8.9 Government intervention in markets

• Government Intervention

  • Governments intervene in the market to correct market failure, they provide healthcare and education, which the free market would underprovided.
• • Ad Valorem taxes are percentages (VAT). The incidence of tax might fall differently on consumers and producers, Government revenue from ad valorem taxes is larger if demand is price inelastic. This is because demand falls only slightly with the tax. 
  • Specific taxes are a set tax per unit. The more inelastic the demand, the higher the tax burden for the consumer and the lower the burden of tax for the producer. 
• Indirect taxes are taxes on expenditure, they increase production costs for producers, so producers supply less. This increases market price and demand contracts. They could be used to discourage the production or consumption of a demerit good or service.
• Indirect taxes could reduce the quantity of demerit goods consumed, by increasing the price of the goods. You can internalise the externality as the polluter pays the damage.
• A subsidy is a payment from the government to a producer to lower their costs of production and encourage them to produce more. Subsidies encourage the consumption of merit goods. This includes the full social benefit in the market price of the good. Therefore, the external benefit is internalised. 
• • Consumers gain more from a subsidy when demand is price inelastic, whilst producers supply more when demand is price elastic. The disadvantages of subsidies include the opportunity cost to the government and potential higher taxes, the potential for firms to become inefficient if they rely on the subsidy and government failure, if they subsidise less efficient industries. 
• • Maximum prices could lead to welfare gains for consumers by keeping prices low, and they could increase efficiency in firms, since they have an incentive to keep their costs low to maintain their profit level. 
  • However it could reduce a firm’s profits, which could lead to less investment in the long run. Moreover, firms might raise the prices of other goods, so consumers might have no net gain.