Importance of government intervention

Governments play an important role in all economies. The table sets out government expenditure as a percentage of GDP for the world's 10 leading industrialised countries. With an average government spending in these countries of over 40 per cent of GDP, you can see how influential governments are in different countries. This is a macroeconomic way of looking at levels of government intervention, but governments are heavily involved at a microeconomic level as well through taxes and subsidies.

Market failure and equity

The IB Economics course looks in detail at the reasons why governments intervene in markets under the topics of market failure and equity. These reasons will be covered in detail in the market failure sections of this textbook in Unit 2.8(3). 

Unit 2.8(3): Government intervention to manage externalities, merit and demerit goods  

Reasons for government intervention

Raise government revenue

Governments raise revenue to pay for public services like health and education. Taxation is a very important source of government finance and indirect taxation of goods and services is a key part of this. In developed economies, indirect tax accounts for about 30 per cent of all tax receipts. 

Support to producers

Many businesses and organisations in the economy are important to the overall welfare of society and are assisted by the government. Farming is supported by governments because food supply is crucial to a country’s population. This is particularly true when making food affordable for people on low incomes. Governments also look to help businesses involved in healthcare, education, energy and infrastructure, etc.

Support for households on low incomes

An objective of many governments is to improve equity and reduce income inequality in society. State support for households on low incomes by subsidising healthcare, energy and housing, etc. is one way of achieving this. For example, free healthcare gives households on the lowest incomes access to doctors, medicine and hospital treatment. If this improves the health of the poorest in society then it gives them the opportunity to make progress in other areas of life such as employment.

Influence the level of production in a market

Some industries can have a negative impact on welfare in society and the state often tries to reduce production in these industries. In recent years the use of fossil fuels is seen as increasingly negative to welfare because of their contribution to climate change. The Paris Climate Agreement has seen governments seek to reduce and phase out the use of coal, oil and gas.

Conversely, the government looks to encourage production in other areas to increase welfare. This is true in markets like energy, healthcare and education. Many governments are now encouraging the use of renewable energy to combat climate change.

Influence the level of consumption in a market

Governments intervene in markets to reduce consumption to protect the welfare of their citizens. For example, the market for recreational drugs is heavily regulated in nearly all countries.

There are also situations where governments encourage the consumption of certain goods and services. This is in markets such as healthcare, where people are, for example, encouraged to get vaccinations because of the benefit to the individual and wider society.

Indirect tax 

Definition

An Indirect or expenditure tax is the tax added to the price of a good or service and collected by the firm selling the good or service and then paid to the government. It is an important source of revenue for governments and it allows the government to affect consumption and production in different markets.

Types of indirect tax

There are two main types of indirect taxation:

• Ad valorem tax is a fixed percentage tax added to the price of a good such as value-added tax (VAT). If you buy a computer for $960 you will pay $160 in VAT if the rate is 20 per cent.
• Specific tax or duty is a set money value of tax added to the price of a good. Specific taxes are placed (levied) on goods like petrol, alcohol and cigarettes.

Reasons for the use of indirect tax

Indirect taxation is an important source of government revenue. In many countries, it represents around 30 per cent of all tax collected. If all tax was put on household income it is likely this would adversely affect worker incentives.

Governments also use specific taxes to reduce the consumption of goods that they think have significant social costs and negatively affect welfare*.

* This aspect of tax is covered in detail in the chapter on market failure where we look at demerit goods and negative externalities.

Unit 2.8(2): Market failure - merit goods and demerit goods  

Market analysis of an indirect tax

Indirect tax affects supply in a market because it increases the costs of production. For example, an airline’s cost of supplying a flight is $700 and a $50 specific tax is imposed. The supply cost of that ticket will now be $750 ($700 + $50). This means the supply curve for airline tickets shifts vertically upwards by the specific tax of $50. Diagram 2.28 illustrates the impact of an indirect tax on the market for airline tickets.

The effects of a specific tax of $50 levied by the government on the airline market would be:

• The producer (airline) would like to pass on all the $50 tax to the consumer. But if they raise the ticket price from $700 to $750 there would be excess supply so the price falls to the new equilibrium at $720 where demand equals supply after the tax is levied. 
• The total tax collected by the government is calculated by multiplying the quantity sold multiplied by the indirect tax per unit.  In this case $50 x 950,000 = $47,500,000 which is partly paid by the consumer and partly by the producer.
• The consumer pays $20 x 950,000 = $19,000,000. This is known as the consumer incidence (yellow area) of the tax and it leads to a reduction in the consumer surplus.
• The producer pays $30 x 950,000 = $28,500,000. This is known as the producer incidence (green area) of the tax and this means a reduction in the producer surplus.

Importance of elasticity

Price elasticity of demand and supply will affect the size of tax revenue received by the government as well as the incidences of tax paid by the consumer and the producer.

Price elasticity of demand

Governments often favour taxing goods with price inelastic demand because the revenue collected is high and the tax incidence falls more on the consumer than the producer. A higher incidence on the producer is more likely to result in a cut in output which could cause unemployment.  In addition, if output falls significantly then the tax revenue will be lower. The example in diagram 2.28 has a PED of: 4.77 [-13.64% / +2.86%]. Diagram 2.28 shows price elastic demand in this case which means the producer incidence is greater than the consumer incidence.

In diagram 2.29 an ad valorem tax of 20 per cent is put on the price of household electricity. Notice that when an ad valorem indirect tax is put on a good the supply curves diverge as the price increases.

If the price of a good is $100 the indirect tax is $20 and if the good costs $500 the tax is $100.

Because the PED of electricity is price inelastic the incidence of tax falls more heavily on the consumer (yellow area) relative to the producer (green area) and the tax revenue for the government is greater.

Price elasticity of supply

PES also affects the tax collected by the government and the size of the incidence on the consumer and the producer. When the PES of a good is greater than the PED the consumer incidence is greater than the producer incidence and when PES is less than PED the producer incidence is greater than the consumer incidence.

For example, if a tax is put on agricultural goods like avocados which is a luxury item where PED is relatively elastic and PES is relatively inelastic then the producer has a higher incidence of tax.  In diagram 2.30 a tax of 0.40c is levied on avocados where the consumer has an incidence shown by the yellow area and the producer the green shaded area.

Impact on stakeholders

Consumers

Individuals who buy goods that have been taxed pay a higher price and experience a loss of consumer surplus. It can be argued that when people are buying goods associated with social costs like alcohol, the higher price reduces their consumption and this increases their welfare in the long term.

Producers

Businesses in markets that are taxed must pay their incidence of tax and this reduces their producer surplus. This may lead to a fall in business profits which reduces long-term investment and this could lead to workers being made redundant.

Government

Governments benefit from the revenue they receive from indirect taxes which they can use to spend on public services. There may also be benefits from a reduction of goods associated with social costs such as alcohol. There may, however, be some negative political consequences from an industry badly affected by a tax. The collapse of an airline following the imposition of air passenger duty could be damaging to a government.

Welfare

When a tax is applied to a good it will change the allocation of resources in the market. Diagram 2.31 shows the welfare loss associated with a $0.40 tax on petrol. This is made up of two elements:

Consumer welfare loss

When the price increases from $1 to $1.30 consumer surplus of the people who would have bought the petrol at $1 but will not buy it at $1.30 disappears. This is called the consumer welfare loss and is shown in diagram 2.31 by the dark blue shaded area.

Producer welfare loss

The producer incidence of the tax in diagram 2.31 is $0.10c. When this is applied to the petrol market some producers will fail (go bankrupt) or will choose to leave the market. Their producer surplus will be lost to the economy and this is shown in diagram 2.31 by the brown shaded area.

Subsidy

Definition

A subsidy is an amount of money paid by the government to producers to encourage the consumption and production of a good or service.  Examples of subsidies include those made to farmers to produce food, energy firms to produce renewable energy, and pharmaceutical businesses to produce new healthcare drugs.

Reasons for subsidies

Government use subsidies to support producers and consumers in different markets:

Consumers

Some goods and services carry significant social benefits to society and their consumption increases welfare in society. For example, governments often subsidise renewable energy because of the environmental benefits it brings to society.

*Positive externalities and merit goods are often supported by subsidies and they are covered in Unit 2.8(2) on market failure.

Unit 2.8(2): Market failure - merit goods and demerit goods  

Producers

Government step into markets to support producers in key industries like farming. Agriculture is often seen as a strategically significant industry because food supply is important for the security of the country. You could also consider industries such as steel and energy as strategically important.  By paying a subsidy to producers the government protects supply in these important markets.

Subsidies are also paid to industries because they are important for economic development and employment. Subsidies paid to larger manufacturing businesses to encourage investment can lead to long-term economic growth.

Finally, subsidies are sometimes paid to domestic firms to protect them from foreign competition. *This is covered in Unit 4.2/4.3 on protectionism.

Unit 4.2/4.3 Trade protectionism 

Effects of a subsidy on a market

When a good is subsidised the supply curve shifts vertically downwards by the value of the subsidy paid to producers in the market. A subsidy paid to producers reduces the costs of producing a good.

For example, if the government decides to subsidise milk by $0.40c per litre then the cost of producing each litre of milk will be $0.40p per unit lower. 

This is shown in diagram 2.32.

The effects of a subsidy of $0.40c per litre on the milk market would be:

• The value of the subsidy paid by the government is calculated as $0.40c x 11m units = $4.4m.
• As the market price of milk falls by $0.30c the consumer benefits from the lower price and an increase in consumer surplus. The yellow area in diagram 2.32 shows the increase in consumer surplus and this can be calculated as: ($0.30c x 10m) + ($0.30c x 1/2m) = $3.15m.
• The producer also benefits from subsidies because they receive an extra $0.10c per litre for the milk they sell. Their gain in producer surplus is shown by the green shaded area in diagram 2.32 and this is calculated as: ($0.10 x 10m) + ($0.10 x 1m/2) = $1.05m.
• When subsidies are applied there is a welfare loss because resources are drawn into the market by the subsidy that is not efficient enough to exist under normal market conditions. This is shown by the blue shared area in diagram 2.32 and can be calculated as: $0.40 x 1m/2 = $0.2m

Importance of elasticity

Price elasticity of demand and supply will affect the size of subsidy paid by the government as well as the subsidy benefits paid to the consumer and the producer. The PED and PES will also affect the size of the welfare loss of the subsidy.

Price elasticity of demand

The impact of the subsidy on milk shown above will be affected by the PED of milk. The more inelastic demand is the greater the reduction in price and the bigger the relative benefit to the consumer. The milk example shows this. As a relative necessity milk has inelastic demand which can be calculated as: [+10% / -25% = 0.40] which means the gain in consumer surplus is great than the gain in producer surplus.

If demand is price elastic the gain in producer surplus is greater than the gain in consumer surplus. This is because the price does not fall as much as it would do if demand was price inelastic, which means the surplus gain is not as great for the consumer.  In diagram 2.33 a subsidy is put on electric cars which have relatively elastic demand. The green shaded area is the gain in producer surplus and the yellow shaded area is the gain in consumer surplus.

The blue welfare loss triangle is bigger when supply is inelastic because more inefficient producers are drawn into the market when demand is price elastic compared to inelastic.

Price elasticity of supply

The impact of a subsidy will also be affected by PES. If the PES of a good is more elastic than demand as in diagram 2.32 then consumers gain more surplus than producers. If PES is less than PED as in diagram 2.33 then producers gain more than consumers.

For example, the market for rented housing is likely to have a higher PES than PED. If a subsidy is introduced by a government on rented housing and quantity supplied increases as new landlords quickly enter a market then the price will fall more and less producer surplus will be available to each producer. The significant fall in price means there is a greater gain in surplus by the consumer relative to the producer.

Impact on stakeholders

Consumers

Subsidies lead to a fall in prices in a market and this benefits consumers because they experience a rise in consumer surplus. If the good is bought widely by low-income households then the benefit to those consumers is likely to be significant. A subsidy, for example, on bread, rented housing or rice, is likely to benefit consumers more than a subsidy on the theatre or the opera. 

Producers

The gain in producer revenue and surplus that comes from a subsidy will help producers. The greatest benefit will be when subsidies are targeted at producers who may not be able to survive without a subsidy. If the subsidy is paid to a farmer who is a rich landowner then this will have less impact than the money paid to low-income farmers who struggle to survive. For example, Prince Charles receives significant amounts of farming subsidies from the EU.

Government

A subsidy needs to be paid for by the government which means there will be an opportunity cost of money that has been sacrificed from other areas of government expenditure. A subsidy on electric cars might mean there is less expenditure on the roads. Alternatively, a government might have to raise taxes to pay for the subsidy. There may also be a cost to the government in terms of managing and distributing a subsidy.

Welfare

Subsidies affect the allocation of resources in markets and this can either increase or decrease welfare. The blue shaded triangles in diagrams 2.32 and 2.33 show the welfare loss associated with the application of subsidies in markets. Producers and resources are drawn into markets that would not be there without the subsidy and the cost of those less efficient producers represent a welfare loss.

Subsidies can, however, also increase welfare if the consumption and production of the goods subsidised bring significant wider benefits to society. For example, subsidies for the development of new healthcare drugs might bring much greater benefits to a country than the cost of the subsidy.

*This subject is developed further in the positive externalities in Unit 2.8(1) on market failure.

Unit 2.8(1): Market Failure – Externalities