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AS Level Economics 9708

3. Government microeconomic intervention

Written by: Adhulan Rajkamal
Formatted by: Adhulan Rajkamal

Index

3.1 Reasons for government intervention in markets
3.2 Methods and effects of government intervention in markets
3.3 Addressing income and wealth inequality

3.1 Reasons for government intervention in markets

Market failure

  • When the free market does not allocate scarce resources efficiently
  • The price mechanism fails when it overlooks some costs and benefits involved in producing or consuming a product
  • Markets are imperfect due to:
    • Inefficient production
    • Consumers not having perfect information → to make informed choices
  • Situation of market failure:
    • Underprovision of public goods
    • Underproduction of merit goods
    • Overconsumption of demerit goods
    • Information failure

Addressing the non-provision of public goods

  • Public goods include: police force, national defense, fire protection, street lights, non-toll roads, flood control systems
  • Non-excludable and non-rival
  • Free rider problem → People can enjoy the use of a public good without contributing towards its cost

🔥 Lighthouse

A lighthouse clearly satisfies both conditions for public goods (non-rival and non-excludable), hence can be included in examples

Addressing the overconsumption of demerit goods

  • Demerit goods are considered undesirable for consumers
  • They are overprovided, therefore over consumed in the free market
  • Main reason → Consumers invariably lack full and proper information on demerit goods
  • Government intervention:
    • Banning smoking in public places
    • Manufacturer may be required to put written warnings and graphic photographs that explain the danger on packaging
  • Government may lose tax with reduced sales of demerit goods (Eg: Tobacco) – however it can make savings in the healthcare budget and improve productivity of the workforce

Addressing the under consumption of merit goods

  • Merit goods are more beneficial to society than the society may realise
  • This is the result of information failure → Consumers do not fully understand the benefit of merit goods
  • When provided by the private sector, the supply of merit goods is insufficient to meet societal needs → Access is restricted to those who can afford to pay
    • The private sector only supplies OX at an average price of p
    • The required quantity is OY (after considering its additional benefits)
    • Government decides to supply the underproduction of OY-OX (government may or may not take over production fully)

Controlling prices in markets

  • Government set maximum prices (to be effective, the maximum price must be below equilibrium price)
  • Example: Rent controls to provide affordable housing → Also used to attract key workers like doctors and teachers to areas where there are shortages due to high cost of housing
  • Government set minimum prices (to be effective → must be above equilibrium price)
    • Primarily to protect the agriculture industry and food suppliers
    • Prices and farmer’s incomes are unpredictable due to uncertain conditions → minimum price to provide farmers security
  • Min and max prices may distort markets → Inefficient allocation of resources

3.2 Methods and effects of government intervention in markets

Indirect taxes

  • Ad Valorem Taxes
    • “Ad valorem” means “according to value” in Latin. These taxes are calculated as a percentage of the price of a good or service
    • Examples: Value-Added Tax (VAT), Goods and Services Tax (GST), and sales taxes
    • How it works:
      • If a product costs $100 and the VAT is 10%, the tax is $10. If the price increases to $200, the tax becomes $20.
      • This means the tax rises with the price of the good or service, making it proportional to the value
    • Advantages:
      • Equity: People who buy expensive goods pay more tax
      • Automatic adjustment for inflation: As prices rise due to inflation, tax revenue also increases without changing the tax rate
    • Disadvantages:
      • Price sensitivity: If prices fluctuate (e.g., luxury goods or volatile markets), tax revenue can be unpredictable
      • Regressive effects: Although the tax seems fair because it’s proportional, poorer consumers still spend a larger portion of their income on taxed goods than wealthier individuals
    • Usage in Practice:
      • Some countries include ad valorem taxes in the published price (e.g., the shelf price of a product in Europe often includes VAT)
      • In other cases, such as in the US, ad valorem taxes like sales tax are added at checkout, so they are not visible until payment
  • Specific taxes
    • A specific tax is a fixed amount charged per unit of a good, regardless of its price
    • Examples: Excise duties on alcohol, cigarettes, and fuel
    • How it works:
      • Imagine a fuel tax of $1 per litre. Whether the price of fuel is $1 or $10 per litre, the tax remains a constant $1 per litre
      • The tax is based on a measurable quantity (e.g., litres, kilograms, or packs) rather than value
    • Advantages:
      • Predictability: Since the tax is fixed per unit, governments can estimate tax revenue more easily based on quantities sold.
      • Encourages reduction of harmful consumption: Fixed taxes on goods like tobacco or fuel act as a deterrent to consumption because they directly increase costs
    • Disadvantages:
      • Not inflation-proof: As prices rise due to inflation, the real value of the tax (what it can buy) decreases unless the government revises the tax rate
      • Regressive impact: Like ad valorem taxes, specific taxes can disproportionately burden lower-income groups because they consume necessities like fuel that are taxed
    • Usage in Practice:
      • Governments often use specific taxes for goods with measurable units to ensure easier collection and enforcement
Feature Ad Valorem Taxes Specific Taxes
Basis of Taxation % of the price Fixed amount per unit
Impact on Price Rises as price increases Independent of the price
Inflation Effect Automatically adjusts with inflation Needs to be revised periodically
Revenue Stability Uncertain (affected by price fluctuations) Stable (depends on quantity sold)

Impact and incidence of specific indirect taxes

  • Incidence → The extent to which the tax burden is borne by the consumer or the producer or both
  • Specific indirect taxes → Technically imposed on the producer but passed onto consumers through increased prices
  • The effect of imposing a specific tax:
    • Supply curve shifts up by the amount of tax imposed (Refer second figure)
    • The incidence of the specific tax:
      • Area A → Consumer incidence
      • Area B → Producer incidence
    • Producer now receives only P2 and the consumer pays  P1 → 
      • P1 – P2 = Per unit tax
      • Q1 (P1 – P2) = Total tax revenue
    • DWL (Deadweight Loss): The total societal welfare lost due to the tax, as it disrupts market equilibrium and reduces benefits for consumers and producers
    • Note the change in consumer and producer surplus
  • The incidence, change in consumer and producer surplus, magnitude of DWL depends on the price elasticity of supply and demand:
  • Figure a → Elastic supply – inelastic demand
  • Figure b → Inelastic supply – elastic demand

The impact and incidence of subsidies

  • Direct payments made by governments to producers
  • Reasons for providing subsidies:
    • Keep down market prices for essential goods
    • Encourage consumption of merit goods
    • Provide services that would not be provided by the free market
    • To raise producers’ income – especially farmers
    • Protectionism
  • Has the opposite effect of an indirect tax → Cost of production falls → Supply increases
  • Incidence of a subsidy:

Evaluating subsidies

  • Food Subsidies: Staples like rice, bread, and cooking oil are subsidized in lower-income countries to support the poorest. However, this can lead to:
    • Unnecessary benefits for wealthier groups
    • Potential shortages due to increased demand
    • Inefficiency among producers, as subsidies reduce incentives for improvement
    • Risks of misusing the funds
  • Public Transport Subsidies: Public transport is subsidized globally, particularly in urban areas, to:
    • Enhance access to jobs for low-income earners
    • Promote social mobility for the elderly
    • Reduce road congestion and environmental harm

The direct provision of goods and services

  • Governments provide certain important services free of charge (funded by tax) → If used equally by all citizens then lowest income group gain most (as % of their income)
    • Eg: Merit goods (healthcare and education), Public goods

Maximum prices

  • Price of a good is too high in the market → Market failure
  • Government imposes maximum price to correct the market failure (only effective if maximum price is below equilibrium price)
    • To assist low income groups
    • To promote consumption of an under consumed good (eg: merit goods)
  • Shortage of Q2 – Q1
    • Consumers who had bought at P are now better off; others are not, since product is not available
  • Since price cannot rise → the available supply has to be allocated in some other way
    • Queuing (a common method in former planned economies) → allocating goods or services on a first-come, first-served basis
      • Wastes time for consumers
    • Rationing → involves distributing a fixed amount of goods to each consumer, often through coupons or quotas, to restrict demand and ensure fair access
      • May lead to black markets, as some consumers are willing to pay more for more than their share
  • Trade-off of maximum price → Free market is distorted and may not bring full benefits that might be expected

Minimum prices

  • Price of a good too low and over consumed in the market → market failure
  • Gov. imposes min price to correct market failure (only effective if above equilibrium price)
  • Examples:
    • Demerit goods such as high-sugar sports drink
    • Agricultural products
    • Wages in certain occupations (usually low skilled) to avoid exploitation of workers
    • Certain types of imported goods where close substitutes are produced locally (protectionism)
  • Excess supply of Q2 – Q1
    • Since price cannot fall → supply is restricted (a lower qty. is therefore traded)
    • In agricultural markets (which usually have inelastic supply) → government may purchase the excess supply at the min. price
      • A good, living income for farmers
      • Government may store agricultural produce to improve food security (resupply into the market during a shortage)
  • Risks of minimum price:
    • May lead to inefficient production → Firms with high costs of production have little incentive to reduce costs since the minimum price protects them from lower-cost competitors
    • Danger of informal market → Consumers will be willing to obtain products at lower price to the regulated minimum price

Buffer stock schemes

  • Prices in the agriculture market can be volatile → due to drastic changes in supply throughout the year
  • A buffer stock scheme involves the government or an agency buying and storing surplus goods when production is high (and prices are low) and releasing them into the market when production is low (and prices are high). This helps stabilize prices
  • Why are buffer stock schemes used:
    • Price Stability: Prevents extreme fluctuations in the price of goods, which can harm producers and consumers
    • Producer Protection: Ensures farmers or producers receive a fair price, even during times of surplus
    • Consumer Protection: Ensures consumers can access essential goods at affordable prices during shortages
  • How does a buffer stock scheme work:
    • During Surplus (Excess Supply):
      • When there is a good harvest or high production, prices may drop.
      • The government or agency buys the surplus at a guaranteed minimum price (price floor) to prevent prices from falling below a certain level.
      • The surplus is stored in warehouses.
    • During Shortage (Excess Demand):
      • In case of poor harvests or low production, prices may rise sharply.
      • The agency releases the stored goods into the market at a maximum price (price ceiling) to prevent prices from rising too high.
  • Disadvantages
    • High Costs: Storing surplus goods and maintaining warehouses can be expensive.
    • Perishability: Some goods (like fruits) cannot be stored for long without spoiling.
    • Market Distortions: Interference in the market mechanism can lead to inefficiencies in resource allocation.
  • Real world example → Food Corporation of India (FCI): Maintains buffer stocks of rice and wheat to stabilize prices and ensure food security

Provision of information

  • Information failure → under consumption of merit goods and over consumption of demerit goods 
  • Examples:
    • Compulsory information on cigarette packets warning the dangers of smoking
    • Public health announcements and campaigns (eg: COVID-19 advertisements and campaigns on vaccination)
    • Nutrition and allergy information on food packaging
    • Advice on non-prescription medicines

3.3 Addressing income and wealth inequality

  • Income → Reward for the services of a factor of production.
    • It is a flow concept → Returns to the various factors of production is variable over any given period time
  • Wealth → Stock of assets built up over time
    • Eg: Businesses, property, shares, gold, etc.
    • These assets provide security, and some cases – an income stream in the future

Gini coefficient

  • Gini coefficient → Numerical measure of the extent of income inequality in an economy
  • If the income distribution in an economy is equal → Gini coefficient = 0
  • If all income accrues to just one person → Gini coefficient = 1

Economic reasons for inequality of income and wealth

  • Inequality of income and wealth → barrier to economic growth
  • Reasons for wealth and income inequality:
    • Lack of formal employment opportunities → Forces individuals into low-paying informal jobs, widening the income gap
    • Lack of investment in education and healthcare → Restricts opportunities for the poor to improve productivity and income potential
    • Poor infrastructure → Hinders economic activity and access to markets, disproportionately affecting low-income groups
    • Lack of credit → Prevents the poor from starting businesses or investing in education, perpetuating inequality
    • Tax policies and government redistribution → Regressive tax systems or weak redistribution mechanisms fail to reduce income and wealth disparities

Policies to redistribute income and wealth

  • Collection of taxes very difficult in low-income and middle-income economies where informal economy is huge → Only a very small % of population pay direct taxes
    • Corruption and tax evasion is also common

Minimum wage rates

  • Minimum wage rate → Legal requirement of what employers must pay an employee per hour (rate before tax and social deductions are made)
  • Disadvantages of minimum wage rates:
    • In low and middle-income economies legislation might only a small proportion of poorly paid workers → many poorly paid workers are employed in the large informal sector
    • The regulation has no relevance where workers are self-employed or run small businesses staffed by family members
    • Might lead to unemployment with reduced demand for labour
      • People willing to work Q2; people employed Q1 → unemployment = Q2 – Q1

Transfer payments

  • Transfer payments → Payment from tax revenue that is received by certain members of the community (usually vulnerable groups)
  • Payment is not made through the market, as no production take place (payment made for non-productive purpose)
  • Transfers income from those able to work and pay tax to those unable to work or need assistance
  • Examples: Old age pensions; unemployment benefits; housing allowances; food coupons; child benefits
  • Limitations:
    • May act as a disincentive to work
    • Extent to which these transfer payments can be paid depends on tax collected (low in low and middle-income economies)
    • Coverage is limited to the formal sector – the large informal sector may not receive transfer payments

Progressive income taxes, inheritance and capital taxes

  • Progressive income tax → addresses income inequality
  • Limitations of progressive income tax:
    • May act as a disincentive to work more
    • People may emigrate to countries with a more favourable tax regime
  • Inheritance tax and capital tax → addresses wealth inequality
  • Inheritance tax → A progressive tax on inheritance or gift
  • Capital tax → Tax payable on the financial gain of a person (paid on the difference between the buying and selling price of an asset)

State provision of essential goods and services

  • Providing important goods and services (financed by tax) → If all citizens use it equally, lowest incomes gain most as a percentage of their income
  • Examples → Healthcare and education
    • Justification for providing this is not solely on market failure but also equity
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