6. Government interventions

Question 1

Government intervention

Answer 1

Regulatory action taken by G that seek to change the decisions made by individuals, groups, and organizations about social and economic matters. They do this with taxes, price controls, and subsidies.

Question 2

Sources of government revenue

Answer 2

1|Taxes
– indirect taxes (VAT), direct taxes (income tax or corporate tax)
2|Profit from state-owned enterprises which sell goods/services
(public transportation – the earnings go to the government budget)
3|Selling (privatizing) state-owned enterprises
– G budget increases in the short-run but possible long-term earnings are given up

Question 3

Indirect tax

Answer 3

• tax imposed upon expenditure/the selling price of a product
• raises the firm’s costs
• shifts the S curve vertically upwards by the amount of the tax
  – less will be supplied at every P

Question 4

Why do governments impose direct taxes

Answer 4

1) source of G revenue
2) discourage the consumption of demerit goods
3) correct negative externalities of consumption and production
4) protectionism
5) redistribution of income

Question 5

1) source of G revenue
2) discourage the consumption of demerit goods
3) correct negative externalities of consumption and production
4) protectionism
5) redistribution of income

Answer 5

1) (inelastic D – TR goes up)
2) impact on price incentives
3) reallocation of resources (tax for cigarettes used in healthcare)
4) protecting one kind of industry by raising the import tax/taxes for other producers (Rimac)
5) collect tax revenue from luxury goods and invest it in healthcare/education which tends to benefit the poor

Question 6

Tax burden

Answer 6

• producers and consumers will between bear the burden of any tax that is put on
  – the amount that each pays will depend upon the elasticity of demand

Question 7

If PED > PES…
If PED < PES…

Answer 7

…producers will pay more of the tax (elastic D)
…consumers will pay more of the tax (inelastic D)

Question 8

graph the impact of an imposed tax on an elastic and inelastic demand curve and show the area which shows how much each stakeholder has to pay

Answer 8

…

Question 9

why does G tend to place indirect taxes on products with inelastic D?

Answer 9

(alcohol and cigarettes)
- by doing this G gain high revenue and don’t cause a large fall in employment
(D changes by a proportionally smaller amount than the change in P)

Question 10

Types of indirect taxes

Answer 10

1|Specific tax
2|Ad valorem tax

Question 11

1|Specific tax

Answer 11

• a fixed monetary value added on every unit of produce
• e.g. $5 tax placed on every packet of cigarettes in an attempt to decrease consumption
• shifts the S curve vertically up by the size of the tax

Question 12

2|Ad valorem tax

Answer 12

• a percentage tax placed on a good/service
• e.g. VAT (Value Added Tax) in the UK is currently 20% (on cigarettes)
• makes the new S curve diverge from the original one (vertical gap between them will increase when moving along the x-axis)
• shifting up the S curve by its specific percentage (changing its slope – making it more steep)

Question 13

graph the effect specific tax and an ad valorem tax have on a supply curve

Answer 13

…

Question 14

types of price controls

Answer 14

price floor and price ceiling

Question 15

Ceiling price (P max)

Answer 15

• G setting a P max below the equilibrium price when the equilibrium price in the market is too high/undesirable (weak consumers cannot afford a necessity)
• prevents producers from raising the P above it

Question 16

markets where P max could be imposed

Answer 16

• generally in developing countries
  1|food market
  – a necessity
• some people might be unable to afford the quantities required for survival
  2|housing market
  – if the equilibrium rent charged is such that a lot of people are homeless

Question 17

show by drawing a graph and explain how price ceilings result in inefficient allocation of resources

Answer 17

…
there is a shortage of goods/services or excess demand (Qd-Qs)

Question 18

why should excess demand be prevented

Answer 18

shortages may lead to the emergence of a black market and queues developing in the shops

Question 19

how can G diminish excess demand

Answer 19

1) shifting the D curve to the left until equilibrium is reached at the Pmax would limit the consumption of the product which goes against the point of imposing the ceiling price
2) shifting the S curve to the right until equilibrium is reached at the Pmax (more being supplied and demanded) by:
i) offering subsidies - encouraging producers to produce more
ii) starting to produce the product itself
iii) release product from their buffer stocks

Question 20

Floor price (P min)

Answer 20

• G setting a minimum price above the equilibrium price preventing producers from reducing the P below it
• mostly introduced to protect the supplier

Question 21

example of why floor prices are introduced

Answer 21

agricultural product markets or labor market
1) wheat/corn during the summer (to protect the farmers)
2) people are supplying labor and to protect them from exploitation G imposes minimum wages

Question 22

show by drawing a graph and explain how price floor result in inefficient allocation of resources

Answer 22

…
price floors cause excess supply

Question 23

why does the G have to intervene after excess supply is created

Answer 23

producers will find that they have surpluses and will be tempted to try to get around the price controls and sell their excess S for a lower price

Question 24

how does G eliminate excess S

Answer 24

1) buying the surplus products at the Pmin, shifting the D curve to the right and creating a new equilibrium (store/destroy/sell the surplus abroad)
2) restricting the supply
- producers limited by quotas
3) increasing D by advertising or, if appropriate, restricting supplies of the product that are being imported through protectionist policies thus increasing D for domestic products

Question 25

why are floor prices problematic

Answer 25

1) producers may not be as cost-conscious as they should be – inefficiency and a waste of resources
2) firms producing more of the protected product than they should and less of other products that they could produce more efficiently
3) G guarantees to purchase most produce leading to constant overproduction (producers don’t change anything or produce less when there is an infinite D independent of Q sold)

Question 26

Subsidy

Answer 26

an amount paid by the government to a firm per unit of output

Question 27

The main reasons for subsidies are:

Answer 27

1|To lower the price of essential goods (consumption increased)
2|To guarantee the supply of products necessary for the economy (basic food supply)
3|To enable producers to compete with overseas trade (protecting the home industry – e.g. shipbuilding)

Question 28

Types of producer subsidy

Answer 28

1|Guaranteed payment on the factor cost of a product
2|An input subsidy subsidizing the cost of inputs used in production
3|Government grants to cover losses made by a business
4|Bail-outs
5|Financial assistance (loans and grants) for businesses setting up in areas of high unemployment

Question 29

1|Guaranteed payment
2|An input subsidy
3|Government grants
4|Bail-outs
5|Financial assistance

Answer 29

1|e.g. guaranteed P min offered to firms
2| e.g. employment subsidy for taking on more workers/program for employing apprentices
3|e.g. a grant given to cover losses in the railways industry or a loss-making airline, shipbuilding
4|e.g. for financial organizations in the wake of a credit crunch (Agrokor)
5|e.g. as part of a regional policy designed to boost employment in underdeveloped regions of a country

Question 30

If a subsidy is granted to a firm, then the S curve for the product will…

Answer 30

…shift vertically downwards by the amount of the subsidy.
Subsidy reduced TC for the firm and more will be supplied at every P.

Question 31

Effect of subsidy depending on PED

Answer 31

elastic D = subsidy causes a small rise in P but high rise in D
– producers benefit because their product surplus increases more than consumer surplus
inelastic D = subsidy causes a substantial fall in price, however, there is only a small increase in D

Question 32

graph producer revenue after a subsidy was introduced

Answer 32

…

Question 33

graph consumer expenditure after a subsidy was introduced

Answer 33

…
total expenditure depends on consumer savings and extra expenditure

Question 34

graph G expenditure after a subsidy was introduced

Answer 34

…
opportunity cost present