Chapter 3: Government

microeconomic intervention
What is laissez faire economics?
• In a free market system, governments take the view that markets are
best suited to allocating scarce resources and allow the market forces
of supply and demand to set prices.
• The role of the government is to protect property rights, uphold the
rule of law and maintain the value of the currency.
• Competitive markets often deliver improvements in allocative,
productive and dynamic efficiency
• But there are occasions when they fail – providing a case for
intervention.
Government intervention: Why do
governments intervene in free market?
• The justification for intervention is usually where there is market
failure – a situation where the market fails to make the best use of
scarce resources, prompting government intervention.
• Government intervention is regulatory action take
by government that seek to change the decisions made by
individuals, groups and organisations about social
and economic matters.
What are the main reasons for government
intervention in markets?
• To correct for market failures
• To achieve a more equitable distribution of income and wealth
• To improve the performance of the economy
Types of government interventions
• Regulations: controlling the free market, Legal and other methods are used to
control the prices, quality and quantity of goods and services that are
produced and consumed.
• Financial intervention: Taxes and subsidies are frequently used by
governments to influence production and the prices of a wide range of goods
and services in the market.
• Government provision: Government to take over the production of a good or
service. In many countries state-owned industries such as electricity
generation, coal mining, water provision and railways are entirely owned and
managed by the state and are often referred to as nationalised industries. It is
also very common to find that some goods and services are produced by both
the state and the private sectors. (Education and healthcare)
Maximum and minimum price controls
• Maximum price (or price ceilings): a price that is fixed below the
normal equilibrium price; the market price must not exceed this price.
• This means that the price that can be legally charged by sellers must
not be any higher.
• Governments use legislation to enforce maximum prices for:
■ staple foodstuff s, such as bread, rice and cooking oil
■ rents in certain types of housing
■ services provided by utilities, such as water, gas and electricity
■ transport fares especially where a subsidy is being paid.
Explain
Minimum price (price floor)
• Minimum price: a price that is fixed; the market price must not go
below this price.
• The minimum price is set above the normal equilibrium price.
Governments use legislation to enforce minimum prices for:
■ demerit goods such as tobacco products and alcohol
■ wages in certain occupations, usually low skilled, to avoid exploitation
by employers
■ certain types of imported goods where domestically produced close
substitutes are available.
■ To guarantee a minimum price to farmers
Effects of minimum
price control
Price fixing: surpluses and shortages
 What is consumer surplus?

Revision:CW
Answer the What is producer surplus?
following
questions:
With the help of diagrams, explain
how changes in supply and
demand affect consumer and
producer surplus.
Taxes – direct and indirect
• Taxes are charges that are imposed by governments on people and
businesses.
• Tax is part of government’s fiscal policy
• There are two types of taxes: Direct and Indirect
Direct and indirect taxes in the UK

• Direct taxes in the UK • Indirect taxes

• Income Tax • VAT
• Corporation Tax • Customs Duty
• Capital Gains Tax • Excise Duties
• National Insurance Contributions • Insurance Premium Tax
• Statutory Payments • Environmental taxes, including Air
• Inheritance Tax Passenger Duty
• Petroleum Revenue Tax • Climate Change Levy
• Student Loans • Aggregates Levy
• Stamp Taxes • Landfill Tax
Countries with the Highest and Lowest
Corporate Tax Rates
• The highest corporate tax rate in the • Ten countries charge a 0% corporate tax:
world belongs to the United Arab • Anguilla
Emirates (UAE), with a 2019 tax rate • Bahamas
of up to 55%, according to KPMG. • Bahrain
• Other countries at the top of the list • Bermuda
include Brazil (34%), • Cayman Islands
• Venezuela (34%), • Guernsey
• France (31%), and • Isle of Man
• Japan (30.62%). • Jersey
• The global average corporate tax • Turks and Caicos Islands
rate is 23.79%. • Vanuatu
Read more about corporate taxes from around
the world:
• https://www.investopedia.com/articles/personal-finance/051915/cor
porate-tax-rates-highs-and-lows.asp#:~:text=The%20highest%20corpo
rate%20tax%20rate,%2C%20and%20Japan%20(30.62%25)
.
Direct and
indirect tax
Tax system in China
• http://www.chinatax.gov.cn/eng/c101270/c101271/c5094511/
content.html
Canons of taxation
• By canons of taxation we simply mean the characteristics or qualities
which a good tax system should possess. In fact, canons of
taxation are related to the administrative part of a tax. Adam Smith
first devised the principles or canons of taxation in 1776.
• equitable – those who can afford to should pay more
• economic – the revenue should be greater than the costs of collection
• transparent – tax payers should know exactly what they are paying
• convenient – it should be easy to pay.
Two main types of taxation in the UK
• Direct taxes such as income tax, corporation tax on the profits of
businesses.
• Indirect taxes such as value-added tax (VAT) on the retail sales of
many goods and services, excise duties on fuel, alcohol and tobacco
products.
Direct tax
• Direct taxes such as income tax, corporation tax on the profits of
businesses and national insurance contributions paid by employers
and employees.
• They are paid directly to the government by taxpayers, either as
individuals or companies, from their incomes.
two main types of indirect taxes are
• Ad valorem taxes, which are a proportion or percentage of the price
charged by the retailer. Example: GST, VAT. The final price paid by
consumers is inclusive of such taxes.
• Specific taxes in the form of a fixed amount per unit purchased.
(Goods with inelastic demand and demerit goods)
• When an indirect tax is imposed, this tax must be paid to the
government by retailers, wholesalers, manufacturers and other
providers of taxable goods and services. This means that the business
receives a price that is higher than the original price by the amount of
the tax. This is represented by a shift to the left of the supply curve by
the amount of the tax. (passed on to consumers through increased
prices)
• The revenue from taxation is then used by the government to fund the
various types of public spending.
• Indirect taxes are widely used to discourage the production and
consumption of demerit goods such as alcoholic drinks and cigarettes
Incidence of taxation: the extent to which the tax burden is
borne by the producer or the consumer or both.
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.

• For example, if demand is very price inelastic, then a higher tax will
mostly be paid for by the consumer in the form of higher prices. If
demand is price elastic, producers will absorb most of the tax increase
in the form of lower profits.
Elastic demand and incidence of tax
• In this case the tax is £7. The tax reduces demand from 120 to 70.
• The price rises from £20 to £21.
• Consumer burden of tax
• The consumer burden is the extra amount the consumers pay. This is
an extra £1. The total consumer burden is the total amount of tax
paid for by consumers.
• Therefore, the consumer burden of the tax is £1 * 70 = £70
• In this case the tax is £7. The tax
reduces demand from 120 to 70.
• The price rises from £20 to £21.
• Consumer burden of tax
• The consumer burden is the extra
amount the consumers pay. This is
an extra £1. The total consumer
burden is the total amount of tax
paid for by consumers.
• Therefore, the consumer burden of
the tax is £1 * 70 = £70
Producer burden of the tax
• The producer burden of the tax is the lost revenue to the firm. Before
the tax they used to get £20. After the tax is paid to the government,
they are left with £14. They are £6 worse off.
• The total producer burden is £6 * 70 = £420
• In this case the total tax revenue = £7 * 70 = £490.
• However, the tax incidence is mostly borne by the producer. The
consumer only pays a small percentage.
Inelastic demand
Usually demand is more price inelastic.
Inelastic demand and the incidence of tax
• In this case the tax is £12. The
tax increases the market price
from £17 to £25.
• The consumer burden is £8 *95
= £760
• The producer burden is £4* 95 =
£380
• In this case a higher percentage
of the tax burden is borne by the
consumer.
Elasticity and the incidence of tax:
• The extent to which the producer is able to pass on the tax by raising
the price depends on the price elasticity of demand for the product.
• The more price inelastic the demand, then the easier it is for the
seller to pass on the tax to the consumer in the form of higher prices.
This explains why essential products like petrol are heavily taxed in
most economies.
• If demand is price elastic, then consumers will invariably buy less of
the product as price rises, resulting in the producer having to absorb a
greater part of the indirect tax.
The relationship between taxation and
income
• The relationship between taxation and income varies for different
types of tax. Three relationships can be identified:
• Proportional taxes, whereby as income rises, the proportion of income
paid in tax remains the same; the tax rate is therefore constant.
• Progressive taxes are those that when income rises, the proportion of
the total paid in taxes increases; the average rate of taxation will
therefore be lower than the marginal rate.
• Regressive taxes are those that as income rises, the proportion of total
income paid in tax falls. Hence, the average and the marginal rates of
taxation are falling.
Progressive, proportional and regressive taxes
• progressive tax—A tax that takes a larger percentage of income from
high-income groups than from low-income groups.
• proportional tax—A tax that takes the same percentage of income
from all income groups.
• regressive tax—A tax that takes a larger percentage of income from
low-income groups than from high-income groups.
Income tax is progressive (in almost every
country)
• The best example of a progressive tax is income tax. Low-paid workers are usually
given allowances that mean that they pay little or even no tax at all. Th e tax rate may
start at 10%, rising in stages to 50% or even 90% in some tax regimes.
• Typical regressive taxes are VAT and GST. These sales taxes are widely applied in
virtually all types of economy. Both are flat-rate sales taxes paid at standard rates of
10, 13, 15 or 20%. This means that the price of a Big Mac or a can of Coca-Cola is the
same for someone on a low wage as it is for a multi-millionaire.
• A regressive tax may be placed in order to reduce demand for demerit goods / good
with negative externalities. For example, a tobacco tax is designed to reduce demand
for cigarettes. It is regressive, but the aim is to reduce smoking rates. They hit the
poor relatively more than the rich. Gambling taxes – Those on low incomes have a
high propensity to spend money on gambling and therefore pay a higher percentage
of their income on gambling taxes.
Regressive tax
Tax: Evaluation
• It is important for the governments to have a right balance between
direct and indirect taxes.
• A trend in many economies has been to collect increasing revenues
from indirect taxes on expenditure since these can usually be
collected quickly, are less liable to evasion and corruption and do not
interfere with the work incentive problem.
Arguments For Using Indirect Taxation
• Changes in indirect taxes can change the pattern of demand by varying
relative prices (e.g. an increase in the real duty on petrol)
• Indirect taxes can be used as a means of making the polluter pay and
“internalizing the external costs” of production and consumption
• Indirect taxes are less likely to distort choices between work and leisure and
have less of a negative effect on work incentives.
• Indirect taxes can be changed more easily than direct taxes – this gives
policy-makers more flexibility.
• Indirect taxes are less easy to avoid
• Indirect taxes provide an incentive to save that help to provide finance for
investment
Arguments Against Using Indirect
Taxation
• Many indirect taxes make the distribution of income more unequal because of their
regressive effects
• Higher indirect taxes can cause cost-push inflation which can lead to a rise in
inflation expectations
• If indirect taxes are too high – this creates an incentive to avoid taxes through
“boot-legging”
• Revenue from indirect taxes can be uncertain particularly when inflation is low or
there is a recession causing a fall in consumer spending
• There is a loss of welfare from duties e.g. loss of producer & consumer surplus
• Higher indirect taxes affect households on lower incomes who are least able to save
Fiscal Policy - Analysing Direct and Indirect Taxes

• https://www.tutor2u.net/economics/reference/fiscal-policy-direct-an
d-indirect-taxes
Tax Competition between Nations
• Tax competition describes a process where a national government
decides to use reforms to the tax system as a deliberate supply-side
strategy aimed at attracting new capital investment and jobs into
their economy.
Tax Competition between Nations
• The issue has become important in the European Union because some
countries including France and Germany complain that poorer countries are
using tax competition as an incentive to attract inward investment, yet they are
also net recipients of EU structural funds.
• Income tax: Estonia (21.3 percent), Latvia (21.4 percent), and the Czech
Republic (31.1 percent) have the lowest top income tax rates of all European
countries covered. The countries with the highest top income tax rates are
Slovenia (61.1 percent), Portugal (61.0 percent), and Belgium (60.2 percent).
• Corporate tax: Portugal and Germany follow, at 31.5 percent and 29.9 percent,
respectively. Hungary (9 percent), Ireland (12.5 percent), and Lithuania (15
percent) have the lowest corporate income tax rates. On average, European
OECD countries currently levy a corporate income tax rate of 21.9 percent.
Subsidies
• Subsidy is another form of government intervention in the market.
• These are direct payments made by governments to the producers of
goods and services.
• When paid to a producer, a subsidy has the opposite effect of an
indirect tax – it is the equivalent of a fall in costs for the producer and
results in a rightward shift in the market supply curve.
• A reduction in a subsidy payment will lead to a shift to the left in the
supply curve.
Figure 3.7
shows that
introducing a
subsidy in the
market results in
a fall in price
from P to P1 and
an increase in
the quantity
traded from Q to
Q1 .
Reasons for paying money (subsidy) to
producers
• to keep down the market prices of essential goods
• to encourage greater consumption of merit goods
• to contribute to a more equitable distribution of income
• to provide services that would not be provided by the free market
• to raise producers’ income, especially in the case of farmers
• to provide an opportunity for exporters to sell more goods
• to reduce dependence on imports by paying subsidies to domestic
producers of close substitutes.
However
• Allocating subsidies from limited government revenue is a controversial
issue.
• It is not only interfering with the workings of the market mechanism but
has opportunity cost implications.
• Another problem is that subsidies are so-called ‘blanket’ or lump sum
payments (not targeted) and, unlike taxes on consumers, cannot easily be
linked to incomes and the ability to pay.
• Staple foods like rice, bread and cooking oil are subsidised in some
developing economies.
• Mass transit (public transport) is heavily subsidised in all parts of the world,
especially in cities and large towns.
Extra reading assignments:
• https://www.theguardian.com/environment/2019/sep/16/1m-a-minu
te-the-farming-subsidies-destroying-the-world
• https://www.theguardian.com/environment/2018/oct/10/huge-reduc
tion-in-meat-eating-essential-to-avoid-climate-breakdown
• https://www.theguardian.com/environment/2019/may/22/eu-ignorin
g-climate-crisis-with-livestock-farm-subsidies-campaigners-warn
What happens when the government
subsidizes a product?
• In this case, the government is
giving a subsidy of £14 (30-16).
The subsidy shifts the supply
curve to the right.
• It leads to a lower market price.
Price falls from £30 to £22.
• Quantity demand increases from
100 to 140
The cost of subsidy
• The government will have to pay
for the subsidy by taxes.
• The cost of the subsidy in this
example is £14 x 140 = £1,960
Effect of subsidy depending on the elasticity of demand
Effect of a subsidy
• If demand is elastic, then a subsidy
causes a bigger percentage rise in
demand. There is only a small fall
in price. In this case, producers
benefit from the subsidy because
their producer surplus increases
more than consumer surplus
• If demand is price inelastic, then a
subsidy causes a substantial fall in
price, however there is only a
small increase in demand.
Subsidy for good with positive externality

• For a good like public transport, there

may be positive externalities to
providing the service.
• If people take a train rather than
drive, it helps to reduce pollution and
congestion. Therefore, in a free
market, we tend to get under-
consumption of public transport.
• A government subsidy causes an
increase in consumption and
increases output to a more socially
efficient level.
Subsidy with elastic and inelastic supply
Subsidy with elastic and inelastic demand
Disadvantages of subsidies
• It would be expensive; the government would have to raise a
significant amount of tax revenue.
• It reduces incentives for firms to cut costs ( or limit to products that
bring net positive externality-solar power)
• It would be expensive; the government would have to raise a
significant amount of tax revenue.
Farming subsidies

• In the US and EU, the biggest government subsidies are given to

farmers. This is not because agriculture gives positive externalities,
but it has become an important political pressure group.
• Subsidies often come indirectly.
• However, farming subsidies have led to an over-supply of food, higher
prices for consumers and inefficiency.
Effect of farming subsidies
• Through guaranteeing minimum prices
(the government buys the surplus to
maintain target price). In the above
example, the government effectively
subsidise farmers by buying the surplus.
However, guaranteeing minimum prices
influences supplier behaviour and it can
lead to an increase in supply, as farmers
are guaranteed to be able to sell to the
government.
• Direct income payments. The EU has
shifted to direct income payments
where they pay farmers directly.
GM, Ford, and Chrysler almost died a decade ago during the
financial crisis - here's how the auto giants have changed
since:
• Automakers' Report Card: Who Still Owes Taxpayers Money? The
Answer Might Surprise You
Subsidies for declining industries

• In 2009, the US government offered a large subsidy to the automobile industry.

The logic for the subsidy was that:
• The car industry was suffering from short-term problems – recession, credit
crunch, over-supply.
• The hope was that the large subsidy would avoid large car firms going bankrupt –
causing a rise in unemployment at a time when unemployment was already high.
• The subsidy would not be permanent but a one-off
• To a large extent, the subsidy was successful. Job losses were avoided, the
industry was able to restructure and the government recovered a large
percentage of its initial subsidy. But, the government also saved unemployment
benefits and the cost of losing more jobs.
• China’s new EV subsidies disqualify luxury models from Tesla, BMW, a
nd Daimler
• https://en.wikipedia.org/wiki/Government_incentives_for_plug-in_el
ectric_vehicles
• https://www.bloomberg.com/news/articles/2020-08-13/europe-s-ele
ctric-car-subsidies-has-market-exceeding-china-sales
Consumer surplus, producer surplus, and
welfare loss from subsidy
Calculating the effects of subsidies on
consumer and producer surplus 86
Elasticity, tax and consumer/ producer surlus
What Is a Transfer Payment?
• A transfer payment is a one-way payment to a person or organization
which has given or exchanged no goods or services for it.
• This contrasts with a simple "payment," which in economics refers to
a transfer of money in exchange for a product or service.
Transfer payments
• Transfer payment: a hand-out or payment made by the government to
certain members of the community.
• Examples:
• old age pensions ■ unemployment benefits ■ housing allowances ■ food
coupons ■ child benefits.
• They are not made through the market, as no production takes place. Their
function is to provide a more equitable distribution of income. The main
recipients are vulnerable groups such as the elderly, the disabled, the
unemployed and the very poor.
• Payments tend to transfer income from those able to work and pay taxes to
those unable to work or in need of assistance.
• They result in less poverty and provide for a more equitable
distribution of income.
• These payments act as a disincentive to accepting work, so increasing
the unemployment rate. As a consequence, output in the economy is
less than it might be and there is a form of inefficiency.
Transfer Payments and the Economy

• Transfer payments are often introduced or expanded during severe economic

recessions. Social Security, for example, was created by the Roosevelt
administration during the Great Depression.
• More recently, though less grand in scale, in March 2020 Congress voted to provide
direct cash payments of $1,200 to most Americans, totaling some $250 billion, as
well as additional direct assistance to U.S. workers affected by the coronavirus-
driven economic collapse. (Congress also approved $500 billion in bailouts for U.S.
corporations.)
• Many countries provide direct cash assistance to people during economic
recessions as a way to support those in need and stimulate the economy. According
to Keynesian economics, there is a "multiplier effect" to transfer payments,
meaning every dollar in payments stimulates a chain reaction that results in more
spending than merely the original dollar.
The Great Depression of 1930s

• The Great Depression was the

worst economic downturn in
the history of the industrialized
world, lasting from 1929 to
1939. ... By 1933, when the
Great Depression reached its
lowest point, some 15 million
Americans were unemployed
and nearly half the country's
banks had failed.
Universal basic income
• The idea of providing a regular, guaranteed payment to citizens,
regardless of need, has been around for centuries.
• Democratic presidential candidate Andrew Yang made universal basic
income a key pillar of his 2020 campaign, which helped shine a
national spotlight on the issue.
• UBI proposals vary in size, although Yang’s plan would give every
American adult $1,000 per month from the federal government.
• One of the core criticisms of basic income is the cost, with some plans
representing more than half of the entire federal budget.
Direct provision of goods and services
• What does the government provide?
• The government provide certain important services free of charge to
the user. Such services are financed through the tax system aimed at
lowering inequality.
• The two most common examples of such free provision in many
economies are merit goods and public goods, such as health care and
education. These markets are subject to various market failures.
• direct provision of merit and public goods – governments control the
supply of goods that have positive externalities. For example, by
supplying high amounts of education, parks, or libraries.
. The main criticism for the direct provision of
goods and services is also a controversial issue:
• The market overprovides especially where no direct charge is made.
• Resources are not allocated efficiently.
• If a charge is made or introduced, demand is likely to fall.
• It can also be argued that many consumers could afford to pay a
charge, so reducing the tax burden or allowing the funding saved in
this way to be put to alternative uses.
Nationalisation and privatization
• Nationalisation: when governments take over a private
sector(shareholders) business and transfer it to the public sector
(government).
• Privatisation: the sale of a state-owned public sector business to the
private sector (shareholders).
Nationalisation, privatisation and
renationalization
• 2020: The ONS announced that private train operating
companies were to be temporarily reclassified as "public non-financial
corporations" from 1 April due to the government assuming the
financial risk of their rail franchises during the COVID-19 pandemic.
The train operating companies' debt is to be included in public
borrowing figures and their employees are to be counted as public
sector employees.
• https://www.theguardian.com/commentisfree/2012/mar/29/short-hi
story-of-privatisation
Arguments for Nationalisation include

• 1. Natural Monopoly A private natural monopoly could easily exploit its monopoly power and
set higher prices to consumers. Government ownership of a natural monopoly prevents this
exploitation of monopoly power.
• 2. Profit shared with taxpayer
• 3. Positive Externalities: For example, public transport plays a key role in reducing pollution and
congestion. A private firm would ignore the positive externalities, but a government run public
transport system could invest in public transport to help improve the economic infrastructure.
• 3. Welfare Issues
• 4. Industrial Relations
• Labour unions often favour nationalisation because they feel they may be better treated by the
government – rather than a profit maximising monopoly.
• 5. Government Investment without government intervention, some industries may suffer from
lack of long-term investment. Railway speed train lot investment
Arguments against Nationalisation include
• Inefficiency: The perceived inefficiency of the public sector is by far
the most common complaint made about nationalisation.
• Government interference: “Not only do government-owned
businesses distort markets, but the money tied up in government-
owned businesses would be far more useful in the hands of the
taxpayers to whom it actually belongs,”
• Governments are motivated by political pressures rather than sound
economic and business sense.
Evaluation of benefits of nationalisation
• Shifting ownership from the private sector to the public sector is only one factor
in whether it will be successful. It also depends on how the nationalised firm is
managed.
• Do workers feel a sense of ownership with nationalised industries? “They pretend
to employ us, we pretend to work.
• In the UK coal mining industry, the initial enthusiasm for nationalisation wore off
because the industry faced serious challenges – declining demand, increased
uncompetitiveness and desire for coal mines. Also, are the funds for investing in
nationalised industries there?
• It depends on the industry
Arguments for Privatisation include
• Increased efficiency
• No political interference.
• Privatization also reduces corruption.
• Raise revenue for the government. Privatisation is a way to sell state-
owned assets and generate a windfall for the government. In theory,
this could be used to finance long-term investment. Though as a
drawback, the government will lose annual profit dividends
• Increased competition. increased competition leads to lower prices,
encourages the development of new products and better-quality
service.
Disadvantages of privatisation
• Natural monopoly: Privatisation would just create a private monopoly
which might seek to set higher prices which exploit consumers. Therefore
it is better to have a public monopoly (water supply/ power supply/rail)
rather than a private monopoly which can exploit the consumer.
• Public interest: There are many industries which perform an important
public service, e.g., health care, education and public transport.
• Government loses out on potential dividends.
• Lack of accountability
• Short-termism of firms: To please shareholders private firms may seek to
increase short term profits and avoid investing in long term projects.
Evaluation of privatisation
• It depends on the industry in question. An industry like telecoms is a typical
industry where the incentive of profit can help increase efficiency. However,
if you apply it to industries like health care or public transport the profit
motive is less important.
• It depends on the quality of regulation. Do regulators make the privatised
firms meet certain standards of service and keep prices low?
• Is the market contestable and competitive? Creating a private monopoly
may harm consumer interests, but if the market is highly competitive, there
is greater scope for efficiency savings.
• Can you create incentives in a nationalised firm? For example, performance
related pay could replace the profit incentive.