IB Economics ch 4 : Government Intervention


Terms in this set (...)

Indirect Taxes
an expenditure and sales tax upon goods and services - collected by sellers and passed onto governments
Excise Taxes
imposed on particular goods and services
taxes on spending on all (or most) goods and services
such as general sales taxes and value added taxes
Why governments impose indirect(excise) taxes
- Source of government revenue
- A method to discourage consumption of goods that are harmful for the individual
- Can be used to redistribute income (Tax goods that can only be afforded by high-income earners)
- Method to improve the allocation of resources by correcting negative externalities
Specific taxes
a fixed amount of tax per unit of the good or service sold
Ad valorem taxes
a fixed percentage of the price of the good or service
Market Outcomes due to the tax
Equilibrium quantity produced and consumed falls from Q* to Qt
Equilibrium price increases from P* to Pc, which is the price paid by consumers
consumer expenditure on the good is given by the price of the good per unit times the quantity of the units bought. It therefore changes from P x Q to Pc x Qt
Consequences of indirect excise taxes for various stakeholders
- Increase in price
- decrease in quantity
- worse off
- fall in price received
- fall in quantity they sell
- fall in revenue
- worse off
- Only stakeholder
- Revenue
- Lower amount of output
- Fewer workers needed: worse off
Direct Taxes
involving payment of the tax by the taxpayers directly to the government
payment from the government to an individual/firm for the purpose of increasing the purchase/supply of a good
Why do government subsidise a product?
1) Increase revenues (and hence incomes) of producers. (Agricultural products)

2) Can be used to make certain goods (necessities) affordable to low-income consumers. (Healthcare, bread)

3) Used to encourage production and consumption of particular goods and services that are believed to be desirable for consumers.

4) Used to support the growth of particular industries in an economy. (e.g. solar)

5) Can be used to encourage exports ( more competitive in global market)

6) Method to improve allocation of resources by correcting positive externalities.
Market Outcomes for Subsidy
1) Equilibrium quantity produced and consumed increases
2)Equilibrium price falls (P* to Pc)
3)Price received by producers increase to Pp
4) Amount of the subsidy is given by (Pp - Pc) x Qsb : government spending
5) Overallocation of resources to the production of the good: Qsb is greater than the free market quantity
Consequences of Subsidies for various stakeholders
- Fall in price of the good
- Increase in quantity purchased
- Better off

- Higher price (Pp>P*)
- Larger quantity
- Increased revenue (Pp x Qsb) : better off

- Burden on budget
- Reduce expenditure elsewhere / raise taxes

- Output expands
- Likely to hire more workers: better off

- Overallocation of resources to the production of the good (Qsb > Q*)

Foreign Producers:
- If exports, lowers price and increases the quantity of exports
- Negative for producer of other countries: have to compete
Why Subsidies?
Economic and Social Justifications for Subsidies
1) To keep prices down and control inflation. (In the last couple of years countries have been offering fuel subsidies in the wake of the steep increase in world crude oil prices
2) To encourage consumption of merit goods and services which are said to generate positive externalities (increased social benefits) such as subsidies for investment in environmental goods and services
3) Slow-down the process of long term decline in an industry
Evaluation Arguments
1) Are the subsidies effective in meeting their aims?
- Will they achieve the desired stimulus to demand / consumption?
- Is a subsidy sufficient? Might other incentives be needed?

2) Will a subsidy affect productivity / Efficiency?
Subsidies for investment and research can bring positive spillovers.
But firms may be dependant on the financial assistance or loss incentive to reach productive efficiency. (Solar subsidies).

3)Does the subsidy help to correct a market failure?
- Is employment higher with child care subsidies?
- Does a subsidy lead to undesired unintended consequences?
Price controls
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.
Price controls result in market disequilibrium, and therefore in shortages (excess demand) or surpluses (excess supply).
Price Ceiling
- maximum legally allowable price for a good, set by a government below the equilibrium price
to make basic goods and services more affordable
Market Outcomes
1) Lower quantity supplied and sold
2) Larger quantity demanded than at the equilibrium price
3) Does not allow market to clear: disequilibrium, shortage, excess demand
Shortages (Effects of price ceilings)
Producers produce less because they get paid less, Consumers want more because the price is lower, hence there is a shortage of the good (Q(D)-Q(S)=shortage)
Not all interested buyers who are willing and able to buy the good are able to do so
Non-price Rationing (Effects of price ceilings)
In a free market, goods are divided up among users by the price mechanism. Once a shortage arises, the prise mechanism is no longer able to achieve its rationing function. Rationing is achieved through
- First come first served
- Coupons / Vouchers
- Favouritism
Informal/Black market (Effects of price ceilings)
At Qs the demand curve rises higher than P(c) or P(E) showing that some consumers have a strong incentive to pay more to consume the good (informally/ on the black market).
Dissatisfied people are willing to pay more than the ceiling price to get the good: inequitable, and frustrate the objective sought by the price ceiling.
Decreased market size (Effects of price ceilings)
At the low maximum price, producers will produce less which means they have lesser goods to sell and gain consumers resulting in market shrink
Under allocation of resources (Effects of price ceilings)
Lower than Pe price results in a lower Qs than Q*, there are too few resources allocated to the production of the good, resulting in an underproduction relative to the social optimum. Society worse off
Negative Welfare impacts
Qs< Qe There is welfare loss(See diagrams), representing benefits that are lost to society because of resource misallocation
Allocative inefficiency: MB > MC at the point of production: Qs: the benefit that consumers receive from the last unit of the good they buy is greater than the marginal cost of producing it.
Consequences of price ceilings taxes for various stakeholders
- Lost area b, gained area c
- loss area c +d
- revenue drop from Pe x Qe to Pc x Qs
- Fall in output: unemployment
- No gains or losses. Maybe political popularity
Examples of Price ceilings
1) Rent control
2)Food price control
Food price control (Examples of price ceiling)
- Lower food prices and greater affordability
- Food shortages as quantity demanded is greater than quantity supplied
- Non-price rationing methods (such as queues) to deal with shortages
- development of underground markets
- Falling farmer incomes due to lower revenues
- more unemployment in the agricultural sector
- misallocation of resources
- possible greater popularity for the government among consumers who benefit.
Rent controls (Examples of price ceiling)
- Housing become more affordable to low-income learners
- A shortage of housing, as the quantity of housing demanded at the legally maximum rent is greater than the quantity available.
- A smaller quantity of housing at the legally maximum rent than at the free market, since owners of housing supply a smaller quantity
- Long waiting lists of interested tenants waiting for their turn to secure an apartment/flat
- a market for rented units where tenants sublet their apartments at rents above the legal maximum (an underground market)
- run-down and poorly maintained rental housing because it is unprofitable for landlords to maintain or renovate their rental units since low rents results in low revenues.
Price floor
minimum legally allowable price for a good, set by a government above the equilibrium price

- because governments may believe the good is important/ necessary, or it maybe supporting employment in a particular industry.
1)Provide income support for farmers.
2)Protect low-skilled, low-waged workers
Why a price support is imposed
(agricultural products)
Income too;
- unstable (low PED and low PES)
- low
Impacts of price floors on market outcomes
(agricultural products, price supports)
Larger Qs than Qe, Smaller Qe than Qe. (Qs - Qd. )
Government can: a) Store it. b)Export it c)Use as aid
All problematic
Impacts of price floors on market outcomes
Firm Inefficiency
Higher than equilibrium product prices can lead to inefficient production. Firms do not face incentives to cut costs by using more efficient production methods, because the high price offers them protection against lower-cost competitors.
Impacts of price floors on market outcomes
Overallocation of resources to the production of the good and allocative inefficiency
Too many resources are allocated to the production of the good, resulting in a larger than optimum quantity produced. Qs is produced where optimum is Qe
Negative Welfare Impacts
Consumer surplus:
lost b +c
Producer surplus:
gained b+c+f
Increase in output
Government paid: Pf (Qs - Qd)
All this area except f is welfare loss, due to allocative inefficiency caused by overallocation of resources to the production of the good. This is also shown by MB < MC at the point of production, Qs, indicating that the society would be better off if less of the good were produced.
Stakeholders in other countries:
Countries that do not have price floors are forced to sell their agricultural products at low world prices. The low prices in these countries signal to local farmers that they should cut back on their production, resulting in an under allocation go resources to these products.
Minimum wage objective
guarantee an adequate income to low-income workers, who tend to e mostly unskilled.
Minimum wage Impacts
Lies above equilibrium wage. The market does not clear
Labour Surplus & unemployment
Minimum wage Impacts
Labour Surplus & Unemployment
Creates a surplus of labour = Qs-Qd : unemployment, due to: a) decrease in quantity of labour demanded by firms, b)increase in quantity of labour supplied, because higher wage makes work more attractive, causing a movement up the labour supply curve
Minimum wage Impacts
Illegal workers at wages below the minimum wage
often illegal immigrants who may be willing to supply their labour at very low wages
Minimum wage Impacts
Misallocation of labour resources
Prevents the market from establishing a market-clewing of labour. Changes the signal and incentive for unskilled labour, whose wage is affected by the price floor. Therefore, industries the rely heavily on unskilled workers are more likely to be affected, and will hire less unskilled labour
Minimum wage Impacts
Misallocation in product markets
Firms relying heavily on unskilled workers experience and increase in their costs of production, leading to a leftward shift in their product supply serve, resulting in smaller quantities of output produced.
Misallocation of labour resources lead to misallocation in product markets
Negative welfare impacts
Employer surplus: (Firms)
lost area b+c
worse off.
Worker surplus:
Lost, e, gained b
Receive a higher wage than previously (Wm >We), but some lose as they lose their job (Qd<Qd) Because minimum wage leads to additional unemployment
negatively affected; increase in labour costs leads to a decrease in supply of products (leftward shift in firm supply curves) --> Higher product prices and lower quantities
Loss of social surplus: c+e : deadweight loses, which arises because there is an under allocation of labour resources relative to the social optimum, since Qd < Qe