Government Intervention

Financial intervention and Regulations

Maximum prices, or price ceilings, are another form of government intervention in markets, and they are the
opposite of minimum prices. Here's how they work:

 A maximum price is a price set by the government that is lower than the market price. This means
that sellers cannot charge more than the maximum price, even if they would be able to in a free
market.

 Equilibrium price was at Pe Govt. in an attempt to set just price enforce maximum price given by P1 at
which demand exceeds the supply by an amount MN. These shortages need to be covered from govt.
warehouses.

 Price ceilings are often introduced to protect consumers from high prices, such as in the case of
essential goods like food or medicine.

 Maximum prices enable families on a relatively lower income to be able to afford products

 these help to keep prices steady and prevent an increase in the country’s inflation rate

 maximum prices mean the price is set below the equilibrium price; this encourages consumers to buy
more goods / services, leading to an increase in demand.

Evaluation

 However, maximum prices can lead to shortages, as producers may not be able to cover their costs at
the lower price, and may reduce production or exit the market altogether. The market will become
less profitable for firms. In the long-term, this may lead to less investment and also decrease supply in
the long-term. For example, rent controls may be a way to deal with the short-term problem of
expensive housing. But, reducing rents will discourage some landlords from letting out property. It
may also discourage people from building houses.
 Critics argue that maximum prices can also lead to black markets, where goods are traded at higher
prices outside of the legal market.
 Firms may be likely to supply less of the product, resulting in less output and higher unemployment.
  Reduced Innovation and Investment: Price controls may lead to reduced investment and innovation
in industries where price controls are imposed, as producers may be less motivated to invest in new
technologies or processes if they cannot raise prices to recoup their investments.
 Market Distortion: Price controls can lead to market distortions, which can create inefficiencies and
reduce the overall welfare of society.
 Administrative Costs: Price controls can be costly to administer, requiring significant resources and
manpower to enforce and monitor.

Black Market Economy;

When the government sets maximum prices, an underground market (sometimes referred to as a shadow
market or black market) is likely to result. An underground market is one where sellers ignore the
government’s price restrictions. Take the case of wartime price controls. The government set maximum prices
for many essential items that were in short supply. This is illustrated in the diagram.

The unacceptably high equilibrium price is Pe. The price fixed by the government is Pg. But at Pg there is a
shortage of Qd – Qs. To deal with the shortage, either the government will have to accept queues, or shops
selling only to ‘regular’ customers; or alternatively a system of rationing will have to be introduced.

Many consumers would be prepared to pay a price considerably above Pg in order to get hold of the good. In
an underground economy such markets can charge a price considerably above Pg. Assume that the dealers buy
up all the supply (Qs) from the producers at the official price and then sell it at a price that clears the market.
The underground-market price will be Pb: at that price, demand is equal to Qs. The dealers gain the extra
revenue shown by the shaded area.

Queuing Problem created by Maximum Price

Queues. One consequence of a maximum price is that people will end up queuing to try and get the good
before it sells out. This will encourage people to spend longer and longer in queues before it runs out. This
time spent queuing represents a significant cost in terms of time. Wasteful activity. Price controls can lead to
wasteful economic activity as people wait in line to get the limited goods. This increases the cost of the good.

Welfare loss

At any given price of a good, producers determine how much they can supply at the market price. When the
market price decreases, the available supply will decrease as well. This will create what is known as a
deadweight loss.
Minimum Price

A price floor is a minimum price that is set for a good or service, meaning that the market price cannot go
below this level. If a price floor, or minimum price, is z the equilibrium price, then there will be no immediate
change to the market - this is a non-binding price floor. A binding (effective) price floor will be a minimum price
above the current market equilibrium, immediately forcing all exchanges to adjust to the higher price.

Figure illustrates how a price floor affects supply and demand. Before the price floor, the market settled at
equilibrium at Pe and Qe. A price floor is set at Min Price, which changes the available supply to Q2 and the
quantity demanded to Q1. Because the price floor increased the price, demand has reduced due to the law of
demand and only Q1 will be purchased. Suppliers will want to sell more at a higher price and will increase their
supply to the market. Therefore there is a surplus of Q1-Q2 from the difference between supply and demand.

Effectiveness of Price Control

Government regulation can intervene by setting a price floor, taking away the larger firm's ability to lower its
prices to drive out competitors. It's important also to consider the full market effect of any policy; a price floor
in a competitive market can inhibit innovation and efficiency. If a firm can't lower its price, then it has no
incentive to invest in a way to produce its product for less money. This will allow inefficient and wasteful firms
to stay in business.

Minimum prices can increase the price producers receive. These have been used in agriculture to increase
farmers’ income.

Higher tariffs necessary on imports. To keep minimum prices, the EU also had to put tariffs on food to keep
prices artificially high.

Minimum prices encourage oversupply and are inefficient. The CAP encouraged farmers to produce food that
no one actually wanted to eat. This included using more chemicals to increase yields.

Assessing the impact of Subsidies; The main benefit of the subsidy is that it increases the quantity
consumed/produced of the good/service thus reducing the welfare loss to society caused by under
consumption/production.
One disadvantage of a subsidy is that it is very expensive for the government to implement. This cost is shown
by the area a-b-c-P2. The large cost of this also means that there is a large opportunity cost. If the subsidy is
relatively ineffective, then the subsidy would have been far better spent on other areas e.g. information
campaigns. The money used for the subsidy could have also been taken away from different areas e.g. the
police force, which is likely have a negative effect on their performance.

Furthermore, not all of the subsidy is passed onto the consumer, some of the subsidy can be kept by the
producer. This is problematic if the purpose of the subsidy is to increase consumption, especially if the demand
for the good/service is price elastic. Subsidies also result in producer inefficiency as they become reliant on it in
order to survive in the market. Therefore by subsidising the firm it distorts free market outcomes.

Indirect taxation; Unlike direct taxes indirect taxes can be passed onto consumers and therefore can be an
effective policy when trying to reduce consumption through higher prices. This is ideal for the government as it
allows them to deal with negative externalities in either production or consumption.

An example of a specific indirect tax used to reduce negative externalities is excise duty. This is a tax on a range
of demerit goods such as cigarettes and alcohol. These goods are often over consumed meaning that quantity
and price are more than socially optimal point .

State provision of public goods

 The government may decide to provide merit or public goods themselves as they believe that the free
market will not do a good enough job regardless of other types of intervention, such as subsidies.
 State provision allows the government to make sure that the market which they are providing a
good/service in operates at the socially optimum point. As a result of this, missing markets for public
goods will no longer exist.
 In addition to this, state provision enables those who are less well-off to enjoy the benefits that these
goods/services bring. This can help to reduce inequalities within society.
  State provision can reduce inequality by redistributing money from the wealthy to the poor. This is
something the market doesn't always do.
 Without state provision, some services might not exist as they aren't profitable.
 The main disadvantage of state provision is the massive opportunity cost to the government. If state
provision turns out to be unsuccessful in fixing the market failure then it will be a very costly mistake.
 In addition to this, the provision of these goods/services by the state gets rid of the profit motive. As a
result of this, there can be massive inefficiencies which can be very costly.
Evaluation of state provision; The overall benefit derived from state provision will be based upon the state’s
ability to ration the excess demand that exists. If they are unable to do this then large amounts of consumers
will miss out on the benefits from the consumption of these goods/services.

Government provision of information; Governments can spread information to try to overcome market
failures. Below are some historic attempts by the UK government to improve market outcomes and welfare by
spreading information.

Evaluation; of provision of information; Cost of information can be passed on to sellers, focused on

May prove less effective in case of habit-forming goods, wastage of money if campaign fails, might conflict
with existing norms, may not prove effective due to herd mentality, and this indeed has higher opportunity
cost

Govt. policy of transfer of payments; Transfer payments may include:

 Unemployment benefits

 Pensions

 Food vouchers etc.

The advantages and disadvantages include:

 They can be targeted at those most in need.

 They can be targeted at the purchase of basic foodstuffs

BUT

 May be costly and have an opportunity cost.

 The policies may not be used for their intended purposes (even vouchers may be sold in illegal markets).

Evaluation;

 Consideration of the relative effectiveness of a maximum pricing policy compared with the use of transfer
payments.

 Consider the impact on low-income consumers of basic foodstuffs

Different methods of allocation for both merit and demerit goods

Indirect taxes Reduce the production and consumption of demerit goods

Subsidies Increase the production of merit goods

Maximum price  Meant to decrease production of demerit goods.

Minimum price Meant to increase production of merit goods. It can also discourage consumption of demerit
goods

Direct provision Govt directly provide public and merit goods.

Legislation Govt legislate to ban consumption and production of certain type of goods

State Owned Ent. Govt. can start the production of goods and services to compete with existing monopolies and
reduce prices of merit goods.