is profit maximization hence operation of
price mechanism depends on profit. If a firm makes profit, will continue its operation and if there is
no profit there is no production. It makes the market very much vulnerable. Since government does
not have the objective of profit therefore it takes the ownership of such firms to avoid vulnerability
To raise economic size and efficiency: By combining small private enterprises into a large, possibly
monopolistic organisation, economies of scale can be achieved and a more competitive organisation
created. So, not only undue duplication is avoided but at the same time efficiencies will rise.
Chapter 3
Price System and Government Intervention

To protect consumers and employment: In certain cases natural monopolies are formed even in
private sector. These firms may exploit consumers by charging high prices and provide sub-standard
product. Similarly, these firms are very important to maintain certain level of employment in the
economy and, if firms stop production due to any reason it will have deter employment considerably
therefore, government takes the ownership to protect employment.
Reasons for privatization
Encourages competition: Competition is the driving force of innovation and efficiency. Private firms
are reluctant to enter in such market where public sector firms operate. However, as firms are
privatized, doors are opened for new firms and competition begins. Due to competition firms raise
their efficiencies to reduce cost of production but also improve quality of product to attract more
customers. So it improves allocation of resources.
Source of Revenue: As businesses are sold in private sector, not only the government is able to
generate a handsome amount once but also private firms become permanent source of tax revenue
for the state. So government can use these resources to produce more merit goods and public
goods.
Less political interference: In public sector mostly decisions are taken on political basis to win
people’s favour which produce undesirable outcomes. To earn political favour usually firm are over
employed which not only increase per unit cost of production but also incur huge losses which are
met by the state to levy more taxes. After privatization all decisions are taken by specialist managers
who are able to change the situation by increasing efficiencies.
Disadvantages of privatization
- There is a danger of conversion of public sector monopoly into private sector monopoly.
- Secondly, there are many firms which perform important public services like education,
health and even transport services. Profit should not be the primary objective in such
industries but due to privatization, private sector firms may emphasize more on profit
instead of provision of these services. 56
- Many of public sector firms make good profit and if these firms are privatized than
government may lose some potential sources of revenue.
- Sometimes large size firms are broken down in relatively small units; therefore, firms may
lose many of the economies which they can gain otherwise.
- As private monopolies are formed, government needs to regulate them to prevent abuse of
monopoly power. Once again economic activities are under state control and in addition
government also incurs administrative costs.

Summary:
●There is a market failure if price mechanism is unable to produce desirable outcomes which
maximize social welfareness.
●Externalities, non provision of public goods, lack of information, asymmetric information, and
economic power are common sources of market failure.
●Externalities are positive or negative spillover effects of economic activities and have impacts on
third party.
●Pure public goods have two important features (i) non rivalry i.e. consumption of one cannot
reduce consumption of others and (ii) non excludability i.e. everyone can consume or available to all.
●Quasi public goods have only some features or some extents of all features.
●Private goods are produced in price mechanism and have features of excludability and rivalry.
●Merit goods are under produced due to lack of information about their positive externalities in
price mechanism.
●Demerit goods are over produced due to lack of information about their negative externalities in
price mechanism.
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Price System and Government Intervention

●In asymmetric information buyers and sellers do not have perfect or equal information.
●In imperfect market structures firms can establish their market power and then may exploit
consumers and workers.
●Taxes and subsidies are types of financial interventions.
●Direct taxes are levied on income whereas indirect taxes are levied on spending.
●Indirect tax may be specific i.e. per unit tax or ad valorem i.e. on the price of the product.
●Burden of tax depends on relative price elasticity of demand and price elasticity of supply.
●High the elasticity, low the burden of tax and vice versa.
●In progressive taxation rate of tax increases as income increases and vice versa.
●In proportional taxation rate of tax remains the same even income changes.
●In regressive taxation rate of tax falls as income increases and vice versa.
●Subsidies are given to encourage production and consumption of merit goods and basic needs and
services.
●Subsidies are shared on the basis of relative PED and PES, low the elasticity more the gain from
subsidy.
●In regulations, there is a deviation from price mechanism.
●For an effective maximum price, price should be below than the equilibrium price.
●For an effective minimum price, price should be above than the equilibrium price.
●Privatization is the transferring of ownership from public sector to private sector.
●Nationalization is the transferring of ownership from private sector to public sector.

Sample questions:
1 (a) Explain, with examples, the meaning of the terms public good and merit good. [8]
(b) Discuss how a government might increase the provision of public and merit goods. 57
[12]
[Nov 2002]
Key points: (a) Define merit goods that are under produce due to lack of information about
positive externalities like health and education. Public goods are not produced at all in price
mechanism due to the feature of non-excludability like defence or national T.V broadcasting.
Must read: Merit goods and public goods
Key point: (b) Reduction in taxes, subsidies, guaranteed price, direct provision of
merit goods, compulsion and information, however public goods are only provided by the
state, problems regarding equity and efficiency, disincentive, opportunity cost.
Must read: How to correct market failure

2 (a) Explain the effect of the removal of an indirect tax upon the market for a product. [8]
(b) Discuss whether an indirect tax is a satisfactory way to tackle a negative externality, such
as air pollution. [12]
[Nov 2003]
Key points: (a) An indirect tax like sales tax will shift supply curve rightwards, however
nature of the shift depends on whether it is specific or ad valorem, however price falls,
quantity traded increase, consumer and producer surpluses increase, gain depends upon
elasticity of demand and supply, higher elasticity lesser gain, low elasticities more gain and it
can be shown with the help of diagram.
Key point (b) Define and explain negative externalities, method to reduce negative
externalities through indirect taxation, limitations like lack of information,
disincentive, inequalities etc. other methods like ban, permit, license to pollute, educational
campaign subsidies to substitutes etc.
Must read: Indirect tax and its limitations, subsidies, other regulations
Chapter 3
Price System and Government Intervention

(b) (a) Explain the meaning of ‘public good’ and ‘private good’. [8]
(b) Discuss whether economic actions by individuals always result in a net benefit to society.
[12]
[Nov 2004]
Key points: (a) No production of public goods under price mechanism, state produces, non
excludability and non rivalry, problems of free rider, example like defence. Private goods,
produced under price mechanism, rivalry and excludability, example like buying of
household goods.
Must read: Public goods, private goods
Key points: (b) Actions by individuals should be in their own interests and maximise their
own benefit. This may contribute to maximisation of benefit to society through the
incentives of the market system. The government has a role in promoting social welfare.
Actions with positive externalities give a greater benefit to society than to the individual.
Some actions may have harmful side-effects or negative externalities which make the cost to
society greater than to the individual. Producers may be unwilling to supply some goods and
services e.g. merit and public goods which society values.
Must read: Private cost and benefits, external costs and benefits, social costs and benefits

4 Discuss the desirability of the direct provision of goods and services by the government.
[12]
[May 2005]
Key points: The desirability depends upon the nature of the goods and services. Private
goods and services may be most efficiently supplied by the market. However in cases of
market failure the government may intervene. Public goods and merit goods may not be
provided or be under-provided by the market. This would include defence and education 58
and would justify the direct provision by the government. Intervention in the provision of
private goods however may result in inefficiency and reduced welfare. Governments may
also use this as a way to tackle monopoly, fair prices and essential goods.
Must read: Public goods, merit goods, public sector production

5 (a) Explain, with examples, the difference between a demerit good and a merit good. [8]
(b) Discuss two methods that a government might use to influence the consumption of
demerit goods. [12]
[May 2006]
Key points: (a) in both of the goods there is lack of information about externalities. Merit
goods are under produced and demerit goods are over produced. Elaborate these concepts
with the help of proper diagrams and examples.
Must read: Merit and demerit goods
Key points: (b) Taxation on demerit goods, educational campaign, subsidies to its
substitutes. Consideration of costs, effectiveness and side-effects.
Must read: indirect taxes, subsidies

6 (a) Explain why the free market is ineffective in arriving at the correct price for merit goods
and demerit goods. [8]
(b) Discuss the policies a government might adopt to ensure the correct price for merit and
demerit goods is charged in the market. [12]
[May 2013/21]
Key points: (a) In market mechanism decisions are taken on the basis of private benefits and
private costs. No consideration of positive and negative externalities but a correct price
should reflect private benefits and external benefits for merit goods and for demerit goods
Chapter 3
Price System and Government Intervention

price should reflect private cost and external cost. Draw diagram for merit and demerit
goods to explain all related concepts.
Must read: Private costs and benefits, external costs and benefits, merit and demerit goods
Key points: (b) Role of indirect taxes for demerit goods and subsidies for merit goods and
limitations of the policies. Analysis and evaluation of policies.
Must read: Indirect taxes, subsidies

7 Discuss the view that attempts to help poorer consumers through the imposition of a
maximum price for food items will always fail. [12]
[May 2014]
Key points: Explain the imposition of effective maximum price which is below than the
market price. A group of consumers may gain benefits another group may suffer due to
possibilities of excess demand. Problem may be sorted out through policies like queuing,
rationing, increasing imports etc. situation will be worsening if producers introduce black
market price. It may not be effective so govt. should use other policies like subsidies or to
increase imports to meet the shortage to sort out problems. Draw appropriate diagram(s) to
explain concepts.
Must read: Maximum price

8 (a) Using a supply and demand diagram explain how the imposition of a subsidy on a good
would affect the surplus enjoyed by the producers of that good. [8]
(b) Discuss whether minimum price legislation or the imposition of an indirect tax is more
effective in improving resource allocation when the consumption of a good causes negative
externalities. [12]
[Nov 2014/21]
Key points: (a) Explain producer’s surplus with the help of diagram. Explain subsidy and how 59
it reduces price for consumers, however, price for producer will rise and the difference is
paid by the state in terms of subsidy. As a result producer surplus will rise.
Must read: Producer’s surplus, subsidy
Key points: (b) Explain negative externalities and how these externalities arise. Explain
effective minimum price which is above than the equilibrium price and its effectiveness to
reduce negative externalities and its limitations. Role of indirect taxation to discourage
consumption of demerit goods, its effectiveness and limitations. Explain these concepts with
appropriate diagrams and linked them with socially desirable consumption of demerit
goods. Must evaluate that which policy is more effective. Perhaps indirect tax is the better
policy because it also discourages production of demerit goods along with consumption and
also a source of revenue for the state.
Must read: Negative externalities, minimum price, indirect taxes

9 (a) Using examples, explain the difference between merit goods and public goods and show
why it is possible for profit to be made in the supply of one of these types of good but not
the other. [8]
(b) Discuss why merit goods are undersupplied in a free market economy and consider the
effectiveness of one policy to deal with this problem. [12]
[May 2015]
Key points: (a) explain merit goods and public goods with examples. Firms can only make
profit in case of merit goods but not in case of public goods due to its feature of non-
excludability.
Must read: Merit goods, public goods
Chapter 3
Price System and Government Intervention

Key points: (b) Reasons for under provision are lack of information about their positive
externalities. Govt. may use policies like subsidies, public sector provision and a campaign in
favour of merit goods. Must address limitations regarding these policies.
Must read: Subsidies, public sector production

10 (a) Explain the role of the factor enterprise in allocating resources in a market economy
when there is an increase in the demand for a good. Use a diagram to support your answer.
[8]
(b) Discuss two methods of increasing the provision of merit goods in a mixed economy.
Consider which is more likely to be effective. [12]
[May 2017]
Key points: (a) Enterprise performs to functions, risk bearing, decision making i.e. how to use
and organize other economic resources with the objective to earn reward in terms of profit.
As demand increases price will rise, to make more profit enterprise extends production and
move along the supply curve upwards. Draw properly labelled diagram to score and
explanation.
Must read: Entrepreneur, market equilibrium
Key points: (b) May be provided by the state, advantages like available to all, more
consumption, reduce inequalities. Disadvantages like lack of information, possibilities of
excess demand or excess supply, disincentive to private sector production, lesser choices for
consumers, problems regarding implementation, opportunity cost etc. May be subsidized,
and advantages like incentives to private sector to produce, reduction in cost of production,
increase in buying power of consumers due to fall in price. Disadvantages like lack of
information about positive externalities to be subsidized, may distort the market,
opportunity cost, supply may be inelastic, and inefficiencies may rise as part of the cost is
borne by the state. 60
Conclusion: public sector provision may be the better option-even some groups are
unable to buy merit goods at subsidized price- possibilities of absorption of most part of
the subsidy by producers-inefficiencies etc.
Must read: Subsidies, public sector production

11 (a) With the use of diagrams, explain how the price elasticity of demand for a product
influences the incidence of an indirect tax on that product. [8]
(b) ‘Indirect taxes reduce consumer surplus and should therefore never be imposed in a
mixed economy.’ Discuss this view. [12]
[May 2018]
Key points: (a) Incidence of the tax is the burden of tax on producer and consumer. Price
elasticity of demand is degree of responsiveness in demand due to change in price.
Incidence of the tax depends on relative PED and PES i.e. low the PED more the burden of
tax and vice versa. Draw appropriate diagram with elastic and inelastic demand curves to
show changes in tax burden on consumers and produces.
Must read: Indirect tax, price elasticity of demand
Key points: (b) Explain consumer surplus, relationship between price and consumer surplus,
indirect tax increase prices and reduce consumer surplus. Why indirect tax shouldn’t be
levied; despite fall in consumer surplus causes cost push inflation, distort function of price
mechanism, dead weight loss, regressive by nature to cause inequalities. Why it should be
levied, discourage consumption and production of demerit goods; reduce negative
externalities, source of revenue for the state etc.
Evaluation can be made that on the basis of discussion, perhaps before levying tax must
consider type of the good and service, and secondly should consider impact on different
income groups etc.