Chapter 4-government-intervention-in-the-markets

Written by: Edmund Quek

© 2011 Economics Cafe All rights reserved. Page 1

CHAPTER 4

GOVERNMENT INTERVENTION IN THE MARKETS

LECTURE OUTLINE

1 INTRODUCTION

2 TAX

2.1 Definition of tax

2.2 Effects of an indirect tax on the supply curve

2.3 Effects of a specific tax on price and quantity

2.4 Incidence of tax

3 SUBSIDY

3.1 Definition of subsidy

3.2 Effects of a subsidy on the supply curve

3.3 Effects of a subsidy on price and quantity

3.4 Incidence of subsidy

4 MAXIMUM PRICE (PRICE CEILING)

4.1 Definition of maximum price

4.2 Use and effects of maximum price

5 MINIMUM PRICE (PRICE FLOOR)

5.1 Definition of minimum price

5.2 Use and effects of minimum price

6 PROBLEMS OF AGRICULTURAL PRODUCTS

6.1 Wide fluctuations in the price of agricultural products in the short run

6.2 Falling price of agricultural products over time

References

John Sloman, Economics

William A. McEachern, Economics

Richard G. Lipsey and K. Alec Chrystal, Positive Economics

G. F. Stanlake and Susan Grant, Introductory Economics

Michael Parkin, Economics

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics



1 INTRODUCTION

In a perfectly competitive market, the equilibrium price and the equilibrium quantity are

determined by the market forces of demand and supply. However, the equilibrium price

and the equilibrium quantity may not be the optimal price and the optimal quantity.

Therefore, there is a role for the government in the markets. This chapter gives an

exposition of government intervention in the markets.

2 TAX

2.1 Definition of tax

A tax is a levy imposed on goods and services, income or wealth by the government. Taxes

are often classified into direct taxes and indirect taxes. Direct taxes are taxes imposed on

income and wealth. Indirect taxes are taxes imposed on goods and services.

There are two types of indirect tax: specific tax and ad valorem tax. A specific tax is an

indirect tax of a certain amount per unit sold (e.g. excise tax - $7.50 per packet of

cigarettes). An ad valorem tax is an indirect tax of a certain percentage of the price of the

good (e.g. GST - 7% of the price of a good).

2.2 Effects of an indirect tax on the supply curve

An indirect tax will lead to a rise in the cost of production which will induce firms to

increase the price by the amount of the tax at each quantity to maintain profitability.

Specific Tax



In the above diagram, a specific tax leads to a vertical upward shift in the supply curve (S)

from S0 to S1 because the amount of the tax is the same at all quantities.

Ad Valorem Tax

In the above diagram, an ad valorem tax leads to a pivotal upward shift in the supply curve

(S) from S0 to S1 because the amount of the tax increases as the price and hence the quantity

increases, although the tax rate remains unchanged.

2.3 Effects of a specific tax on price and quantity

Consider the demand and the supply schedules of whisky over a week and the effect of a

specific tax of $3 per bottle.

Price Quantity demanded Quantity supplied

(before tax)

Quantity supplied

(after tax)

12 6 15 9

11 7 13 7

10 8 11 5

9 9 9 3

8 10 7 1

7 11 5 ---

6 12 3 ---

5 13 1 ---



In the above diagram, the initial price and quantity are $9 and 9 bottles. Firms pay $3 to the

government for each bottle sold and this induces them to increase the price by $3 at each

quantity to maintain profitability. However, the new price is not $12 but $11 because at the

price of $12, the quantity supplied exceeds the quantity demanded. The tax revenue of $21

($3 × 7) collected by the government is represented by the shaded area.

2.4 Incidence of tax

Firms do not usually bear the full burden of a tax. In other words, when the government

imposes an indirect tax, in most cases, firms and consumers each pay a fraction of the tax.

The incidence of the tax is the distribution of the burden of the tax between firms and

consumers. Consumers pay the tax in the sense that the price rises and firms pay the tax in

the sense that the rise in the price is less than the amount of the tax. In the previous example,

the per-unit tax of $3 leads to a vertical upward shift in the old supply curve (S0) by the

amount of the tax to the new supply curve (S1). The vertical distance between S0 and S1 is

the per-unit tax of $3. Consumers pay a higher price of $11 and firms receive a lower price

of $8 after paying the per-unit tax of $3 to the government. Therefore, consumers pay

two-thirds [($11 $9)/$3] of the tax and firms pay one-third [($9 $8)/$3] of the tax. In

this instance, consumers pay a larger fraction of the tax.

In general, whether consumers or firms will pay a larger fraction of an indirect tax depends

on the elasticities of demand and supply. The side of the market which is less sensitive to a

change in price will pay a larger fraction of the tax. In other words, if demand is less elastic

than supply, consumers will pay a larger fraction of the tax. Conversely, if supply is less

elastic than demand, firms will pay a larger fraction of the tax.



Demand is less elastic than supply

In the above diagram, the demand curve (D) is steeper than the supply curve (S) and hence

consumers pay a larger share of the tax (t). The fraction of the tax paid by consumers, (P1

P0)/t, is greater than the fraction of the tax paid by firms, [P0 (P1 t)]/t.

Supply is less elastic than demand

In the above diagram, the supply curve (S) is steeper than the demand curve (D) and hence

firms pay a larger fraction of the tax (t). The fraction of the tax paid by firms, [P0 (P1

t)]/t, is greater than the fraction of the tax paid by consumers, (P1 P0)/t.



3 SUBSIDY

3.1 Definition of subsidy

A subsidy is a payment made by the government to a firm not in exchange for any good or

service.

3.2 Effects of a subsidy on the supply curve

A subsidy will lead to a fall in the cost of production which will allow firms to decrease the

price by the amount of the subsidy at each quantity. Therefore, the supply curve will shift

downwards vertically by the amount of the subsidy.

3.3 Effects of a subsidy on price and quantity

Consider the demand and the supply schedules for rice over a week and the effect of a

specific subsidy of $3 per sack.

Price Quantity demanded Quantity supplied

(before subsidy)

Quantity supplied

(after subsidy)

12 6 15 ---

11 7 13 ---

10 8 11 ---

9 9 9 15

8 10 7 13

7 11 5 11

6 12 3 9

5 13 1 7



In the above diagram, the initial price and quantity are $9 and 9 sacks. Firms receive $3

from the government for each sack of rice sold and this allows them to decrease the price

by $3 at each quantity. However, the new price is not $6 but $7 because at the price of $6,

the quantity demanded exceeds the quantity supplied. The government expenditure of $33

($3 x 11) on the subsidy is represented by the shaded area.

3.4 Incidence of subsidy

Firms do not usually enjoy the full benefit of a subsidy. In other words, when the

government gives a subsidy, in most cases, firms and consumers each receive a fraction of

the subsidy. The incidence of the subsidy is the distribution of the benefit of the subsidy

between firms and consumers. Consumers receive the subsidy in the sense that the price

falls and firms receive the subsidy in the sense that the fall in price is less than the amount

of the subsidy. In the previous example, the per-unit subsidy of $3 leads to a vertical

downward shift in the old supply curve (S0) by the amount of the subsidy to the new supply

curve (S1). The vertical distance between S0 and S1 is the per-unit subsidy of $3.

Consumers pay a lower price of $7 and firms receive a higher price of $10 after getting the

per-unit subsidy of $3 from the government. Hence, consumers receive two-thirds [($9

$7)/$3] of the subsidy and firms receive one-third [($10 $9)/$3] of the subsidy. In this

instance, consumers receive a larger fraction of the subsidy.

In general, whether consumers or firms will receive a larger fraction of a subsidy depends

on the elasticities of demand and supply. The side of the market which is less sensitive to a

change in price will receive a larger fraction the subsidy. In other words, if demand is less

elastic than supply, consumers will receive a larger fraction of the subsidy. Conversely, if

supply is less elastic than demand, firms will receive a larger fraction of the subsidy.

4 MAXIMUM PRICE (PRICE CEILING)

4.1 Definition of maximum price

A maximum price, or a price ceiling, is the highest price that firms are legally allowed to

charge.

4.2 Use and effects of maximum price

The government may set a maximum price on a good to prevent the price from rising above

a certain level to ensure that the good is affordable to consumers. Therefore, a maximum

price will only be effective or binding if it is set below the equilibrium price.

A maximum price will lead to a shortage.



In the above diagram, before the maximum price regulation, the price is equal to the

equilibrium price (P0). A maximum price (PMAX) leads to a fall in the price from P0 to PMAX.

At PMAX, the quantity demanded (QD) is greater than the quantity supplied (QS). When a

shortage occurs, a black market may emerge. In other words, the good may be illegally sold

at prices above the price ceiling which will render the maximum price regulation

unsuccessful. Further, in the absence of government intervention, some consumers will be

forced to go without the good and this is undesirable if the good is a necessity.

To overcome these problems, the government can draw on its buffer stock. However, if the

shortage persists, the government will exhaust its buffer stock eventually. Therefore, the

long-term measure to solve a persistent shortage problem is to either reduce demand or

increase supply. Demand can be decreased by developing more substitutes. Supply can be

increased by direct government production or by giving a subsidy to firms.

5 MINIMUM PRICE (PRICE FLOOR)

5.1 Definition of minimum price

A minimum price, or a price floor, is the lowest price that firms are legally allowed to

charge.

5.2 Use and effects of minimum price

The government may set a minimum price on a good to prevent the price from falling

below a certain level to protect producers’ income. Therefore, a minimum price will only

be effective or binding if it is set above the equilibrium price.

A minimum price will lead to a surplus.



In the above diagram, before the minimum price regulation, the price is equal to the

equilibrium price (P0). A minimum price (PMIN) leads to a rise in the price from P0 to PMIN.

At PMIN, the quantity supplied (QS) is greater than the quantity demanded (QD). When a

surplus occurs, firms may illegally sell the good at prices below the price floor to reduce

their stocks which will render the minimum price regulation unsuccessful.

To overcome this problem, the government can buy the surplus and keep it as buffer stock.

However, if the surplus persists, this will lead to an over-accumulation of the buffer stock.

Therefore, the long-term measure to solve a persistent surplus problem is to either increase

demand or reduce supply. Demand can be increased by finding alternative uses for the

good or by reducing the demand for substitutes. Supply can be decreased by restricting

producers to particular output quotas.

6 PROBLEMS OF AGRICULTURAL PRODUCTS

6.1 Wide fluctuations in the price of agricultural products in the short run

The price of agricultural products fluctuates widely in the short run due to wide

fluctuations in the supply and the price inelastic nature of both the demand and the supply.

The supply of agricultural products depends to a large extent on weather conditions. When

weather conditions become more favourable, the supply of agricultural products will rise

and vice versa. Therefore, wide fluctuations in weather conditions lead to wide fluctuations

in the supply of agricultural products. The demand for agricultural products is price

inelastic due to the high degree of necessity and lack of close substitutes. Further, since the

growing time of agricultural products is long and farmers cannot keep stocks due to the

perishable nature of the goods, the supply is price inelastic.



In the above diagram, an increase in the supply of agricultural products (S) from S0 to S1

leads to a huge fall in the price (P) from P0 to P1 and a decrease in the supply (S) from S0 to

S2 leads to a sharp rise in the price (P) from P0 to P2. Since the demand for agricultural

products is price inelastic, a fall in the price will lead to a smaller percentage increase in the

quantity demanded resulting in a fall in farmers’ income. The converse is also true. Due to

the positive relationship between the price of agricultural products and farmers’ income,

wide fluctuations in the price of agricultural products leads to wide fluctuations in farmers’

income.

6.2 Falling price of agricultural products over time

The price of agricultural products has been falling over time due to the rapid increase in the

supply relative to the demand. The continual increase in agricultural productivity due to

improvements in farming methods and inputs has led to a continual increase in the supply

of agricultural products over time. However, due to the low income elasticity of demand

for agricultural products, the demand has not increased at the same rate.



In the above diagram, a large increase in the supply of agricultural products (S) from S0 to

S1 and a small increase in the demand (D) from D0 to D1 lead to a fall in the price (P) from

P0 to P1. Due to the positive relationship between the price of agricultural products and

farmers’ income, the falling price of agricultural products leads to falling farmers’ income.

Technology

Chapter 4-government-intervention-in-the-markets