Government Microeconomic Intervention

Maximum & Minimum Prices

Minimum Prices

• Definition -> Price control set by the Government as the lowest legal price that can be set for a good or service

• Alias -> Price Floor

• Aim -> Discourage consumption/production of goods/services

• Minimum Wage -> Type of minimum price; could reduce employment but, encourages positive externalities

o Positive Externalities -> Improved socioeconomic welfare and incentivises work

• **

Key Takeaways from Minimum Price Graph (above)

1. 1)Quantity Supplied (Qs) > Quantity Demanded (Qd)

o Supply -> Rises from Q* to Qs

o Demand -> Reduced from Q* to Qd

2. 2)Price Minimum is ABOVE Equilibrium -> Makes it more profitable to sell the good; incentivises production, and less
affordable to consume (discourages consumption)

o More Quantity Supplied (Qs) -> Suppliers are encouraged to supply more of their product

o Less Quantity Demanded (Qd) -> Consumers are discouraged from purchasing the product, since it becomes less
affordable

3. Main Outcome → Excess Supply (difference between Q* and Qs)

Eg. of Minimum Price) Minimum Wage

1. Definition -> Minimum hourly wage an employer must pay an employee

2. Aim/Purpose -> Reduce poverty; increasing living standard of workers

3. Perverse Outcomes (Negative Side Effects)

o Unemployment Increased -> More expensive to hire workers; firms must lay off part of their workforce

o Labour Costs Rise

o Reward for Working Rises -> More workers are willing to supply their labour

o Hurts Unskilled Workers -> Since firms are stricter in the abilities they demand of their employees at higher wage
rates

4. Requisites to be Effective:

o Minimum Wage must be ABOVE Equilibrium -> Or else employers will ignore minimum wages below the market
wage (equilibrium level)

o Consider the Elasticity of Labour Demand

▪ Inelastic Demand -> Will result in a smaller excess of unemployed workers; firms don’t respond in such
extreme degree to rise in labour costs

▪ Elastic Demand -> Will result in a more accentuated excess of unemployed workers; firms respond adhoc to
the rise in labour costs

Minimum Price Impact on Producer & Consumer Surplus

Minimum Price Advantages & Disadvantages

 Advantages Disadvantages

1)Discourage Demerit Good Consumption - 1)Informal Labour -> Workers who are employed unofficially in
> Reduces negative externalities order to work for less than the minimum wage

2)Raise Living Standard of the Poorest 2)Unemployment Rate Rises

3)Incentive for People to Work 3)Decrease in the Wealth of Consumers

4)Inflation

Maximum Prices

• Definition -> Price control set by the Government as the highest legal price that can be set for a good or service

• Alias -> Price Ceiling

• Aim -> Encourage consumption/production of goods/services; avoid goods from getting too expensive

• ** \n **

Key Takeaways from Maximum Price Graph Above

1. Quantity Demanded (Qd) > Quantity Supplied (Qs)

o Supply -> Falls from Q* to Qs

o Demand -> Rises from Q* to Qd

 2. Price Maximum is BELOW Equilibrium -> Makes it less profitable to supply the good; discourages production, and more
affordable to consume (encourages consumption)

o Less Quantity Supplied (Qs) -> Suppliers are discouraged from supplying their product, since it becomes less
profitable to sell

o More Quantity Demanded (Qd) -> Consumers are encouraged to purchasing the product, since it becomes more
affordable

3. Main Outcome -> Supply Shortage // Excess Demand (difference between Q* and Qs)

o Consumers Require Rationing of the Good -> Since more consumers want the product than what is currently available

o Rationing Mechanisms -> Must be put in order to fairly distribute the product’s output

Eg. of Maximum Price) Real Estate Rent Prices

1. Aim/Purpose -> Maintain the rent affordable for tenants (consumers)

2. Perverse Outcomes (Negative Side Effects)

o Landlords (Suppliers) -> Unwilling to supply their real estate to the market, since prices aren’t as profitable than
before the maximum rent limit

o Tenants (Consumers) -> Struggle to find available housing, since less landlords are willing to rent

o Black Market Arises -> Landlords accept bribes from desperate tenants; results in extremely exclusive rent prices,
since demand accentuates significantly)

3. Requisites to be Effective:

o Price Ceiling must be BELOW Equilibrium -> Or else producers will ignore price ceilings

Maximum Price Impact on Producer & Consumer Surplus

 • ** \n **

Maximum Price Advantages & Disadvantages

Advantages Disadvantages

1)Essential Goods become More Affordable 1)Supply Shortage // Excess Demand -> Results in the
need of a rationing mechanism to fairly distribute the
supply of the desired product

2)Housing Market -> Theoretically prevented from 2)Bribery & Corruption -> Regarding those responsible
becoming too expensive for regulating the queue or rationing process

3)Transportation Market -> Fares are restricted from 3)Informal/Black Market -> Supply scarcity is satisfied
reaching an exceeding price through illegal means outside of the legal market;
informal price becomes far more expensive than both
the maximum and equilibrium price

4)Prevents Monopoly Exploitation -> Monopolies can’t 4)Reduction in Firms’ Profits -> Less profit revenue,
exceed a set price level legally, so even though they could hence less money to reinvest into the business; this may
manipulate all alternative supply options, they would not also lead to restricted economic growth
be able to get away with it
 Advantages Disadvantages

5)Can Result in Welfare Gains -> Due to lower prices 5)May Lead to Government Failure
making goods more affordable; better standard of living
(theoretically)

6)Increase in Firms’ Efficiency -> Since they must figure

out how to cut their costs in order to raise their
profitability again

Buffer Stock Schemes

• Markets with Supply Variations -> Experience price volatility (price equilibrium varies constantly)

o Reasons -> Eg. Agriculture Industry: difficult weather conditions

o Agricultural Markets -> Have their supply fixed in the short run

• Government Intervenes -> Aims to reduce price volatility through the use of buffer stock schemes

• Buffer Stock -> Amount of a commodity that is held to limit its price volatility

o When Commodity has Production Surplus -> Product is bought and stored in the buffer stock

o When Commodity has Production Shortage -> Buffer stock supplies the amount needed to cover the shortage

** **

Key Takeaways from Buffer Stock Graph (above)

• Eg. of Buffer Stock Scheme) Demand & Supply in Agricultural Market

 o Supply in Any Year -> Perfectly Inelastic (PES=0, vertical supply curve)

o Years 1-3 -> S, S1, S2

o Government’s Aim -> Wants equilibrium to be at price P* and quantity Q*

• Year S1

o Equilibrium Quantity -> Q1

o Equilibrium Price -> P2

o Government Buys Extra Output (Q1-Q*) -> This shifts the equilibrium price to P*

• Year S2

o Equilibrium Quantity -> Q2

o Equilibrium Price -> P1

o Government Sells Buffer Stock to Cover Shortage (Q2-Q*) -> This shifts the equilibrium price to P*

Buffer Stock Scheme Advantages & Disadvantages

Advantages Disadvantages

1)Solves Price Volatility -> Achieves to establish price 1)May be Arbitrary to Determine the Equilibrium Price -
stability in uncertain markets > Uncertainty about what the equilibrium price of a
commodity should be

2)Stable Incomes for Farmers/Workforce of Unstable 2)Additional Costs of Operating the Buffer Stock Scheme
Markets -> Eg. agricultural market’s profits are stabilised -> Either the Government or producers will need to
 Advantages Disadvantages

contribute; may distract the Government from focusing in

other responsibilities

3)Encourages Producers to Engage in Long-Term 3)Difficulties to Store Excess Supply -> Perishability of
Business Plans & Deals -> Gives way to economic the produce must be considered
growth, discovery of new industries, international
competitiveness, etc.

Taxation

Example of Average v/s Marginal Tax

• Money Earned -> $100,000

• Money Paid in Income Tax -> $25,000

• Net Income -> $75,000

• Average Rate of Taxation -> 25%

• Marginal Tax Rate -> The rate of tax that you pay on your next dollar earned

o May be Different from Average Rate of Taxation -> Since it depends on the next tax bracket the individual is on

• Tax Rate Formula -> [(Total Tax Paid) / (Total Income)] * 100

• Tax Rate Eg. -> [(21,036.75)/(21,036.75)/(100,000)] * 100 = 21.04% **

• Marginal Tax Rate in Image Above -> 28%

Direct Taxes

• Definition -> Taxes that are levied on income, wealth and profit

• Payee (Recipient of Tax Payments) -> Direct taxes are paid directly to the Government

• Responsibility -> Bears on the Consumer/Firm through income, inheritance, etc.

• Examples -> Income Tax, Capital Gains Tax, Corporation Tax

Indirect Taxes

• Definition -> Taxes which are levied on expenditure of goods and services

• Collected from Sellers -> This increases the production costs of producers, thus resulting in less supply

• Market Price of Good Rises -> Hence Quantity Demanded is lower (contracts)

• Consumer Incidence -> The amount of tax passed from the producer to the consumer

• Producer Incidence -> Portion of the tax which the producer pays

• Examples -> VAT (UK), Sales Tax (USA)

• Excise Duty -> Specific Tax on a particular good

• 2 Main Types -> A)Specific/Per-Unit Tax and B)Ad Valorem/Value Added Tax

• A) Specific/Per-Unit Tax -> Fixed amount of tax charger to the seller per each unit of good/service sold

o The Most Common Type of Indirect tax

o Largest Source of Tax Revenue for Governments

• B) Ad Valorem/Value Added Tax -> Tax based upon the total value of a transaction, levied as a % of a good’s value

Proportional, Progressive & Regressive Taxes

 Type Marginal Tax Rate Definition Examples

Proportional Flat = Average Rate of Fixed rate for all taxpayers, regardless of Corporation Tax; Firms, LLcs,
Tax income etc.

Progressive Rises with income Taxes those with higher incomes more Income Tax

Regressive Falls with income Lower incomes pay more in taxes Sales Tax
(indirectly)

** \n Impact v/s Incidence of a Tax

• Impact -> The individual/company on which the tax is levied on

• Incidence of a Tax -> Eventual distribution of the burden of a tax

A1)Impact of a Specific tax

• Elastic Demand

• Impact on Elastic Product

o Quantity Demanded -> Reduced from Q* to Q1

o Price -> Rises from P* to Pconsumer

• Inelastic Demand
 • Impact on Inelastic Product

o Quantity Demanded -> Minimally reduced from Q* to Q1

o Price -> Rises sharply from P* to Pconsumer

o Ineffective to Reduce Demerit Good Demand -> Since addicted consumers purchase anyways

o Great source of revenue for Government

A2)Incidence of a Specific Tax

• Inelastic Product

• Elastic Product

• Main Takeaway -> The more inelastic a product is, the greater the burden lies on the consumer.

Scenarios for Complete Consumer Burden

• NO Producer Burden -> Either because consumers absorb all the burden or producers refuse to adjust to consumers’
demands

• Perfectly Inelastic Demand -> PED = ∞ ; consumers absorb all the burden since they do not respond to changes in price;
vertical demand curve
** **

• Perfectly Elastic Supply -> PES = ∞ ; consumers absorb all the burden since producers refuse to adjust to consumers’
demands; vertical supply curve

** **

B1) Impact of an Ad Valorem Tax

• Main Difference from Specific Tax -> Tax value rises as the price rises

• Elastic Demand

** **

• Impact on Elastic Product

o Quantity Demanded -> Reduced from Q* to Q1

o Price -> Rises from P* to Pconsumer

• Inelastic Demand

** **

• Impact on Inelastic Product

o Quantity Demanded -> Minimally reduced from Q* to Q1

o Price -> Rises sharply from P* to Pconsumer

B2) Incidence of an Ad Valorem Tax

** **

Taxation Graph Calculations & Formulas

• Value of the Tax -> Difference between Pconsumer and PSupplier

• Tax Revenue -> Q1 * Value of Tax // Q1 * (Pconsumer-Psupplier)

• Producer Burden

o Area -> Above Psupplier, below market/equilibrium price, left of Q1

o Inelastic Market -> Producer burden is smaller; more money spent on product

o Elastic Market -> Producer burden is greater; less revenue due to less sales

• Consumer Burden

o Area -> Below Pconsumer, above market/equilibrium price, left of Q1

o Inelastic Market -> Consumer burden is greater; more money spent by consumers

o Elastic Market -> Consumer burden is smaller; consumers don’t tolerate a rise in price, less demand, less sales

• Deadweight Loss (DWL) -> Inefficient allocation of resources, market failure; no party enjoys the benefit

o Inelastic Market -> DWL is much smaller; revenue is collected anyway since consumers still buy the product

o Elastic Market -> DWL is much greater; revenue is much smaller since consumer demand contracts

Subsidies

Subsidies

• Definition -> Benefit given by the government to producers to reduce their production costs.
 • Aim -> Encourage further production

• Financing/Budget for Subsidies -> Tax Revenue

• Opportunity Cost -> Government revenue could have been used elsewhere; potential government failure: there may be
inefficient spending.

Impact of a Subsidy

• Shift Supply Curve to the Right // Supply Expands -> Producers can supply more of their product at each given price.

• Market/Equilibrium Price -> Lowered from P* to Pconsumer (see below)

• Value of Subsidy Per-Unit -> Difference between P* and Pconsumer

• Total Government Spending on Subsidy -> Per-Unit Subsidy * Output

• Elastic Demand

** **

• Impact on Elastic Product:

o Price -> Slightly reduced from P* to Pconsumer

o Quantity Supplied -> Large increase from Q* to Q1

Incidence of a Subsidy

** **

• Consumers -> Do not fully benefit from the full value of the subsidy

• Producers -> Absorb some of the benefit of the subsidy for their own gain
 • Inelastic Demand

** **

• Main Takeaway from Inelastic Demand -> Leads to greater consumer benefit

• Elastic Demand

** **

• Main Takeaway from Elastic Demand -> Leads to Greater Producer Benefit.

Income & Wealth Inequality

Income v/s Wealth

• Income -> Flow of money; variable

• Wealth -> Stock of money or assets; constant

Income

• Definition -> Money received, especially on a regular basis

• Wages & Salaries -> Paid to people as a reward for the work they have carried out

• Benefits -> Ways in which income can be received; pensions or tax credit

• Profits -> Income that flows into businesses

• Dividends -> Income distributed to shareholders of businesses

• Rental Income -> Flow of income to people who own and rent/lease out their property

• Interest -> Paid to people who hold money in interest-paying accounts with financial institutions
Wealth

• Savings -> Held in multiple types of accounts with financial institutions

• Shares -> Ownership of shares issued by limited companies

• Property -> Ownership of property

• Bonds -> Money held in bonds

• Pension Schemes -> Wealth held in occupational pension schemes and life assurance schemes

The Gini Coefficient

• Definition -> A statistical measure of the degree of inequality of income in an economy

o The Lower the Figure -> The more equal the distribution of income

o The Bigger the Figure -> The more unequal the distribution of income

• Purpose -> Measuring income & wealth inequality

2020’s Highest Gini Coefficients // Most Inequality

Country Gini Coefficient

1)South Africa 0.630

2)Namibia 0.610

3)Botswana 0.605
 Country Gini Coefficient

4)Zambia 0.571

5)Central African Republic 0.562

6)Lesotho 0.542

7)Mozambique 0.540

8)Swaziland 0.515

9)Brazil 0.513

10)Colombia 0.508

2020’s Lowest Gini Coefficients // Least Inequality

Country Gini Coefficient

1)Azerbaijan 0.166

2)Ukraine 0.250
 Country Gini Coefficient

3)Slovenia 0.254

4)Iceland 0.256

5)Czech Republic 0.259

6)Moldova 0.263

7)Slovakia 0.265

8)Kyrgyzstan 0.268

9)Kazakhstan 0.269

10)Belarus 0.270

Economic Reasons for Income and Wealth Inequality

1. Employment -> Hard to find well-paid employment

o Increase in Unemployment -> Fewer people receiving wages, more receiving state benefits

o Fewer Full-Time Positions -> Part-time jobs rise, income inequality increases since wages are lower in part-time
positions
 2. Government Policy:

o Wage Freezes -> The wage increase rate rises slower than inflation; seeks to reduce further inflation

o Fall in Standard of Living -> Mostly seen in public sector workers

3. Taxation -> The Government may raise tax levels to increase public revenue, makes taxes even more regressive for lower
sectors of the economy

4. Distribution of Wealth:

o People Who Already Hold Wealth -> Can invest, which creates even more wealth for them

5. The existing Concentration of Wealth -> Makes inequality a vicious cycle

Policies to Redistribute Income and Wealth

1. Minimum Wage:

o Government -> Can establish a minimum wage

o Main Issue -> Some workers may be unemployed since firms may not be able to pay all workers the minimum wage

o Side Effect -> May lead to unemployed workers living off benefits

2. Transfer Payments:

o Definition -> One-way payments (in-kind benefits) in which no good, money or service is exchanged

o Purpose -> Ensure basic living standards for all, reduce inequality and poverty, redistribute income from the rich to
the poor

o Important Note -> Transfer payments are not a reward for any productive effort

o Revenue from Taxation -> Used to provide financial support to people

 o Government Provisions -> Social security, unemployment benefits and housing benefits

3. Progressive Income Taxes:

o Definition -> Where the proportion of income paid in tax increases as income increases

o Purpose -> Achieve a more equitable distribution of income

o Important Note -> These do not only take more from a person as their income rises but also a higher proportion of
their income

o Increase in the Marginal Rate of Taxation -> For. Income tax might start at 20% and then increase by 30%, later 40%,
and later 50% as income levels rise

4. Inheritance & Capital Taxes:

o Inheritance Tax -> A tax which is paid on the money, property and possessions of someone who has died

o Capital Gains Tax -> A tax which is paid on the surplus obtained from the sale of an asset for more than was originally
paid for it

o Government’s Purpose -> Intervene in the economy to try to bring about a more equitable distribution of wealth

5. State Provision of Essential Goods & Services:

o Purpose -> Help redistribute income & wealth

o Money for Provision Funding -> Comes from the money received from taxation

o Main Effect -> Helps reduce inequality since money goes from the well-off to the less well-off

o Great Example -> State Provision of Health Care

6. Public Goods -> Must be provided by the State, or they would not be provided at all

Effect of Transfer Payments on the Market

 • Transfer Payments -> Can be given in various forms of income support to those who struggle economically.

• Unemployment Benefit -> Money paid out to unemployed workers

o Side Effect -> May discourage workers from finding employment (benefits are argued to be too high)

o Perverse Outcome -> Inefficient allocation of resources; labour is NOT fully employed

Direct Provision of Goods & Services

State Provision of Public Goods

• Public & Merit Goods -> May not be provided or underprovided by the private sector.

o Examples -> Education, Defense, State Provision of Wealth, etc.

o Government Intervention -> Attempts to ensure there is an optimal level of provision of public & merit goods

• E.g. Street Lighting, Police and National Defence -> Provided by the State, since otherwise they would not be provided at all.

• Redistribute Income & Wealth -> Money used to pay for provision comes from taxation.

o Reduces Inequality -> Tax revenue pays for goods/services the poor are not able to afford

o Tradeoff -> Increased spending = less spending elsewhere

Effects to Notice

• Reduced Role of the Private Sector -> The State has no competition and is not motivated by profit.

o May Lead to Less Efficiency -> Since there is a lack of incentive to reduce production costs

• Solution -> The Government can pay private firms to provide goods/services

o Delegate Provision to Firms -> Instead of supplying them themselves

• May Result in Lower Costs -> Firms may compete to be hired by the Government
Provision of Information

• Governments -> Attempt to ensure there is no information failure; must raise awareness of the advantages of merit goods
and the disadvantages of demerit goods.

• Imperfect Information -> May lead to market failure

• Consumers & Producers -> Require perfect information to make informed economic decisions

• Example -> Second-hand car dealers must show the entire history of a car

• Downsides & Challenges -> It’s expensive to regulate information provision properly

Nationalisation & Privatisation

Nationalisation

Advantages Disadvantages

May Lower Costs -> By assuming control of an Lack of Competition -> The Government lacks incentives to
industry cut costs, hinders innovation and development

Industries Run for the Benefit of Society -> Instead Lower Quality Goods/Services -> Due to lack of competition
of seeking profit

Private Monopoly Prevented -> Since the Reduced Pool of Options for Consumers
Government can assume control of an entire industry

Privatisation

• Definition -> Transfer of ownership, property or business from the Government to the Private Sector
 • Method -> The Government sells the ownership of the previously state-owned asset; private firms pay the State for
ownership

• Example -> British Airways shares were open to the market

Advantages Disadvantages

1)Reduction in Costs -> Due to the constant 1)Benefit of Society not Ensured -> It may not be addressed due
pressure of competition within the industry to profit-seeking behaviour

2)Higher Quality Goods/Services -> Due to 2)Monopolies May Arise

competition

3)National Budget May Rise -> Through the sale 3)Fewer Income Streams for Government Budget -> The State
of state-owned industries can no longer rely on an ex-industry as a source of revenue