Government Intervention in Markets 1

Taxes

Markets are efficient Adam Smith, 1776 – the “invisible hand of

the market” Markets allocate resources using the price

mechanism (shortage, surplus, equilibrium) Allocation is automatic due to the signal and

incentive role of price Related markets are concatenated (linked)

through demand and supply, and the price mechanism

Result is social optimum (community surplus maximized) at equilibrium price

Markets are efficient BUT… Adam Smith, 1776 – the “invisible hand of the market”

Markets allocate resources using the price mechanism (shortage, surplus, equilibrium) Allocation is automatic due to the signal and incentive role of price Related markets are concatenated (joined) through demand and supply, and the price

mechanism Result is social optimum (community surplus maximized) at equilibrium price

Governments intervene in markets using their legal authority to…▪ Raise funds through taxation▪ Regulate activity (enforce laws)▪ Support industries through subsidies▪ Provide public goods, and merit goods ▪ Deal with “externalities”, e.g. pollution

I would like you to…

Consider government intervention in markets as a question! Should government intervene?▪ Maybe yes, maybe no… it all depends

Sometimes government action helps resource allocation, and sometimes it doesn’t! You have to weigh the plusses and

minuses of the results of government action

Forms of Intervention

Taxes – indirect and direct taxes Government takes funds $$$

Subsidies – industry support Government gives funds $$$

Price Controls – government sets prices Ceilings Floors Minimum Wages

Governments need money For 99% of the world, governments

get the money they need in the form of taxes

Goods and Services are taxed (indirect tax)

Income is taxed (direct tax)

This revenue allows government to provide services

(Governments also borrow money)

Types of Taxes

Specific tax, per unit (domestic) Excise tax, per unit (domestic)

Value-added Tax, percentage (domestic)

GST, percentage (domestic)

Customs Duty, percentage (international)

Per Unit Taxes Look Like…

Supply curves are parallel because the same amount of tax applied for each unit of output

Excise tax, specific tax look like this

Percentage Taxes Look Like…

Supply curves diverge from the origin because the amount of tax rises as output increases, e.g. 10% of price10% of $100 = $10 while 10% of $300 = $30

Sales Taxes, VAT, GST and Customs Duties look like this

INDIRECT TAXES – The Theory

Indirect taxes are imposed on goods and services by the government.

The burden is shared between consumers and producers.

Taxes are remitted by producers to the government.

Direct taxes are on the income of the citizen directly, e.g. income tax (more later)

Types of Indirect Taxes Excise Tax: Taxes imposed on particular

G+S– usually goods with inelastic demand eg: petrol, cigarettes and alcohol

Thinking Point: Can you think of an economic reasons why governments target these types of goods??

General Sales Tax (GST) or Value Added Tax (VAT): Taxes imposed on all or (most) G+S

Indirect Excise taxes can be either: Specific Tax: A tax of a specific amount to

be paid on every unit of a product sold. Eg: $2 per pack tax on cigarettes.

Ad Valorem Tax: A tax based on a particular percentage of the sales price of a product. In this case the tax increases as the price of G+S increases.

Eg: 50% tax on sales of cigarettes ($PxQ)

Specific Tax Diagram

S2 curve is parallel to S1.Amount of tax is fixed for each unit of output

Ad Valorem Tax DiagramS2 curve is steeper than S1 because tax increases as price increases

If tax = 10% and P = $ 20 Tax per unit sold = $2 (0.1x 20)

If Tax = 10% and P = $ 30 Tax per unit sold = $ 3 (0.1x 30)

WHY DO GOVERNMENTS IMPOSE INDIRECT TAXES (EXCISE TAX)?

Source of Government Revenue Method to discourage consumption of

goods that are harmful to individuals/ society

Tax revenues used to redistribute income from rich to poor

Method to improve allocation of resources (reduce allocative inefficiency) or to correct negative externalities

IMPACT OF INDIECT (EXCISE TAX) ON THE MARKET

When tax is imposed on G+S it is paid to government by firms.

This leaves fewer resources for production, c.p.

Thus, for every price the firm produces less

The supply curve shifts left Let’s use diagrammatic analysis to find

the extent of the reduction in output, and the incidence of the tax burden

Market Outcomes of Specific Tax

Before Tax: P* = Eqb P Q* = Eqb Q (intersection of S1 & D curves)

After Tax: S curve shift to S2 (S1+Tax) P paid by consumers increase to Pc and Q falls to Qt.Pc= P paid by consumers Amount of tax = Pc – Pp (tax per unit)

The market outcomes due to the Specific tax Equilibrium quantity produced and consumed fall from

Q* to Qt Equilibrium price increases from P* to Pc (P paid by

consumers) Consumer expenditure on the good changes from P*x

Q* to Pc x Qt Price received by firms fall from P* to Pp =( Pc – tax) Firm revenues fall from (P* x Q*) to (Pp x Qt) Government receives tax revenues = (Pc – Pp) x Qt

amount of tax per unit times the number of units sold (shaded area)

There is an under allocation of resources to the production of the good Qt less than free market Q (Q*)

Market Outcomes of Ad Valorem Tax

Before Tax:

After Tax :

Student Task: Use same steps as the previous diagram to determine the market outcomes

The Market outcomes due to an Ad Valorem Tax

Outcomes are exactly the same as the specific tax – just relate back to diagram (b) instead.

CONSEQUENCES OF INDIRECT EXCISE TAXES ON STAKEHOLDERS  

Stakeholders affected

Consumers

Producers

Government

Society

Consumers

Consumers (households) are worse off – how?? Pay higher prices Consume less quantities Spending is reduced also on other

goods due to paying more on the taxed good

Increase consumption of substitute good which may be less desirable.

Producers

Producers (firms) are worse off – how?? Receive lower prices than before Sell less quantities – ie leads to lower

revenues and profits Firms produce less output so leads to

supply shortages in the future

Government

Governments are the only winners from taxes Increase revenues – lead to budget

surpluses Decrease spending on public goods

such as health care and environment because people who smoke or use petrol now contribute to the costs

Society as a whole

Society as whole is worse off due to higher prices of goods and lower quantities consumed and produced.

Allocative inefficiencies – society not producing what is desirable