2.7

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• HL IB Economics
• 2.7 The Role of Government in Microeconomics
• Contents


  • 2.7.1 Reasons for Government Intervention in Markets
  • 2.7.2 Government Intervention: Indirect Taxes & Subsidies
  • 2.7.3 Government Intervention: Price Controls
  • 2.7.4 Government Intervention: Direct Provision, Regulation & Nudges

  
• 2.7.1 Reasons for Government Intervention in Markets

  
• Reasons why Governments Intervene

  • Correct market failure
  • Earn government revenue
  • Promote equity
  • Support firms
  • Support poorer households

  
• Nearly every economy in the world is a mixed economy & has varying degrees of government intervention
• Governments intervention is necessary for several reasons
• Diagram showing several reasons for government intervention in mixed economic systems

  • Correct market failure
  • Earn government revenue
  • Promote equity
  • Support firms
  • Support poorer households

  
• In maximising their self-interest, firms & consumers will not self-correct this misallocation of resources & there is a role for the government

  
• Equity


  A normative concept. Governments aim to reduce the opportunity gap between the rich & poor but the extent to which it occurs depends on what the society & government believe to be fair.
• Ways in which equity is promoted

  • Laws to protect workers e.g. minimum wage laws, health & safety laws
  • Laws to prevent monopolies from forming as they result in higher prices
  • Laws to prevent environmental damage
• Ways in which governments support firms

  • Providing subsidies or tax breaks
  • Limiting foreign competition until new firms are well established & are able to compete internationally
• Poverty has multiple impacts on both the individual & the economy
• Redistribution policies


  Progressive tax structures & welfare payments to help reduce poverty
• Four of the most common methods used to intervene in markets

  • Indirect taxation
  • Subsidies
  • Maximum prices
  • Minimum prices
• 2.7.2 Government Intervention: Indirect Taxes & Subsidies
• Indirect Tax


  A tax paid on the consumption of goods/services, usually levied by the government on demerit goods to reduce the quantity demanded and/or to raise government revenue
• Specific Tax


  A fixed tax per unit of output (specific amount) e.g. $3.25/packet of cigarettes
• An indirect tax is levied by the government on producers


  This is why the supply curve shifts
• Ad Valorem Tax


  A tax that is a percentage of the purchase price e.g. Value added tax (VAT)

  
• VAT raises significant government revenue
• Diagram showing an ad valorem tax (VAT) and the tax incidence for producers and consumers

  • Initial equilibrium
  • Supply shifts left due to the tax
  • The two supply curves diverge as a percentage tax means more tax is paid at higher prices
  • The price the consumer pays increases
  • The price the producer receives decreases
  • The government receives tax revenue
  • Producers and consumers each pay a share (incidence) of the tax
  • New equilibrium

  
• If the decrease in quantity demanded is significant enough, it may force producers to lay off some workers
• Exam Tip: When drawing this diagram, students often find it hard to identify the three price points. The tax incidence boxes are formed by drawing the new equilibrium quantity through the original supply curve. The three price points are the old equilibrium point, the new equilibrium point - and where the new quantity crosses the original supply curve.

  
• Irrespective if you are dealing with taxes or subsidies, always use the new equilibrium point to determine your incidence boxes.

  
• The consumer incidence is paid from the consumer surplus area and the producer incidence is paid from the producer surplus area.
• Worked Example


  • Calculate the tax revenue collected by the government
  • Calculate the incidence of tax paid by the producer
  • Calculate the change in consumer spending after the imposition of the tax
  • Calculate the deadweight loss caused by the imposition of the tax
  • Calculate the producer surplus after the imposition of the tax