Government Intervention (Microeconomics)

Indirect taxation

Indirect taxation is a tax on expenditure to buy goods and services and it raises the cost of production and thereby reduces the supply of the good or service

Purpose

reduce the quantity consumed by increasing the price of the good (especially for socially undesirable goods)

Impact of taxes

On prices

Types of indirect tax

Specific tax

Ad-valorem tax

fixed amount of tax levied per unit of output sold

causes a parallel leftward shift of the SS curve. Because:

  • Producers will now receive the market amount less the amount of tax
  • In order to supply the same amount of the good, they have to charge a higher price (causing an upward shift of the SS curve, Eq is lowered and Ep is increased)
  • if the demand for the good is relatively more price inelastic, then the total tax revenue collected is greater

amount of tax on a certain percentage of the price or value of the good sold

When imposed:

  • the producers will receive the market amount less the amount of tax
  • In order to supply the same amount, producers have to charge a higher price (pivoted leftward shift of the SS curve, Eq is lowered, Ep is increased)
  • if demand is more price inelastic, then the total tax revenue collected will be greater

On output

on consumer and producer surplus

on tax incidence (distribution of tax burden)

Prices will rise when a tax is imposed

The extent of the rise in price depends on PED. (if PED < 1, then the extent of increase in price will be greater, if PED > 1, then the extent of increase in price will be smaller)

Output will always fall when a tax is imposed

The extent of decrease in output depends on PED and PES (if PED < 1, then the extent of fall in Qdd is smaller, if the PED > 1, then the extent of increase of Qdd is greater)

CS and PS will be reduced, part of which is transformed to government revenue (tax revenue), and the other part as deadweight / welfare loss (result of the under-allocation of resources in the production of the good)

Generally, the less responsive party experiences a greater burden of the tax (burden of the tax fall proportionately more on the group whose activities are less responsive to a change in price)

PED < 1, consumers experience a greater burden of the tax; PED > 1, producers experience a greater burden of the tax

Subsidies

Definition

Purpose

To guarantee supply of goods and services that the government deems to be necessary for the economy

To enable firms to compete with foreign / overseas trade and hence protect the home industry

To lower prices of essential goods and services for consumers in order to increase the consumption of such goods and services

Impact of subsidies

On "incidence of subsidies"

Welfare effect of subsidies

On consumer expenditure and producer revenue

amount of money that is paid from the government to firms, per unit of output, to encourage production and lower prices for consumers

When subsidies are given, the cost of supplying the good reduces (SS curve shifts vertically downwards by the full amount of subsidies, Ep falls and Eq rises)

The cost of the subsidies to the government is smaller when the good has price inelastic demand

The producer revenue will rise, and when PED > 1, the extent of rise in PR will be greater

Whether consumer expenditure falls or not depends on PED (PED > 1, CE will rise (more than proportionate rise in Qdd))

PS and CS will both rise when a subsidies is granted, this is because:

  • PS: producers receive an amount for the good, that is greater than the equilibrium price, hence, the PS rises
  • CS: consumers pay an amount for the good, that is less than the equilibrium price, hence, the CS rises

However, the government expenditure on the subsidies could have been spent elsewhere in society, and thus the social losses due to government expenditure is greater than the gain in PS and CS --> deadweight loss (due to the over-allocation of resources to produce a more than optimum quantity of the good)

When PED > 1, a greater amount of the subsidies is given to the producers as compared to the consumers

When PED < 1, a greater amount of the subsidies is given to the consumers as compared to the producers

Price intervention (Price Ceiling)

Definition

Purpose

Effects

Managing impacts

legally established maximum price and producers can only sell at or below the upper limit (only effective if it is set below Ep)

To prevent producers from exploiting consumers by charging exorbitant prices during times of shortage

To prevent or discourage the production of some goods and thus freeing up resources for other uses (government may want to shift resources out of some industries to the production of other goods)

To keep prices of essential goods at affordable levels for low incomed consumers, thereby making the access to such goods more equitable (fair)

Welfare lost

Black market

Producer revenue

Prices of goods will fall and quantity exchanged will also fall (producer are only willing to supply a smaller quantity although consumers demand for a larger quantity). Hence, the total revenue of producers will fall due to the persistent shortage (prevented from readjusting -- extent of shortage depends on PED, PED > 1, shortage is greater)

A deadweight lost is formed due to the under-allocation of resources to the production of the good (lower than optimum quantity of output is produced). CS rises and PS falls

The persistent shortage can lead to the formation of underground parallel markets (black markets -- goods are sold illegally at prices above the upper limit)

This is because unsatisfied buyers will be willing to pay a higher price to obtain the good (profits can be made by black marketeers who buy at the controlled price and resell the goods at the maximum possible price consumers are willing to pay)

the problem of black markets is worser the more price inelastic the demand because consumers are willing to pay an even higher price

First come first serve

Seller preference

Random allocation

Government rationing

(most equitable out of the 4) Government can distribute sufficient coupons to match the available supplies, and the coupons can be distributed based on age, family income, family size or other criterions

Goods are distributed at random to various individuals

Waitlist or long queues may form as people have to queue up to get the good, and latecomers will not be able to buy any of the good

Sellers can choose to whom to sell the good to (tie in sales, to close friends and family, under the counter sales) --> biased

Price intervention (Price Floor)

Definition

Legally established minimum price, and when imposed sellers can only sell at or above the lower limit (only effective if set above Ep)

Purpose

To ensure minimum wages for workers and thus prevent exploitation by employers (low E.wages is considered to be inequitable and unfair to workers)

To discourage the consumption of socially undesirable / demerit goods

To support the prices of goods and hence the income of producers at a much higher level than what is possible at Ep

Effects

Managing impacts

Diverted to other markets

Dumped

Bought by government

Destroyed

Welfare effect

Producer revenue

Price of the good increases while the quantity of the good falls

Assuming government did not buy up the surplus, the effect on PR depends on PED (PED < 1, then PR will rise)

Permanent surplus arises as the market is not allowed to readjust (extent of surplus depends on the PED, PED > 1, then resultant surplus is greater)

A greater supply of the good that would be generated in the free market is produced, which leads to a welfare loss due to the over-allocation of resources to the production of the good (government expenditure to maintain the price floor, assuming government buys up the surplus, could have been used for other things)

PS rises and CS falls

The government can buy up the surplus, but this is only feasible should the good be non-perishable, however, storing is expensive

For example, a milk surplus can be diverted to cheese production

The surplus can be dumped in other countries (when a firm sells abroad at a price below the average cost or marginal COP or domestic price). however, this often cause angry reactions from foreign governments as the dumped products can harm the domestic industries

The surplus can be destroyed, however, this is deemed to be wasteful