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AS Level
Chapter 3: Government microeconomic intervention

 Market failure

Market failure occurs when the price mechanism or market mechanism fails to allocate the scarce
resources efficiently. A free market is said to have failed if the functioning of the price system fails to
deliver what is expected by the society. In other words, a free market fails if the goods involved are
produced and consumed in the quantities lower or higher than the socially desirable quantity or the
optimum quantity.

Some of the sources/reasons of market failure are:

 Presence of externalities in an economy

 Problem of information failure associated with merit and demerit goods
 Public goods and the problem of free rider issue
 Abuse of monopoly power

Government intervention in the functioning of the price system/ free market occurs with the objective
of achieving efficiency in the allocation of resources (correcting market failure) and reducing
inequalities in the distribution of income and wealth. A government uses the following methods of
intervention to achieve these objectives:
 Regulation (use of legal methods)
 Financial intervention (use of taxes and subsidies)
 State provision
 Maximum and minimum price control
 Provision of information
 Transfer payments
 Direct provision of goods and services
 Minimum wage
 The tax system

Methods of intervention used to achieve efficiency in the allocation of resources

Regulation
It is the use of legal methods to control the quantity and quality of goods/ services produced and
consumed in the free market. It forces the producers and consumers to behave in certain ways so that
efficiency is achieved in the allocation of resources.
Some examples of regulation used to control the quantity and quality of goods produced and consumed
in the economy are:
 Ban on smoking in public places
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 Setting of minimum legal age at which a person can buy certain things like cigarettes, tobacco,
alcohol, etc.
 Making certain drugs available only at the prescription of a qualified doctor.
 Hygiene laws that guarantee the quality of goods produced and consumed.
 Setting standards that restrict the amount of pollution that can be legally dumped.
 Making government-funded education compulsory up to certain age.

Government may also use regulation to control the prices of goods /services produced and consumed in
an economy. Some examples of price control used by the government are rent control, minimum wage,
maximum and minimum price control etc.

Financial intervention (Indirect taxes and subsidies)

 Indirect taxes
A government imposes indirect taxes when the goods involved are overproduced and over consumed in
an economy due to the presence of negative externalities or the problem of information failure. For
example, government imposes indirect taxes on demerit good to discourage their production and
consumption.
Imposition of indirect taxes raises the costs of production which, in turn, raises the prices of the goods.
This rise in costs and prices reduces the production and consumption of the goods to the optimum level.
Thus the problem of market (over production and over consumption) failure is corrected and efficiency
is achieved in the allocation of resources.

Fig : Use of indirect taxes to correct the problem of overproduction

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Fig (b): Effect of imposition of indirect taxes

In the above diagram,

Tax per unit = vertical distance between two supply curves=
Qty. traded after tax=
Total tax revenue received by government =
Consumers’ tax burden = rise in unit price x quantity bought=
Producers, tax burden=
Producer’s sales revenue after tax=

 Other tax issues

Tax incidence

Tax incidence refers to how the burden of a tax is distributed between firms and consumers (or between
employer and employee). The tax incidence depends upon the relative elasticity of demand and supply.

 The consumer burden of a tax is reflected by the amount by which the market price rises.
 The producer burden is the decline in revenue firms face after paying the tax.

Fig: Perfectly elastic demand and incidence of tax

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Note: If the demand for a product is perfectly elastic, the entire incidence of tax (tax burden) falls on the
producers.

Fig: Perfectly inelastic demand and incidence of tax

Note: If the demand for a product is perfectly in elastic, the entire incidence of tax falls on the
consumers.

Fig: Unitary elastic demand and the incidence of tax

Note: If the demand for a product is unitary elastic, the incidence of tax is distributed equally between
producers and consumers.
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Fig: Inelastic demand and the incidence of tax

Fig: Elastic demand and the incidence of tax

Fig: Inelastic demand elastic supply and the incidence of tax

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Fig: Elastic demand inelastic supply and the incidence of tax

 Direct and indirect taxes

Direct taxes are those whose burden cannot be shifted from one person to another. The impact (initial
burden) and incidence (ultimate burden) of direct taxes fall on the same person. Some examples of
direct taxes are income tax, wealth tax, inheritance tax, gift tax, road tax, capital gain tax etc.

Indirect taxes are those whose burden can be shifted from one person to another. These are the taxes
imposed on the producers which are shifted to the consumers by adding them to the prices of the
products. That is the impact (initial burden) of indirect taxes is borne by the producers while the
incidence (ultimate burden) is borne by the consumers. Some examples of indirect taxes are VAT, GST,
tariff, excise tax, custom tax etc.

 Types of Indirect taxes

Indirect taxes are of two types- specific and ad valorem.
Specific tax is imposed per unit of any good produced or consumed. For example, $2 per unit of good x
produced or consumed. Specific tax causes a parallel shift in the supply curve to the left.

Fig: Effect of specific tax

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Ad valorem tax is imposed as a percentage of prices of the goods produced and consumed. For
example, 20% of the price of any good produced or consumed. Ad valorem tax causes a pivotal (non-
parallel) shift of the supply curve towards the left.

Fig: Effect of specific and ad valorem tax

 Types of tax system

Progressive tax system
It is where the tax rate (% of income and wealth paid in tax) increases with an increase in income and
wealth vice versa.
Example:
Individual B’S taxable Income Marginal rate of Calculation Tax paid
($80,000) taxation
Up to $10,000 0%
Income between $10,000 and 30%
$25,000
Income between $25,000 and 40%
$50,000
Income above $50,000 ($30,000) 50%
Total income $80,000

Proportional tax system

It is where the same tax rate is imposed on all levels of income and wealth.
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Regressive tax system

It is where the tax rate decreases with an increase in income and vice versa. That is, those on lower
incomes pay higher proportion of their income in tax to the government than those on higher incomes.
For example, the indirect taxes imposed on goods / services are regressive in nature

Example:
Individual A’s income=$100
Individual B’s income =$200
Tax paid on purchase of good x = $5
% of income paid in tax by A = 5%
% income paid in tax by B =2.5%

Fig: Progressive, proportional and regressive tax system

 Canons of taxation

It means the quality of a good tax system. As described by Adam Smith, a good tax system should
possess the following features:

 Canon of equity
Those on higher incomes should pay higher % of their income in tax than those on lower income.

 Canon of economy
The revenue received from taxes should be higher than the costs incurred in raising taxes.

 Canon of transparency
The tax payers should know how, when and how much they should pay in taxes.

 Canon of convenience
The tax payers should find it easy to pay taxes.
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Subsidies

A government provides subsidies to the producers when the goods involved are under produced and
under consumed in the free market due to the presence of positive externality or the problem of
imperfect information. For example, subsidies are provided to the producers of merit goods as they are
under produced and under consumed in the free market due to the presence of positive externality and
the problem of imperfect information.
Provision of subsidies to the producers reduces the costs of producing the goods and hence the prices
of the goods fall. Thus the production and consumption of the goods involved is encouraged and the
problem of under production and under consumption is corrected and efficiency is achieved in the
allocation of scarce resources.

Fig (a): Effect of providing subsidies to producers

Fig (b): Effect of providing subsidies

In the above diagram,

Subsidy per unit= Vertical distance between old and new supply curves=ac=P1P2= $15- $5 = $10

Qty. Produced and consumed after subsidy =OQ1= 70 units

Total government spending on subsidy=$10 x 70 = $700

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Benefit of subsidy enjoyed by the consumers= $5 x 70 =$350

Benefit of subsidy enjoyed by producers=$700 - $350 =$350

Fig: Effect of subsidy on stakeholders

 Government or state Provision

A government may take over the production of some goods or services fully or partially. In many
countries the activities such as electricity generation, coal mining, railways and drinking water are
entirely owned and managed by the government. They are often called the state owned enterprises or
nationalized industries. It is also commonly found that some goods and services are provided both by
the state and private sector. For example in many countries education and health care services are
provided both by the government and the private sector. In case of market failure caused by public
goods, government provision is the only solution as the private producers don’t allocate any resources
for the production of public goods.

 Maximum and minimum price control

A maximum price (price ceiling) is the mandated maximum amount a seller is allowed to charge for a
product or service.
In case of market failure, maximum pricing (price ceiling) is used by the government to increase/
encourage the consumption of the goods when the free market prices are too high for the consumers to
afford. It is usually set on the goods of basic necessities such as staple food, fuel, housing, transportation
etc. The setting of maximum price raises the purchasing power of consumers and the consumption
increases. The effective maximum price is set below the free market price. As a result, the quantity
consumed/demanded increases while the quantity supplied decreases. Thus, there occurs a shortage of
the good in the market.
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Fig: Effect of maximum price

As seen in the diagram, the setting of maximum price causes a shortage of the good in the market. The
shortage of Q3-Q2 created due to the setting of maximum price may put pressure on the price to rise to
P1. In order to stabilize the price at ‘max price’ the government should eliminate the shortage created in
the market. The government can eliminate this shortage by selling the good from the buffer stock or
providing subsidies to producers of the good to increase production.

Minimum price control (price floor)

A minimum price or price floor is the lowest legal price that can be paid in a market for goods and
services
In the context of market failure, minimum price can be used to encourage production or discourage
consumption of the goods involved. Minimum pricing (price floor) is usually used by the government to
protect the real income of the producers and thus encourages production. It is set when the market
price is too low to cover up the costs of production. The setting of minimum price encourages the
producers to increase production as they receive a reasonable price for their products. The effective
minimum price is set above the equilibrium price. This setting of minimum price increases the quantity
supplied of the good while the quantity demanded decreases. Thus, there occurs an excess supply of the
good in the market.

Fig: Effect of minimum price

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In the above diagram, the minimum price set by the government is Pmin. which is above the free market
price Pe. This setting of minimum price results in an excess supply of Q2 - Q1. If not eliminated, this
excess supply will make the minimum price ineffective and put pressure on the price to fall to Pe. In
order to stabilize the price at the minimum of Pmin, the government should eliminate the excess supply
from the market. If the objective of the government is to encourage production, the government should
buy the surplus quantity of the good and maintain a buffer stock if the good can be stored. While if the
objective of the government is to discourage consumption, the government should impose indirect tax
on producers to reduce production.

 Effect of price controls on consumer and producer surplus

Fig: Effect of maximum price (price ceiling)

Before setting the maximum price (price ceiling)

Consumer Surplus = ½($8 x 40) = 160
Producer Surplus= ½($8 x 40) = $160
Total Surplus = $320

After price ceiling

Consumer Surplus = ½($ 4 x 20) + ($8 x 20) =$200 (Red area)
Producer Surplus =1/2 ($4 x 20) = $40
Total Surplus = $240

Deadweight Loss = Area of green triangle

=1/2($8 x 20)
=$80

Fig: Effect of minimum price (price floor)

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Before setting the minimum price (price floor)

Consumer Surplus = ½($8 x 40) = 160
Producer Surplus= ½($8 x 40) = $160
Total Surplus = $320

After price floor

Consumer Surplus =1/2 ($4 x20) = $40
Producer Surplus =1/2($4 x20) + ($8 x20) =$200
Total Surplus = $240

Deadweight Loss = Area of green triangle

= ½($8 x 20)
=$80

provision of information
In case of market failure caused by the problem of imperfect information or information failure, a
government may correct the problem by providing information to the consumers about the actual value
(harmfulness or goodness) of the goods produced and consumed in an economy. A government may
launch education campaign, awareness program and various other measures to provide information to
the consumers. This provision of information helps the consumers realize the actual value of the goods
involved and thus the optimum level of production and consumption is achieved.
For example, provision of information helps the consumers realize the actual harmfulness of consuming
the demerit goods like cigarettes, alcohol, tobacco etc. This discourages the consumption of such goods
and hence the optimum level of production and consumption is achieved.
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 Government intervention (policies) to reduce income and wealth inequalities

Transfer payments
They are the payments made from the tax revenue to those who are on low income and are in need of
financial assistance. The transfer payments are designed to increase the purchasing power of the low
income individuals and families. These payments are not made through the market as production and
exchange of goods and services does not take place against these payments. Such payments tend to
transfer the income from those able to work and pay taxes to those unable to work and need assistance.
Some examples include unemployment benefits, state pensions, housing allowances, food coupons, old
age allowances, etc.

Direct provision of goods and services

Inequalities in the society can also be reduced by providing certain important services free of charge to
the users. Such services are financed through the tax system. If such services are used equally by all the
citizens then, those on low income gain the most as a percentage of their income. Thus inequality is
reduced. For example, in many countries education and health care services are provided free of charge
to the citizens.

The tax system

Use of progressive tax system helps to reduce income inequalities. In a progressive tax system, those on
higher income pay higher proportion of their income in tax than those on low income. Tax can also be
used to reduce wealth inequalities. Inheritance tax is tax used to reduce wealth inequalities.

Minimum wage
The minimum wage has been regarded as an important element of public policy for reducing poverty
and inequality. Setting of minimum wage raises the earnings for millions of low-wage workers and
therefore lower earnings inequality. The total annual incomes of families at the bottom of the income
distribution rise significantly after a minimum wage increase. Workers in low-wage jobs and their
families benefit the most from these income increases and thus reducing poverty and income inequality.

Fig: Effect of minimum wage

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Labor markets, like other markets, have a supply side (workers supply labor) and a demand side
(employers demand labor), and their interactions result in an equilibrium price—in this case, the price
paid per unit of labor is an equilibrium wage. The minimum wage acts as a price floor for low-skilled
labor. When the government (federal or state) increases the legal minimum wage (labeled Wm in the
diagram) above the equilibrium wage that the market would determine (We in the diagram), predictable
outcomes occur: The higher wage (Wm) increases the quantity of workers willing to work at the higher
wage (Qs, quantity supplied, in the diagram), but the higher wage also decreases the quantity of workers
that firms wish to employ (Qd, quantity demanded, in the diagram). The result is a surplus of workers
(Surplus in the diagram), where more workers seek employment than there are jobs available at the
mandated minimum wage—and the workers who fail to find employment are unemployed.

In many cases, economists who support a higher minimum wage acknowledge that the policy might
reduce employment, but they argue that the employment effects are likely to be very small and the
benefits to wage earners are certainly large. So, many workers would have higher wages, which would
boost their family income, and a smaller group would be jobless, which would reduce their family
income. In short, the benefits of the higher wage outweigh the costs in terms of lost jobs.

 Relationship between equality and equity

Equality means each individual or group of people is given the same resources or opportunities. Equity
recognizes that each person has different circumstances and allocates the resources and opportunities
according to the need of the people.

Although both promote fairness, equality achieves this by treating everyone the same regardless of
need, while equity achieves this by treating people differently dependent on need. However, this
different treatment may be the key to reaching equality. So, if equality is the end goal, equity is the
means to get there.

 The meaning of economic inequality

• Unequal distribution of income

Income inequality is how unevenly income is distributed throughout a population. Higher income
inequality means less equal distribution of income.

• Unequal distribution of wealth

Wealth refers to the total amount of assets of an individual or household. This may include financial
assets, such as bonds and stocks, property and private pension rights. Wealth inequality therefore refers
to the unequal distribution of assets in a group of people.

 Measuring economic inequality

• Lorenz curve and Gini coefficient (index)

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A Lorenz curve is a graphical representation of inequality in the distribution of income or wealth within a
population. It takes data about household income gathered in national surveys and presents them
graphically.

Let us consider the following data:

Countries Survey Lowest Second Third Fourth Highest GNI Index

Year 20% 20% 20% 20% 20% (2002-2007)
Bolivia 2007 2.7 6.5 11.0 18.6 61.2 58.2
Brazil 2007 3.0 6.9 11.8 19.6 58.7 55.0
Croatia 2005 8.8 13.3 17.3 22.7 37.9 29.0
Madagascar 2005 6.2 9.6 13.1 17.7 53.5 47.2

Here, households are ranked in ascending order of income levels and the share of total income going to
groups of households is calculated. For example, if we look at Brazil, we see that the poorest 20%
households receive only 3.0% of the total household income while the richest 20% of the households
receive 58.7%. This contrasts with Croatia, where the data suggests more equality in distribution, with
the poorest 20% receiving 8.8% of the total household income and the richest 20% receiving 37.9%. This
information can be graphed using Lorenz curves.

Fig: Lorenz curves for Brazil and Croatia

In the above diagram, the X- axis measures the cumulative percentage of the total population divided up
in the quintiles and the Y- axis measures the cumulative percentage of total income earned by the
quintiles. The line of absolute equality indicates a perfectly equal distribution of income where, for
example, 10 % of population earns10% of the income and 90%of the population earns 90%of the
income. Each country has its own Lorenz curve based on the income data. The farther away a country’s
curve is from the line of absolute equality, the more unequal is the distribution of income. In the above
diagram, the curve drawn for Brazil is farther away from that of Croatia. This shows that income is less
equally distributed in Brazil than in Croatia.
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The Lorenz curve model is useful to compare two or more countries in terms of income distribution or to
compare the change in income distribution for a single country over time.

The Gini index (also called Gini coefficient or Gini ratio) is the numerical measure of inequality in the
distribution of income and wealth in an economy. It is derived from the Lorenz curve and is the ratio of
the area between the line of equality and a country’s Lorenz curve (area ‘a’) to the total area under the
line of absolute equality (area ‘a’ + area ‘b’).

Mathematically,

Area' a '
Gini Index =
Area ' a '+ Area' b '

The value of Gini coefficient ranges from 0 to 1 where 0 represents cpmplete equality and 1 represents
complete inequality. As inequality increases, the Gini index moves away from 0 and close to 1.

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Exercise:

1. Explain the use of taxation and subsidies to correct the problem of market failure.
2. Explain any two methods of government intervention used to encourage the production and
consumption of merit goods.
3. Explain any two methods of government intervention to discourage the production and
consumption of demerit goods.
4. Discuss whether the imposition of indirect taxes is the best way to reduce cigarette
consumption.
5. Discuss whether the imposition of maximum prices can improve the allocation of scarce
resources.
6. Discuss whether indirect taxes and subsidies could be used to improve the consumption of merit
and demerit goods if the demand for both of these goods is price inelastic.
7. Explain the methods of intervention a government uses to reducde income and wealth
inequalities in an economy.
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