Chapter 2C Flashcards
Govt intervention
When markets fail to allocate resource efficiently and the govt believes price mechanism in a market is inefficient and not desirable for economy govt intervenes with
- direct intervention policies- direct price controls
- market based policies - indirect price controls
The reason for govt intervention
- encourage/discourage or prohibit production/consumption of a good
- raise revenue
- make certain goods more affordable
- redistribute income
Direct price controls
- Price floor (P min)
- Price ceiling (P max)
used when equilibrium price may not be deemed by the govt as most desirable. Hence price might be kept artificially lower or higher
Price ceiling
The maximum legal price set and allowed by the government
legal market price is set below the equilibrium price to be effective
no good should be transacted at a price higher than the P max upper limit
Reasons for price ceilings
- affordability and fairness
allow the poor to buy a good that might otherwise be otherwise be unaffordable
prevent exploitation by supplier who may charge high charges during times of shortage - anti inflationary policy
detrimental to economic growth and people’s SoL
Effects of price ceilings
- Shortage
- Emergence of black markets
- Allocation of the good or service to a first come first serve basis
- Issue of fairness is a problem
- Firms deciding which customers should be allowed to buy
- Rationing through issue of coupons
- Producers have less incentive to invest in quality control and innovation
FREAPSI
- Shortage
availability of goods and services may also decrease over time as new production is discouraged and resources are being allocated to production of substitutes since producers expect lower future profits
2.Emergence of black markets
when goods are illegally sold at prices above a legal price ceiling. Allowing producers to earn more revenue
emerges with setting of price ceilings as long as there are potential consumers willing and able to pay more than legislated maximum market price to obtain goods and services
govt’s objective of achieving a fairer distribution of the goods and services by ensuring their affordability is not met
3.Allocation of the good or service to a first come first serve basis
Adoption of queuing system/ waiting systems
consumers incur the additional opportunity cost of extra time spent searching/waiting for good
4.Issue of fairness is a problem
People who need it most may not be the amongst the first in line to get the good
- Firms deciding which customers should be allowed to buy
for instance giving preference to regular customers
6.Rationing through issue of coupons
Through the issue of coupons
- Producers have less incentive to invest in quality control and innovation
due to lower profitability of providing the goods and services the benefit of lower price thus offset in part by lower quality and variety
Price floors
minimum legal market price set and allowed by the government
market price not allowed to fall below the legislated minimum market price and no good should be transacted at prices below the lower limit
legal market price has to be set above free market equilibrium price for effectiveness
Reasons for price floors
- Protect producers’ income (for example of farmers’)
- Create a surplus
3.Minimum wage
prevent wage rates from falling below a certain level to ensure acceptable level of living standards
Protection of producer income
if industry is subjected to fluctuations minimum prices would prevent producers’ incomes from falling dueing periods of low demand
in addition to price floor the govt has to buy up surpluses
Create a surplus
In periods of glut which can be stored in preparation of future shortages
Effects of a pricefloor
- Producers selling their goods at prices lower than legislated prices so they can earn higher revenue (esp if price elastic)
- Law abiding producers earn lesser revenue compared to pre intervention levels of revue due to more than proportionate fall in quantity if demand is price elastic
3.Artificially high prices cushion inefficiency
firms feel less need to find more efficient methods of production
- Discourages firms from producing alternative goods which they could produce more efficiently or which are in higher in demand but nevertheless have lower market price
How the govt deals with surpluses and limitations
- Govt could buy surpluses and store it/destroy it/sell it abroad
- Buying up surpluses is expensive
-offloading surplus into global market may cause competition between foreign and local goods
further depresses world price due to increase in world supply
- if goods are perishable then storage is a poor choice
- storing of goods can be costly - Supply can be artificially lowered by restricting producers to particular quotas
- quotas inevitably lower quantity available for transaction and will cause market prices to increase hence rendering price controls unnecessary
- loss of consumption due to disruption of market forces will lower economic welfare for all - Raising demand by advertising by finding alternative uses for good or reducing consumption of good
- however if demand can be increased then there is no need for price floor.
- costs are incurred in advertising
Direct quantity controls
1.Quotas
Quota
legal limit set by govt on quantity of a good that can be transacted in a market
set the legal maximum quantity of the good that can be purchased
equilibrium quantity not allowed to rise above the legislated legal maximum and no good should be transacted beyond this upper quantity limit
Reasons for Quotas
- to reduce consumption of certain goods that are overconsumed or harmful
- To protect domestic industries from foreign competition by restricting quantity of foreign imports legally allowed to be supplied in the country
Effects of a quota
- societal welfare is reduced
- setting a quota below the free market equilibrium quantity decrease consumption of good raising its prevailing market price ceteris paribus reducing consumption of certain goods by restricting qty available in market and increasing its price
Indirect price controls/Market based policies
- Taxes
2. Subsidies
Taxes
involuntary payment of funds to the govt by a household or firm for which for which the household or firm receives no good or service in return
- direct
- indirect
Direct taxes
Taxes on income/wealth paid directly to the tax authorities
e.g. income tax and capital gains tax
Indirect taxes
Taxes on expenditure paid to tax authorities by the suppliers of the goods. consumers pay the tax indirectly in the form of higher prices
e.g. GST, VAT (values added), excise duties on cigarettes
Direct and indirect taxes
can be imposed as a specific tax or ad valorem tax
Specific tax
fixed amount of tax charged per unit sold therefore tax per unit of good is the same regardless of the price of the good
Ad valorem tax
a percentage of the price or value added at each stage of production. good or service is taxed a certain percentage based on the value of the product (higher price, higher tax)
Effects of specific indirect taxes
- Producers’ per unit cost of production will increase leading to decrease in supply
- The govt receives tax revenue
- decreases demand
How price elasticity affects impact of specific indirect taxes
impact on equilibrium price and quantity will depend on the relative price elasticities of demand and supply
draw the diagram out
Price inelastic demand
-Govt receives more tax
Price elastic demand
- Govt receives less tax
Direct subsidies
Subsidies that increase households’ income and wealth paid directly to households e.g. cash benefits
Indirect subsidies
Subsidies on expenditure paid directly to the suppliers of the goods and services and consumers benefit indirectly through reduced prices e.g. subsidised education
Effect of specific indirect subsidies
- Increases supply by lower unit cost of production for producers
- increases demand
- Govt pays subsidy expenditure
How price elasticity affects impact of specific indirect subsidies
impact on equilibrium price and quantity will depend on the relative price elasticities of demand and supply
draw diagram
Price inelastic
Subsidy expenditure is lesser
Price elastic
subsidy expenditure is greater
