Government Intervention

Why Governments Intervene in Markets

• Earn revenue for the government
• Governments earn revenue from indirect taxes. Note that this is different
from direct taxes.
• Provide support to firms
• This may be to support small firms to become established to compete with
larger firms.
• This may also be to support the growth of an industry, such as the Chinese
government supporting the growth of automobile industry.
• The government may also support firms to protect them from foreign
competition.
• Provide support to households on low incomes
• Methods include subsidies, price ceilings, and direct provision of services.
Why Governments Intervene in Markets
• Influence the level of production of firms
• Subsidies, price floors, or trade protection measures also can increase the firms’
level of production, while indirect taxes have the opposite effect.
• Influence levels of consumption of households/consumers
• Government may want to influence the consumption of merit goods or demerit
goods.
• This can be done through the use of subsidies, indirect taxes, direct provisions,
nudges, or command and control methods.
• Correct market failure
• Since the methods described above can influence consumption, it can also be
used to correct overconsumption or underconsumption of goods or services.
• Promote equity
• Governments may redistribute income, or use price ceilings and subsidies.
Price Controls
• Price controls refer to the setting of minimum or maximum prices by
the government so that prices are unable to adjust to their
equilibrium level determined by demand and supply.
• Note that this differs from other types of government intervention
such as taxes and subsidies. Tax and subsidy results in a new
equilibrium, where there is a balance of demand with the new supply,
while price control results in a persisting market disequilibrium.
• Therefore, shortages or surpluses will emerge.
Price Ceilings
• A government may in some situation
set a legal maximum price for a Market for Corn
particular good, this is called a price P
ceiling. S

• Price ceilings are only effective when

set below the market equilibrium
price.
Pe
• Price ceilings are, for the most part,
set in order to make certain goods Pmax
considered to be necessities more D
Shortage
affordable. Qs Qe Qd Q
• Common examples are rent controls
and food price controls.
Price Ceilings
• Consequences for markets
• Shortages
• Non-price rationing
• Underground (or parallel) markets
• Underallocation of resources to the
good and allocative inefficiency
• Negative welfare impacts
• Please draw a diagram showing
the negative welfare impacts
when a price ceiling is imposed.
Price Ceilings
• Consequences for stakeholders
• Consumers partly gain and partly lose. Those who are able to buy the good at
the lower price are better off, while some consumers remain unsatisfied since
they don’t get to buy the good at all.
• Producers are worse off, as they will sell a smaller quantity of the good at a
lower price, and their revenues drop.
• Workers are also clearly worse off as some workers are likely to be
unemployed, since output fell.
• Government does not gain or lose from price ceilings, although they may gain
in political popularity among consumers.
Price Ceilings
• The diagram shows a price ceiling of
$30 that has been set for good X.
Calculate: 80
S
70
a. The shortage
60
b. The change in consumer expenditure 50
c. The change in producer revenue

P ($)
40
d. The change in consumer surplus 30
e. The change in producer surplus 20
f. Welfare loss 10
D
2 4 6 8 10 12 14

Q of X (thousands)
Price Floors
• Price floor is a minimum price set
above the equilibrium price, in Labor Market
order to provide income support Wage Labor surplus
S of labor
to farmers or to increase the (Unemployment)
wages of low-skilled workers. Wmin

• The most common examples are

minimum price on agricultural We

goods and through minimum

wage laws.
D for labor
Qd Qe Qs Q of labor
Price Floors
• Consequences for markets
• Obviously there will be surpluses in the market. A fundamental difference is
that since governments are aiming at increasing farmers’ income, it will need
to purchase the surpluses in the market.
• Government must then take measures to dispose the surplus it purchased.
Usually there are two ways of doing this – either store the surplus and bear
the cost of storage, or sell the surplus abroad at a low price.
• Firms will also become more inefficient and reliant on the government as
there is no incentive to cut cost and try to compete.
• Due to the higher price and government’s promise to purchase the surpluses,
a larger than optimum quantity will be produced, leading to over allocation of
resources to the production and thus allocative inefficiency.
• There will be negative welfare impacts, let’s use a diagram to show this.
Price Floors
• You should be able to show a few Market for Corn
P
things on this diagram: S
• What is the change in consumer
surplus and producer surplus?
• What is the change in producer
revenue?
Pe
• What is the government
expenditure of government
purchases?
• What is the welfare loss?
D
Qe Q
Price Floors
• Consequences for stakeholders
• Consumers are worse off as they must pay a higher price and will only be able to
buy a smaller quantity of the good.
• Producers gain as they receive a higher price and will sell a larger quantity, and
since the government buys up the surpluses, they increase their revenues.
• Workers are likely to gain as employment increases due to greater production of
the good.
• There will be a burden on government budget as it buys the excess supply. In
addition, there are further costs of storing the surplus or subsidizing it for export.
• Stakeholders in other countries are also affected. Even though consumers in
these countries will be able to purchase the good for cheap, producers will have
to sell at lower prices and cut back on production. This works against the
interests of less developed countries in the long-run.
Price Floors
• The diagram shows a price floor of
$50 that has been set for good Y.
Calculate: 80
S
70
a. The surplus
60
b. The change in consumer expenditure 50
c. The change in producer revenue

P ($)
40
d. The change in consumer surplus 30
e. The change in producer surplus 20
f. Welfare loss 10
D
2 4 6 8 10 12 14

Q of Y (thousands)
Price Floors
• Consequences of minimum wages for the economy
• Labor surplus and unemployment
• Illegal workers at wages below the minimum wage
• Misallocation of labor resources
• Misallocation in product markets
• Consequences of minimum wages for various stakeholders
• Firms are obviously worse off as they face higher labor costs.
• Some workers will gain since they will receive a higher wage, but some will
lose their jobs.
• Consumers are negatively affected, since the increase in labor costs leads to a
decrease in supply of products and higher prices.
In the Real World
• Economists agree that
price floors for
agricultural products are
highly inefficient, yet
they continue to be used
in many countries
because of strong
political pressure.
• In the US, this is also tied
with campaign
contributions by large
agricultural companies.
In the Real World
• Minimum wages in the real world are very controversial, as it is
questionable whether they lead to unemployment as economic
theory predicts. Sure, some unemployment is to be created if
minimum wage is set at a high level, but a large and growing number
of studies show that a minimum wage may have no effect or even a
positive effect on total employment. Labor productivity may even
increase as workers may feel more motivated due to the higher
wages.
• In fact, the 2021 Nobel prize in economics was awarded to David
Card, for his insight on minimum wage. I would recommend reading
his paper if you have the time. It would also be very helpful for
understanding how to write an Economics EE.