2.7.2 Main forms of government intervention in markets Notes

1. Governments intervene in markets using different methods to influence demand and supply, thereby shaping market outcomes.
2. The main forms of government intervention are:
   1. Price controls:
      1. Price ceilings.
      2. Price floors.
   2. Indirect taxes and subsidies
   3. Direct provision of services
   4. Command and control regulation and legislation
   5. Consumer nudges (HL only)

Price controls: price ceilings (maximum prices) and price floors (minimum prices)

1. Governments set price controls to not allow markets to reach their natural equilibrium.
2. By setting price controls, governments force disequilibrium in the market, thus creating:
   1. Shortages (excess demand)
   2. Surpluses (excess supply)

Price ceilings (maximum prices)

1. The imposition of a price ceiling ensures that the price at which sellers are allowed to sell a good cannot exceed the maximum price set by the ceiling.
2. This government-imposed limit prevents prices from rising above a specific level for the good or service in question.

1. As it can be seen in Figure 1, at the initial equilibrium price ($P_1$) there is a quantity of $Q_1$ bread demanded. After the price ceiling ($P_{ceiling}$) is imposed:
   1. The quantity demanded increases to $Q_3$, while the quantity supplied decreases to $Q_2$.
   2. Meaning that the market demand is higher than the market supply, hence a shortage of $Q_3-Q_2$.

As it can be seen in Figure 2:

1. Before the price ceiling:
   1. Consumer surplus = $a+d$
   2. Producer surplus = $b+c+e$
2. After the price ceiling
   1. Consumer surplus = $a+b$
   2. Producer surplus = $c$

Therefore there is a welfare loss (WL) of the areas $d+e$.

1. This is the amount of social welfare (surplus) lost due to resource misallocation arising from the price ceiling.
2. Remember allocative efficiency is achieved when Marginal benefits (MB) = Marginal Costs (MC).

Calculating the welfare impacts of price ceilings (HL only)

In order to calculate the change in welfare impacts due to price ceiling, we need to look at Figure 3:

Looking at Figure 3 we can see that that the equilibrium price ($P_e$) and quantity ($Q_e$) are both equal to 6. Using the information in Figure 3 we can calculate:

1. Consumer expenditure
   1. Consumer expenditure is equal to the number of units purchased ($Q_e$) multiplied by the price per unit paid ($P_e$).
      1. So at equilibrium the consumer expenditure is $6 \times 6=36$
      2. After the price ceiling the consumer expenditure is $4 \times 4=16$
2. Producer revenue
   1. Producer revenue is equal to consumer expenditure
      1. So at equilibrium producer revenue is $36\$$.
      2. After price ceiling producer revenue is $16\$$.
3. Consumer surplus (CS)
   1. Consumer surplus is represented by the area below demand curve, and above the price paid (up to the quantity purchased).
      1. So at equilibrium $CS = a+d = \frac{(10 - 6) \times 6}{2} = 12\$$
      2. After price ceiling $CS = a+b = \frac{((8 - 4) \times 4) + ((10 - 8) \times 4)}{2} = 20\$$
4. Producer surplus (PS)
   1. Producer surplus is represented by the area above the supply curve, and below the price received by the producers.
      1. So at equilibrium $PS = b+c+e = \frac{((6 - 2) \times 6)}{2} = 12\$$
      2. After the price ceiling $PS = c = \frac{((4 - 2) \times 4)}{2} = 4\$$
5. Welfare loss(WL)
   1. Welfare loss is equal to the difference between social surplus before and after the price control. In Figure 3, this is the area marked $WL$.
      1. $WL = d+e = \frac{((8 - 4) \times (6 - 4))}{2} = 4\$$

Price floors (minimum prices)

1. The imposition of a price floor ensures that the price at which sellers are allowed to sell a good cannot fall below the minimum price set by the floor.
2. This government-imposed limit prevents prices from dropping below a specific level for the good or service in question.

1. As it can be seen in Figure 4, at the initial equilibrium price ($P_e$) there is a quantity $Q_e$ being demanded.
2. After the price floor ($P_{floor}$) is imposed:
   1. The quantity demanded decreases to $Q_d$, while the quantity supplied increases to $Q_s$.
   2. This creates a situation where the market supply is higher than the market demand, hence a surplus of $Q_s-Q_d$.
3. This spare surplus that consumers are not willing and able to buy is then bought by the government. Then, the government either:
   1. Stores the surplus.
   2. Exports the surplus.
4. When the government buys the excess supply, the demand for the good/service increases, shifting the demand curve to the right ($D → D_{gov}$).

The welfare impacts of price floors

In order to calculate the change in welfare impacts due to price ceiling, we need to look at Figure 6:

As we can see in the diagram:

1. Before the price floor:
   1. Consumer surplus= $a+b+c$.
   2. Producer surplus= $d+e$.
2. After the price floor:
   1. Consumer surplus loses areas $b+c$.
      1. Therefore, new Consumer surplus = $a$
   2. Producer surplus gains areas $b+c+f$.
      1. Therefore, new Producer surplus = $d+e+b+c+f$.
   3. The government pays for the excess supply, which equals to the price per unit times the surplus amount, hence $P_f \times (Q_s-Q_d)$.
   4. To buy the surplus, the government uses the money collected from tax revenue, which has an opportunity cost for other uses in society.
   5. Therefore all the money spent by the government ($P_f \times (Q_s-Q_d)$) translates into welfare loss.
   6. However, while government spending loses area $f$ to society, this area $f$ is gained by producers' surplus.
   7. Therefore, the welfare loss ($WL$) after the price floor is represented by the areas $c+e+g$.
      1. Welfare loss = $c+e+g$.

Indirect Taxes

1. The imposition of an indirect tax increases the price of a good or service paid by consumers.
2. Hence, governments impose indirect taxes to influence the consumption of a good or service.
3. Additionally, imposing indirect taxes benefits the government by generating revenue from the tax collection.
4. However, while the tax is levied on consumers, the producers are the ones who collect and pay it.
5. As a result, indirect taxes have the primarily effect of increasing the costs of production, and hence shifting the supply curve to the left.

Figure 6 represents an imposition of a specific tax on a market:

1. As can be seen, at the initial equilibrium price ($P_e$) a quantity of $Q_e$ is demanded.
2. When the specific tax is imposed:
   1. The supply curve shifts upwards from $S$ to $S_{+tax}$.
   2. With this new supply curve ($S_{+tax}$), a new equilibrium is stablished at the intersection of $S_{+tax}$ and $D$ ($P_c,Q_{ tax }$).
   3. Therefore, the quantity demanded decreases from $Q_e \text{ to } Q_{tax}$.
   4. Additionally, the price ($P_c$) is the price consumers pay for the good or service.
   5. However, in this price ($P_c$), there is the tax included. Therefore, the price producers receive, after paying the tax to the government, is $P_p = P_c - tax$.
   6. As a result of the tax, a new equilibrium is reached where less cigarettes are being consumed, and at a higher price.

Figure 7 represents an imposition of an ad-valorem tax on a market:

1. As can be seen, at the initial equilibrium price ($P_e$) a quantity of $Q_e$ is demanded. When the ad-valorem tax is imposed:
   1. The supply curve shifts upwards from $S$ to $S_{+tax}$.
   2. The supply curve becomes more upward-slopping. This is because the ad-valorem tax is a fixed percentage of the price, and therefore the higher the price, the higher the amount of tax paid.
   3. Ultimately, as a result of the ad-valorem tax, there is also a new equilibrium reached where less cigarettes are being consumed, and at a higher price.

Impacts of indirect tax on stakeholders

Figure 8 above showcases the different effect that an indirect tax will have on different stakeholders:

1. Consumers: consumers pay higher price ($P_c$), then they would have paid in the original equilibrium ($P_e$), since ($P_c>P_e$)
2. Producers: producer receive lower price ($P_p$), then they would have received in the original equilibrium ($P_e$), since ($P_p<P_e$).
3. Government: the government earns tax revenue equal to the area $(P_c-P_p) \times Q_{tax}$
4. Society: society is worse off as a whole, since there is a welfare loss of area $WL$.

Subsidies

1. The provision of a subsidy decreases the production costs of producers, and the price paid by consumers.
2. Hence, governments offer subsidies to encourage production or consumption of a specific good or service.
3. Since subsidies are directly provided to producers by the government, and they have the primary effect of decreasing the costs of production, the result is a supply curve shift to the right.

Governments provide subsidies for multiple reasons:

1. To make certain goods more accessible for lower income households: by providing a subsidy, the government increases the price received by the producers, hence allowing them to charge a lower price for their good/service.
2. Encourage the production of a certain good/service: if there are any goods that a government may find that is desirable for the economy, it may provide subsidies to increase its production.
3. Encourage exports: governments may provide subsidies to domestic firms to increase the export of a certain good.
4. Support the growth of certain industries in economy: the government may want to develop a specific industry in the economy, hence subsidies are one way to encourage that growth.

The effect a subsidy has in the market of a good or service is depicted below by Figure 10:

1. In Figure 10, it can be seen that at the original market equilibrium, there is a price $P_e$ and quantity produced of $Q_e$.
2. However after the introduction of the subsidy:
   1. The supply of the good increases from $S \text{ to } S_{sub}$.
   2. At this level a quantity of $Q_{sub}$ is being produced and demanded.
   3. Consumers pay price $P_c$.
   4. Producers receive price $P_p$.
3. The the amount of subsidy paid by the government equals to the area $(P_p-P_c) \times Q_{sub}$.

The welfare impacts of subsidies

Figure 10 shows the welfare impact of a subsidy.

1. Both consumers and producers gain in surplus, as:
   1. Producers: receive higher price than in equilibrium ($P_p$).
   2. Consumers: pay a lower price than in equilibrium ($P_c$).
2. However, there is still a welfare loss (equal to area $WL$), because:
   1. The government spending in area $WL$ does not translate to any gains in social surplus.

Direct provision of services

Sometimes governments may decide to directly provide a certain good/service to the public themselves because:

1. The private firms failed to meet the market needs and caused market failure (subtopic 2.8).
2. Make sure that the provided good/service is affordable and everyone has easy access to it (healthcare, education, water...).
3. Keep the quality high to ensure public welfare (transportation, COVID masks...).

Command and control regulation and legislation

1. Command and control regulation and legislation includes the use of laws, and government regulations to affect the market outcomes.
2. The use of laws and regulations can help to:
   1. Solve the inefficiencies caused due to the fail of voluntary compliances.
   2. Can quickly reduce risks to public welfare.

However, there are some disadvantages to command and control regulation:

1. The establishment of new laws and regulation can take a while to be approved.
2. Government has to dedicate resources to make sure that economic entities follow these regulations.
3. these resources may require extra time and money, which has to be compensated from tax revenue which has high opportunity cost.
4. The decision of the market outcome relies on a few people, who may have underlying political interests contrary to economic needs.

Consumer nudges (HL Only)

Purposes of consumer nudges may include:

1. Pursuing consumers to follow a certain behavior which will lead them them to make more beneficial decisions both for themselves and for the economy.
2. Improve social welfare without using any financial or heavy regulation.

Consumer nudges are a beneficial way of influencing a market outcome because:

1. They allow to influence the decisions of consumers while preserving their individual freedom and not forcing any regulation over them.
2. Low costs and high benefit method of affecting market outcome saves preserve scarce government budgets.