Government Intervention in price

systemsCore

Kalaiyarasi Danabalan

A’ Level

Subtopic

Externalities

Social costs and social benefits

Decision making using cost-benefit analysis

Private and public goods

Merit and demerit goods

Examples of government intervention

Market Failure

In a market where there is equilibrium, the resources are allocated in the best possible manner and there is 'allocative efficiency'.

Allocative efficiency is when situation where Marginal cost is equal to Marginal revenue.

Market failure exists when the resources are not allocated efficiently. Community surplus is not maximized and thus there is market failure. From a community's point of view, producer surplus is not equal to consumer surplus.

Market failure is thus caused by

Abuse of monopoly power

Lack of public goods

Under provision of merit goods

Overprovision of demerit goods

Environmental degradation

Inequality in distribution of wealth

Immobility of factors of production

Problems of information

Short termism

Externalities A loss or gain in the welfare of one party resulting from an activity

of another party, without there being any compensation for the losing party.

This activity can be due to consumption or production of a good or service.

If the third party suffers due to this activity then it is known as negative externality. It’s the production or consumption activity that creates an external cost.

When the third party gains from this activity is it known as positive externality. It’s the production or consumption activity that creates an external benefit.

Externalities occur when there is a divergence between social and private costs and benefits.

Private costs - costs involved in an action that accrue to the decision maker.

Social costs - all costs that are associated with a particular action.

Private benefits - benefits that accrue solely to the decision maker.

Social benefits - all the benefits that accrue from a particular action. (

The market demand and supply curves therefore reflect the MPB and MPC accruing to buyers and sellers.

MPC= MPB P & Q equilibrium reflected at this point are ‘socially optimum’.

Social cost (SC) = Private costs (PC) + External costs (EC)

In marginal terms (when each additional unit of good is produced),

Marginal Social Costs (MSC) = Marginal Private Costs (MPC) + Marginal External(MEC)

Net External benefit = External benefit – external cost

External benefit arises when social benefit exceeds private benefit. It refers to the benefit from production (consumption) experienced by people other than the producer (consumer).

Positive externality

Social benefit- the full benefit to society from consumption and production of any good. From the society's point of view, the price system must consider both private benefit and external benefit.

Social benefit (SB) = Private benefit (PB) + External benefit (EB)

In marginal terms (when each additional unit of good is produced),

Marginal Social benefit (MSB) =Marginal Private benefit (MPB) + Marginal External benefit (MEB)

How would net external benefit be calculated?

A external benefit minus external cost

B external benefit plus private benefit

C private benefit plus social benefit

D social benefit minus private cost

Negative Production Externalities

Side effects of production activities. An individual / firm making a decision does not

have to pay the full cost of the decision.

Pollution producers don't take responsibility for external

costs that exist--these are passed on to society.

Producers have lower marginal costs than they would otherwise have and the supply curve is effectively shifted down (to the right) of the supply curve that society faces.

Because the supply curve is increased, more of the product is bought than the efficient amount--that is, too much of the product is produced and sold.

Since marginal benefit is not equal to marginal cost, a deadweight welfare loss results.

How to reduce negative production externalities? Legislation and regulation

Legislations will lower the quantity of goods produced and bring it closer to the optimal quantity Q* by shifting the MPC curve upward towards the MSC curve. It might include legislations to

- Limit the emission of pollutants by setting limits to the extent of pollutants produced by a firm.

- Limit the production to a certain level.

- Force polluting units to install technologies which reduce emissions.

Taxes

- Government may impose a tax on the firm either on per unit of production or per unit of pollutants emitted.

Tradable permits

- Market-driven approach to reducing greenhouse gas emissions. A government must start by deciding how many tons of a particular gas may be emitted each year.

- Tradable permits will result in firms to lower the quantity of goods produced so that it equals Q* and to raise the price of the goods

Government impose Tax

Positive Production Externalities

When firms train their employees which result in better manpower or invest in research and development and succeed in developing new technologies which benefits the society.

Due to the fact that positive externality is produced, the MSC lies below the MPC. The diagram below illustrates positive production externalities.

Corrective positive production externalities

Subsidies can be provided to firms which produce these goods. The effect will be the lowering of MPC and thus the MPC will more downward to MSC.

This will increase the output to a level Q2 near to the socially optimal level Q*. The price will also fall from P1 to P2.

Negative Consumption Externalities

By smoking in public places, the consumer is creating negative externalities, in the form of passive smoking, for non-smokers. Other examples :- using fossil fuels that pollute atmosphere, playing loud music and disturbing neighbours, discarding garbage in public places.

MPB is not reflecting social benefit and thus MSB lies below MPB. The vertical difference between MPB and MSB is the negative externality. The optimal level of consumption is where MSB=MSC i.e. Q*.

However the negative externality is being ignored and thus there is an over consumption of the goods at Q1.

How to reduce negative consumption externalities?

Advertising

Legislations and regulations

Imposing indirect taxes

Positive Consumption Externalities

consumption of education and health care. Both these will lead to more productive workforce and hence high rate of economic growth for the society.

The MSB lies above the MPB and the difference between the two consists of positive externality.

The socially optimal level is where MSB=MSC i.e Q*, however, due to under-allocation of resources the output/consumption is at Q1.

Corrective Positive consumption externalities

Subsidies

MSC curve shifting to MSC+subsidy which means high output/consumption at socially optimal level Q* and at lower prices from P1 to P*.

Advertising

Consumers to increase their consumption and thus lead to a shift of MPB to the right i.e. increase in demand. If the MPB curve shifts enough, it will coincide with MSB and Q* will be produced and consumed.

Goods Demerit Goods

goods which are deemed to be socially undesirable, and which are likely to be over-produced and over-consumed through the market mechanism. Examples :-cigarettes, alcohol and all other addictive drugs such as heroine and cocaine.

The consumption of demerit goods imposes considerable negative externalities on society as a whole, such that the private costs incurred by the individual consumer are less than the social costs experienced by society in general.

Merit Goods

Benefits on society in excess of the benefits conferred on individual consumers; in other words, there is a divergence between private and social costs and benefits, as the social benefits accruing to society as a whole from the consumption of such goods tend to be greater than the private benefits to the individual.

individual consumers and producers make their decisions on the basis of their own, internal costs and benefits, but, from the standpoint of the welfare of society at large, externalities must be considered.

Private Goods and Public Goods

Demerit Goods Merit Goods

Consumer Surplus and Producer Surplus

Consumer Surplus - difference between total benefit of consuming a given quantity of output and the total expenditures consumers pay to obtain that quantity.

Producer Surplus - difference between the amount that a producer of a good receives and the minimum amount that he or she would be willing to accept for the good.

Community Surplus - the welfare of society and it is made up of a consumer surplus plus a producer surplus. It exists when it is impossible to make someone better off without making someone else worse off.

When the consumer surplus is equal to producer surplus, it exists when the market is in equilibrium, with no external influences and no external effects.Market is said to be socially efficient and community surplus is at its maximum.

Consumer SurplusProducer Surplus

Community Surplus and Allocative Efficiency(Let we draw)

Indirect Taxes tax collected by an intermediary i.e. seller, from the person who bears the

ultimate economic burden of the tax i.e. consumer.

it is a tax which is imposed on goods and services sold. It is usually added to the cost of the good or service and charged from the ultimate consumer. The seller will then file a return to the government on all the taxes he has collected from the consumer.

Example :- sales tax and excise duty

Reasons for imposing taxes

To generate Government revenues: excise duties on beers, wines and spirits are price inelastic in demand, so tax price increases by levying specific alcohol and tobacco taxes raise consumer expenditures as a whole on these categories and therefore taxation revenues.

To discourage consumption: Government might use taxes to discourage consumption of certain demerit goods such as cigarettes.

To alter the pattern of consumption: Government might use direct taxes a a mean to alter the consumption patter of its population. Certain goods can be made more price attractive through lower taxes while goods which have high marginal social cost can be made expensive through taxation.

Distinction between specific and ad valorem taxes

Specific tax is a flat rate of tax whereas ad valorem tax is a percentage tax.

Ad valorem literally the term means “according to value.” It is imposed on the basis of the monetary value of the taxed item.

Consequences of imposing indirect tax Imposition of tax results in three economic observations.

Incidence: Incidence of tax means the party who actually pays the tax.

Government revenue: the amount of tax government will receive as revenue

Resource allocation: the amount of fall in quantity demanded and produced created by the tax..

Incidence or tax burden When a tax imposed on a good or service increases the price by the

amount of the tax, the burden of the tax falls on consumers.

If instead it lowers wages or lowers prices for some of the other factors of production used in the production of the good or service taxed, the burden of the tax falls on owners of these factors.

Tax incidence and price elasticity of demand and supply Scenario 1: When PED is greater than PES

Where PED is greater than PES, it implies that consumers are more sensitive to price changes as compared to suppliers. Thus the incidence of tax will be more on the suppliers because if too much burden of tax is passed on to the consumers then the demand will fall drastically.

Scenario 2: When PES is greater than PED

When the supply curve is relatively elastic, the bulk of the tax burden is borne by buyers. This is because PED as compared to PES is elastic, which means; consumers are not that price sensitive and will not reduce their consumption even if the prices rise. Because the PES is elastic, suppliers will stop the supply if the cost of production goes up.

Scenario 3 : PED is equal to PES

Why subsidies are given?

A subsidy is a form of financial assistance paid by the government to a business or economic sector.

Subsidy and Elasticity

Subsidies might be given to

Lower the cost of necessary goods which might affects a major part of population. Example, subsidies given to essential food items and oil (in India).

Guarantee the supply of merit goods, which the government thinks consumers should consume.

Help domestic firms become more competitive in the international market, also known as protectionism.

Effect of subsidy Subsidy reduces the cost of production. Thus the supply curve for the

product shifts vertically downwards by the amount of subsidy provided.

Impacts of Subsidies on Producers Subsidies are monetary benefits provided to the

producer by the Government on account of production of certain commodity. Subsidies lead to increase in producer revenue. Due to subsidy the supply curve (S-subsidy) will shift vertically downwards by the amount of subsidy. This reduces the cost of production and more is now being supplied at every price. Through the diagram, we can see, initially the market was at equilibrium with Qe being supplied & demanded at Price (Pe).

Government provides subsidy WZ per unit.

Producers lower their prices to P1 Increase output till a new equilibrium is reached at Q1

The producer will however not pass all the subsidy benefit to the consumer.

Initial producer revenue was OPeXQe which now increases to ODWQ1.

Impacts of Subsidies on Consumers

Consumers will now consume more of the product due to lower prices. Consumers pay less as the prices fall from Pe to P1.

however, they end up consuming more from Qe to Q1. It is difficult to say by how much the consumer expenditure will increase or fall as it will depend on their relative saving and extra expenditure.

Subsidies and elasticity

Scenario 1: When PED is elastic relative to PES

The consumers do not benefit from a great fall but, because their demand is relative elastic, they increase their consumption by a significant amount.

Scenario 2: When PED is inelastic relative to PES

Consumption of the product is increased and so is the revenue of the producer.

The consumer benefit from a relatively large price fall, but their demand is relative inelastic, their consumption does not increase by a great amount.

Government Intervention in Market Prices Maximum Price or PRICE CEILINGS

In some markets, governments intervene to keep prices of certain items higher or lower than what would result from the market finding its own equilibrium price.

A price ceiling occurs when the government puts a legal limit on how high the price of a product can be. In order for a price ceiling to be effective, it must be set below the natural market equilibrium.

Minimum Prices or Price Floor

A minimum allowable price set above the equilibrium price is a price floor.

With a price floor, the government forbids a price below the minimum Price Floors are minimum prices set by the government for certain commodities and services that it believes are being sold in an unfair market with too low of a price and thus their producers deserve some assistance.

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