MANAGERIA ECONOMICS

Government in the Market Place

MODULE 6

Overview

This module assumed widely the first half on the concepts from the lumen learning
course considering the clear and detail explanation of the topic. The second half of this
creative piece is from individual authors and from the published journals of government
and economics 2021.

LEARNING OUTCOMES

At the end of the module the students would be able to:

identify reasons why the government might choose to intervene in

markets;
describe price ceilings and its bearing on the market environment;
explain how price controls lead to economic inefficiency;
define price floor and its effect on the market;
recognize the influences of the government on the market.

1- Government Intervention and Disequilibrium

Why Governments Intervene in Markets

• Governments intervene in markets when they inefficiently allocate resources.

• The government tries to combat market inequities through regulation, taxation,
and subsidies.
• Governments may also intervene in markets to promote general economic
fairness.
• Maximizing social welfare is one of the most common and best understood
reasons for government intervention. Examples of this include breaking up
monopolies and regulating negative externalities like pollution.
• Governments may sometimes intervene in markets to promote other goals, such
as national unity and advancement.

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What is an inefficient market?

An economy where social optimality is not achieved; an economy where

resources are not optimally allocated

Governments intervene in markets to address inefficiency. In an optimally efficient

market, resources are perfectly allocated to those that need them in the amounts they
need. In inefficient markets that is not the case; some may have too much of a resource
while others do not have enough. Inefficiency can take many different forms. The
government tries to combat these inequities through regulation, taxation, and subsidies.
Most governments have any combination of four different objectives when they intervene
in the market.

Maximizing Social Welfare

In an unregulated inefficient market, cartels and other types of organizations can

wield monopolistic power, raising entry costs and limiting the development of
infrastructure. Without regulation, businesses can produce negative externalities without
consequence. This all leads to diminished resources, stifled innovation, and minimized
trade and its corresponding benefits. Government intervention through regulation can
directly address these issues.

Another example of intervention to promote social welfare involves public goods.

Certain depletable goods, like public parks, aren’t owned by an individual. This means
that no price is assigned to the use of that good and everyone can use it. As a result, it
is very easy for these assets to be depleted. Governments intervene to ensure those
resources are not depleted.

Macro-Economic Factors

Governments also intervene to minimize the damage caused by naturally

occurring economic events. Recessions and inflation are part of the natural business
cycle but can have a devastating effect on citizens. In these cases, governments
intervene through subsidies and manipulation of the money supply to minimize the
harsh impact of economic forces on its constituents.

Socio-Economic Factors

Governments may also intervene in markets to promote general economic

fairness. Government often try, through taxation and welfare programs, to reallocate
financial resources from the wealthy to those that are most in need. Other examples of
market intervention for socio-economic reasons include employment laws to protect
certain segments of the population and the regulation of the manufacture of certain
products to ensure the health and well-being of consumers.

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Other Objectives

Governments can sometimes intervene in markets to promote other goals, such

as national unity and advancement. Most people agree that governments should provide
a military for the protection of its citizens, and this can be seen as a type of intervention.
Growing a large and impressive military not only increases a country’s security, but may
also be a source of pride. Intervening in a way that promotes national unity and pride can
be an extremely valuable goal for government officials. 1

Price Ceilings

A price ceiling is a price control that limits how high a price can be charged for a
good or service.

• An artificially set maximum price in a market.

• For a price ceiling to be effective, it must be less than the free-market equilibrium
price.
• The purpose of a price ceiling is to protect consumers of a certain good or service.
By establishing a maximum price, a government wants to ensure the good is
affordable for as many consumers as possible.
• Rent control is an example of a price ceiling.

An example of a price ceiling is rent control. These regulations require a more

gradual increase in rent prices than what the market may demand. This regulation is
meant to protect current tenants. Without rent control, there could be situations where the
demand for housing in an area could cause rent prices to make a substantial jump. Unable
to afford the new, significantly higher rent, a majority of the neighborhood’s tenants may
be forced to move out of the neighborhood. Rent controls limit the possibility of tenant
displacement by minimizing the amount by which rent can be increased.

This was recently done by the government during the time of lockdown due to
pandemic especially in the urban areas/ cities. It is obviously seen in the market where
government intervention occurs during unexpected situation.

By definition, however, price ceilings disrupt the market. By setting a maximum

price, any market in which the equilibrium price is above the price ceiling is inefficient.
There will be excess demand because the price cannot increase enough to clear the
excess.

The price established through competition such that the amount of goods or
services sought by buyers is equal to the amount of goods or services produced by sellers

For a price ceiling to be effective, it must be less than the free-market equilibrium
price. This is the price established through competition such that the amount of goods or
services sought by buyers is equal to the amount of goods or services produced by

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sellers. It is also the price that the market will naturally set for a given good or service. If
the price ceiling is higher than what the market would already charge, the regulation would
not be effective. As a result, a government will do significant research into the current
market conditions for a good before setting a price ceiling.

Price Ceiling Impact on Market Outcome

The price established through competition such that the amount of goods or
services sought by buyers is equal to the amount of goods or services produced by
sellers.

• A price ceiling has an economic impact only if it is less than the free-market
equilibrium price.
• An effective price ceiling will lower the price of a good, which decreases the
producer surplus. The effective price ceiling will also decrease the price for
consumers, but any benefit gained from that will be minimized by the decreased
sales due to the drop-in supply caused by the lower price.
• If a ceiling is to be imposed for a long period of time, a government may need to
ration the good to ensure availability for the greatest number of consumers.
• Prolonged shortages caused by price ceilings can create black markets for that
good.

upply curve
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Consumer
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surplus e cess demand

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1
Source: https://courses.lumenlearning.com/boundless-economics/chapter/government-intervention-and-
disequilibrium/

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Price Ceiling Chart: If a price ceiling is set below the free-market equilibrium price (as shown where the supply
and demand curves intersect), the result will be a shortage of the good in the market. The dead weight loss,
represented in yellow, is the minimum dead weight loss in such a scenario. If individuals who value the good
most are not capable of purchasing it, there is a potential for a higher amount of dead weight loss.

A price ceiling will also lead to a more inefficient market and a decreased total
economic surplus.

Economic surplus, or total welfare, is the sum of consumer and producer surplus.

Consumer 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 that they are willing
pay.

Producer surplus is the amount that producers benefit by selling at a market price
that is higher than the least they would be willing to sell for.

An effective price ceiling will lower the price of a good, which means that the
producer surplus will decrease. While the effective price ceiling will also decrease the
price for consumers, any benefit gained from that will be minimized by decreased sales
caused by decreased available supply for sale from producers due to the decrease in
price.

This translates into a net decrease total economic surplus, otherwise known as
deadweight loss. This loss is signified in the attached chart as the yellow triangle.

Rationing

If a ceiling is to be imposed for a long period of time, a government may need to

ration the good to ensure availability for the greatest number of consumers.

• One way the government may ration the good is to issue ticket to
consumers.
• A government will only allow as much of good to be out in the marketplace
as there are available tickets.
• To obtain the good, the consumer must present the ticket and the money to
the vendor when making the purchase.
• This is generally considered a fair way to minimize the impact of a shortage
caused by a ceiling, but is generally reserved for times of war or severe
economic distress.

Black Market

Prolonged shortages caused by price ceilings can create black markets for that
good.

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• A black market is an underground network of producers that will sell

consumers as much of a controlled good as they want, but at a price higher
than the price ceiling.
• Black markets are generally illegal. However, these markets provide higher
profits for producers and more of a good for a consumer, so many are willing
to take the risk of fines or imprisonment.

Price Floors

A binding price floor is a price control that limits how low a price can be charged
for a product or service.

Generally, floors are set by governments, although groups that manage

exchanges can set price floors as well.

The purpose of a price floor is to protect producers of a certain good or service.

By establishing a minimum price, a government seeks to promote the production of the
good or service and ensure that the producers have sufficient resources to go about their
work.

For a price floor to be effective, it must be greater than the free-market equilibrium
price.

This is the price established through competition such that the amount of goods or
services sought by buyers is equal to the amount of goods or services produced by
sellers.

It is also the price that the market will naturally set for a given good or service. If
the price floor is lower than what the market would already charge, the regulation would
serve no purpose.

Since the price is set artificially high, there will be a surplus:

• there will be a higher quantity supplied and a lower quantity demanded than
in a free market.
• As a result, a government will generally do significant research into the
current market conditions for a good or service before setting a price floor. 1

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2Source: https://courses.lumenlearning.com/boundless-economics/chapter/government-intervention-and-
disequilibrium/

Price: If a price floor is set above the equilibrium, consumers will demand less and producers will supply
more

2- Governments' Influence on Markets

In the 1920s, very few people would have identified the government as the major
player in the markets. Today, very few people would doubt that statement. In this article,
we will look at how the government affects the markets and influences business in ways
that often have unexpected consequences.

• policy, including raising or lowering interest rates, which has a huge impact on
business.
• They can boost the currency, which temporarily lifts corporate profits and share
prices, but ultimately lowers values and spikes interest rates.
• Governments can intervene when companies or entire segments of the economy
are failing, or threatening to undermine the whole economic system, by providing
bailouts.
• Governments can create subsidies, taxing the public and giving the money to an
industry, or tariffs, adding taxes to foreign products to lift prices and make
domestic products more appealing.
• Higher taxes, fees, and greater regulations can stymie businesses or entire
industries.

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Monetary Policy: The Printing Press

Of all the weapons in the government's arsenal, monetary policy is by far the most
powerful. Unfortunately, it is also the most imprecise. True, the government can do some
fine control with tax policy to move capital between investments by granting favorable
tax status (municipal government bonds have benefited from this). On the whole,
however, governments tend to go for large, sweeping changes by altering the monetary
landscape.

Currency Inflation

Governments are the only entities that can legally create their respective
currencies. When they can get away with it, governments always want to inflate the
currency. Why? Because it provides a short-term economic boost as companies charge
more for their products; it also reduces the value of the government bonds issued in the
inflated currency and owned by investors.

Inflated money feels good for a while, especially for investors who see corporate
profits and share prices shooting up, but the long-term impact is an erosion of value
across the board. Savings are worthless, punishing savers and bond buyers. For
debtors, this is good news because they now have to pay less value to retire their debts—
again, hurting the people who bought bank bonds based on those debts. This makes
borrowing more attractive, but interest rates soon shoot up to take away that attraction.

Governments have a substantial and far-reaching influence on markets due to

their ability to regulate everything from monetary policy to currency prices to the rules
and regulations that impact each industry.

Fiscal Policy: Interest Rates

Interest rates are another popular weapon, even though they are often used to
counteract inflation. This is because they can spur the economy separately from inflation.

Bailouts

Bailouts can skew the market by changing the rules to allow poorly run companies
to survive. Often, these bailouts can hurt shareholders of the rescued company or the
company's lenders. In normal market conditions, these firms would go out of business
and see their assets sold to more efficient firms to pay creditors and, if
possible, shareholders. Fortunately, the government only uses its ability to protect the
most systemically essential industries like banks, insurers, airlines, and car
manufacturers.

Subsidies and Tariffs

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Subsidies and tariffs are essentially the same things from the perspective of the
taxpayer. In the case of a subsidy, the government taxes the general public and gives
the money to a chosen industry to make it more profitable. In the case of a tariff, the
government applies taxes to foreign products to make them more expensive, allowing
the domestic suppliers to charge more for their products. Both of these actions have a
direct impact on the market.

Government support of an industry is a powerful incentive for banks and

other financial institutions to give those industries favorable terms. This preferential
treatment from the government and financing means more capital and resources will be
spent in that industry, even if the only comparative advantage it has is government
support. This resource drain affects other, more globally competitive industries that now
have to work harder to gain access to capital. This effect can be more pronounced when
the government acts as the main client for certain industries, leading to well-known
examples of over-charging contractors and chronically delayed projects.

Regulations and Corporate Tax

The business world rarely complains about bailouts to certain industries, perhaps
because of the knowledge that their industry may one day need help as well. But Wall
Street does object when it comes to regulations and taxes. That's because while
subsidies and tariffs can give an industry a comparative advantage, regulations and
taxes can negatively impact profits.

Lee Iacocca was the CEO of Chrysler during its original bailout. In his
book, Iacocca: An Autobiography, he points at the higher costs of ever-increasing safety
regulations as one of the main reasons Chrysler needed the bailout. This trend can be
seen in other industries. As regulations increase, some smaller providers get squeezed
out by the economies of scale the larger companies enjoy. The result can be a highly
regulated industry with a few large companies that are necessarily intertwined with the
government.

High taxes on corporate profits have a different effect in that they may discourage
companies from coming into the country. Just as states with low taxes can lure away
companies from their neighbors, countries that tax less will tend to attract any mobile
corporations. Worse yet, the companies that can't move end up paying the higher tax
and are at a competitive disadvantage in business as well as for attracting
investor capital.

The Bottom Line

Governments play a substantial role in the financial world. Regulations, subsidies,

and taxes can have an immediate, and long-lasting impact on companies and whole
industries. For this reason, Fisher, Price, and some other famous investors
considered legislative risk as a notable factor when evaluating stocks. A great

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investment can turn out to be not that great if it's at risk of seeing its competitive
advantage and profits dwindle as a result of certain government actions. 2

tiglitz article on “The proper role of government in the market economy:

The case of the post-COVID recovery” ummed up that the long-lasting, widespread
COVID-19 pandemic has imposed huge challenges on public health as well as economic
recovery. Governments must take an active role in designing and enforcing economic
policies to address various problems that pure market forces cannot, such as externalities
and the absence of risk markets. Covid-19 has exposed deficiencies in current
arrangements and the need to develop better institutions. There is also a need to develop
better understandings of the relationship between government, the market, and other
institutions within society.

Conclusion

In addition to the provision of a fiscal stimulus package, there is a long list of other
ways in which the government is needed to fill the gaps of the market in facilitating a
robust economic recovery. To name a few, beyond ensuring full employment, these
include, regulating externalities, promoting robust competition, guarding against
exploitation, limiting market power, and providing social protection. In the countries with
the most successful COVID-19 responses, government has played these roles effectively.
The pandemic has laid bare the dire need for reforms to create good governance,
addressing both government and market failures, and improve institutions. Unfortunately,
in some Western countries, including the United States, there is a pervasive and
unfounded belief that the market will solve everything on its own. However, wealthy and
powerful market players tend to work against solutions that are best for society as a whole
when it means they must relinquish some of their money and authority, hence the need
for government intervention. But those same forces will try to impede the government
undertaking the roles which it should play. Moreover, some governments are corrupt. The
power to do good also enables the capability to do bad, as seen in the Trump
administration. Thus, we must work to correct market failures and government failures. It
is a never-ending struggle to create good institutions.
That is why research on government and economics is important. It is only by
studying these institutions and finding out when they succeed and when they fail that
They can move toward building better institutions. They are never going to create perfect
institutions, but believing they can create better institutions both in the public and private
sector, and develop better frameworks for them to work together and with others,
including civil society and NGO's.3

Jinglin Xiang on his “ arket disputes and government intervention: an explanatory

framework of risk transformation” e amines the government intervention in market
governance, that is, why a local government that claims to be a rule maker or market
regulator would intervene deeply in transaction disputes between market players. Based
on the institutional analysis in the fields of sociology and economics, the author constructs
a theoretical framework of risk transformation to study the case of a loan dispute at the

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Wenzhou Private Lending Service Center. The study shows that there are two aspects in
the process of government intervention in transaction disputes: the transformation of
economic risk into political risk and the government’s response to risk transformation. The
completeness of law, the relationship between government and market players, and the
ability of the government to withdraw from society are the three structural factors that
affect risk transformation. Facing risk transformation, the greater the potential political risk
perceived by the government, the more likely it is to intervene in transaction disputes.
This paper provides a new analytical approach for studying the role of government in
market transition and the social construction of market institutions.

uggested Reading’s Links

hanker Lal “How government e-marketplace is revolutionizing procurement in India”

https://blogs.worldbank.org/governance/how-government-e-marketplace-revolutionizing-procurement-
india

Discussion /Questions

1. How does the government influence the market?

2. What is the proper role of government in the market economy?
3. Discuss the government intervention market governance.
4. Why government intervene in the market?

End Notes
1
Lumen. “ Government Intervention and dise uilibrium” Retrieved on Nov. 16, 2021.
https://courses.lumenlearning.com/boundless-economics/chapter/government-intervention-and-
disequilibrium/
2
Coslagliola . Oct. 10, 2021. “Governments' Influence on arkets” Retrieved on Nov. 16, 2021.
https://www.investopedia.com/articles/economics/11/how-governments-influence markets.asp

3
tiglitz J. E., 2021. “The proper role of government in the market economy: The case of the post-COVID
recovery”. Retrieved Nov. 16, 2021.
https://www.sciencedirect.com/science/article/pii/S2667319321000045

4
Xiang Jinglin. “Market disputes and government intervention: an explanatory framework of risk
transformation“ Retrieved on Nov. 16, 2021.
https://journalofchinesesociology.springeropen.com/articles/10.1186/s40711-020-0115-z

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Image

1. Price Ceiling. https://courses.lumenlearning.com/boundless-economics/chapter/government-

intervention-and-disequilibrium/

2. Price Floor. https://courses.lumenlearning.com/boundless-economics/chapter/government-

intervention-and-disequilibrium/

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