Government
Microeconomic
Intervention
Measures to Tackle Different
Forms of Market Failure
● The demand curve, also known as the Marginal Private Benefit (MPB)
● The supply curve, also known as the Marginal Private Cost (MPC)
● Equilibrium in the market is where Marginal Social Costs (true level of supply)
= Marginal Social Benefits (true level of demand).
● Market Failure is an inefficient distribution of goods and services in the free
market.
● Causes of market failure:
○ Negative production externalities
○ Negative consumption externalities
○ Positive production externalities
○ Positive consumption externalities
Negative Production Externalities
● Negative production externalities cause market failure due to the inefficient
distribution of resources due to overproduction (as they only consider private
costs).
● Distance AB is MEC (Marginal external cost), and the ideal situation is where
indirect tax = MEC.
● Tax burden is shared by producer (P1, C, B, P3) and consumer (P2, A, C, P1)
Measures to Realise Negative Production Externalities
● Specific Indirect Tax: an indirect tax charged at a fixed rate on sales of goods
and services.
● The tax effect here is a shift in the supply curve, causing the equilibrium from P0
to P1 and Q0 to Q1.
● The tax revenue for the government would be the shaded area AB, A being
the consumer tax portion and B being the producer tax portion.
● Ad valorem tax: an indirect tax charged as a percentage of the price of a good
or service.
● The effect of the tax is shifting the slope of the supply curve, which causes the
price to shift from P0 to P1 and the quantity from Q0 to Q1.
● Regulation: a wide range of legal and other requirements from the government
and other organisations.
○ This makes producing products with negative externalities higher in cost.
Discouraging firms from producing.
● Property Rights: Where owners can decide how their assets may be used. 2
possibilities:
○ Polluting firms have the rights. This means it can stop its polluting
activities if paid compensation for its loss or gets paid to leave, which
would require government intervention through the warning of new
regulations.
○ The affected party would have the rights and can sue the company;
however, it depends on bargaining power.
● Pollution Permits: a form of licence given by governments that allows a firm to
pollute up to a certain level. Firms and countries can sell permits; they control the
quantity and price of permits according to the effect desired.
● Licensing: Permits a firm to operate in specific markets or locations, e.g. to
operate as a pub or a taxi business. 2 types of licensing:
○ Exclusive: Licensing given to only 1 firm.
○ Non-exclusive: licensing to more operators at a lower price than
exclusive licence.
○ These result in restrictions on entry into the market.
Negative Externalities in Consumption
● Consumers cause spillover costs.
● MSB is lower due to external cost, but MPB has caused an increase in demand
that is met with over-estimated supply, as the MEC is not considered.
● Imposing indirect tax shifts quantity from Q1 to Q0 and price from P1 to P2.
Measures to Realise Negative Consumption Externalities
● Indirect Tax
○ Specific indirect Tax deters consumers from purchasing due to the high
consumer tax burden.
● Minimum Price Controls
○ Minimum price controls/price flooring reduces the incentives for
consumers to buy demerit goods, as the price is higher than equilibrium.
● Provision of Information
○ Governments actively provide information to educate consumers about the
content and long-term/short-term negative effects of demerit goods.
● Production Quotas
○ The government restricting the quantity firms supply will limit the demand.
Positive Production Externalities
● Spillover benefits created by producers.
● Subsidies allow a rightward supply shift by adding external benefits fixes,
allowing for lower prices, more quantity, and an accurate social cost (MSC).
● Market failure caused by production externalities is usually due to the lack of
incentives for firms to produce, causing an underproduction of these goods.
● This leads to Allocative inefficiency and, thus, market failure.
Measures to Realise Positive Production Externalities
● Subsidies:
● Subsidies provided by the government incentivise firms to produce these merit
goods for society.
○ This is shown above through the shift from S1 to S2, an increase in
supply, price changes from P2 to P3, and a quantity from Q1 to Q2.
● Provision of Information
○ Governments providing firms with the long-term effects of producing the
merit goods and how that will positively affect business performance over
time will incentivise firms to produce.
Positive Consumption Externalities
● It occurs as a result of decisions made that impact consumers favourably.
● Original equilibrium (F) shows MPC = MPB, but as external benefits are
realised, this equilibrium shifts to point G, with more quantity at price P2.
Subsidies are introduced to reduce the burden on firms, so the supply shifts right,
making price P3 and the new equilibrium at point H.
Measures to Realise Positive Consumption Externalities
● Direct Provision
○ Informing consumers about the contents and long-term/short-term benefits
of merit goods will increase their awareness and result in them consuming
more.
● Subsidies
○ Providing subsidies to firms will reduce the prices of merit goods and
increase their quantity, incentivising the demand to increase.
Other Measures to Correct Market Failure
Nationalisation
● Nationalisation: governments take over a private sector business and transfer it
to the public sector.
● As private sector businesses are MPC and MPB-motivated, they often
underproduce merit and public goods. Using nationalism will increase positive
externalities by supplying more to consumers (encourages positive consumption
externalities) and increasing demand.
● Nationalisation will also reduce negative externalities by restricting consumer
supply and lowering demand.
Privatisation
● Privatisation: selling a state-owned public sector business to the private sector.
● Privatisation allows for increased competition, forcing firms to be more efficient in
allocating their resources.
Deregulations
● Deregulation: occurs when the government removes or reduces the restrictions
in a particular industry to improve business operations and increase competition.
● Removing regulation from the market will allow the free market forces to balance
itself out naturally.
● Governments can steer the market forces by implementing other policies.
Nudge Theory
● Nudge Theory is a way of achieving beneficial economic and social outcomes
without regulations.
● It is a way to indirectly manipulate people into taking specific or desired
outcomes.
● This is done by providing information to consumers/producers and making them
aware of specific accepts, e.g., the harmful effects of demerit goods or the
benefits of merit goods.
Government Failure in
Microeconomic Intervention
● Government Failure: where the government intervenes to correct market failure,
which causes further inefficiencies.
Causes of Government Failure
● Imperfect Information
○ Correct policies need accurate information, or these policies may lead to
greater economic inefficiencies.
● Unintended Consequences
○ Policies put in place to solve a problem may inadvertently create new
problems or unintended consequences.
○ Unintended consequences are due to an imperfect understanding of the
market and behaviour response.
● Undesirable Incentives
○ Policies like tax can disincentive the desire to work or demand for
products.
○ Political objectives override economic welfare, especially when retaining
power and gaining votes.
○ Public services and inappropriate incentives, as they lack private sector
profit motive.
● Policy Conflict
○ When used to deal with negative externalities, policies like taxes can have
a distributional impact, increasing income inequality. This creates a conflict
in policies.
○ Tax and subsidies may have different effects on different groups and may
not always have a positive effect.
Consequences of Government Failure
● Deadweight Loss
○ Government failure can cause even more undesirable consumption and
production.
● Reduced Consumer Surplus
○ Reduction of consumer surplus means increasing prices, discouraging
consumption, and producing inefficiency in producers.
● Decrease Economic Welfare
○ Government failure would cause disturbance in the market, which could
lead to reduced competition and efficiency.
○ This may affect economic growth and prosperity and may result in
increased welfare.
Equity and Redistribution of
Income and Wealth
● Equity: recognises that each person has different circumstances and allocates
the exact resources and opportunities needed to reach an equal outcome. The
distribution is fair.
○ Horizontal Equity - consumers and others with the same circumstances
pay the same level of tax.
○ Vertical Equity - taxes fairly apportioned between rich and poor in society.
● Equality: each individual or group is given the same resources or opportunities.
● Efficiency addresses how well the economy's resources are used and allocated,
while equity deals with how goods and services should be distributed.
Different Kinds of Poverty
● Extreme Poverty: Living below the international poverty line.
● The International Poverty Line: the monetary threshold under which an
individual lives in poverty, currently $2.15 per person per day.
● Absolute Poverty: When individuals and households don’t have sufficient
income to meet basic needs.
● Relative Poverty: when households receive 50% less than average household
incomes. They can afford basic needs but nothing beyond that. It depends on the
economic growth of the country.
● The Poverty Trap is where an individual or a family are better off on
means-tested benefits than working.
○ This is one of the negative consequences of the means-tested benefit
employed by the government.
Policies Towards Equity and Equality
● Universal Benefits are available to all, regardless of income or wealth.
○ However, operating is expensive as it implies paying people not in need of
this benefit.
● Means-tested Benefits: Benefits paid only to those whose income falls below a
certain level.
○ The poverty trap is a consequence that could rise.
● Negative Income Tax: a unified tax and benefits system where people are taxed
or receive benefits according to a single set of rules.
○ People can use the benefits provided to pay for tax; if the difference is
positive, the person is rich and has to pay the direct tax.
○ If the benefits are greater than the tax, then the person benefits from the
government.
● Universal Basic Income: a social welfare proposal in which all citizens of a
given population regularly receive a minimum income through an unconditional
transfer payment.
● Progressive Tax: one where the rate raises more than proportionately to the rise
in income. It can create a disincentive to work.
● Regressive Tax: one where the ratio of taxation to income falls as income
increases.
Labour Market Forces and
Government Intervention
The Demand for Labour
● Labour Demand: a concept that describes the demand for labour that an
economy or firm is willing to employ at a given time.
● Derived Demand: demand for a good or service depends upon the use that can
be made from it.
● Labour Demand is a Derived Demand, increasing when the need/use of labour
increases. However, it is based on 2 assumptions:
○ The firm operating in a competitive market
○ The firm is a profit maximiser
● Factors affecting demand for labour:
○ The wage rate is the compensation for labour. The wage rate affects the
willingness of firms to employ labour; the higher the minimum wage, the
less labour is demanded by firms.
○ Productivity of Labour is the amount of goods and services produced in
a given time. If the firm operates at a low productivity, it will demand more
labour to increase that productivity.
○ Productivity of labour is affected by the law of diminishing returns,
meaning that at a marginal rate, after a certain number, more workers will
mean less productivity.
○ Demand for the Product. The greater the demand for the product, the
more firms are willing to supply; therefore, the demand for labour
increases.
The Demand Curve for Labour:
● Movement along the demand curve for labour results from a change in a price of
labour (wage rates) which causes changes in the firm’s willingness to employ
labour. e.g. The higher the minimum wage, the less the firms demand labour,
causing a leftward/upward movement along the curve.
● Shifts in the demand curve depend on the level of labour firms required for
production. e.g., high demand for a product will mean increased production
capacity for firms, thus the need for more labour and a rightward shift in the
curve.
○ These shifts could also be due to increased labour skills (due to education
and training), which would help lower production costs.
○ The increased use and progress of capital machinery and technology
could result in a leftward shift in the curve due to fewer levels of demand
required by firms.
● Marginal Revenue Product (MRP): the addition to total revenue from employing
one or more workers.
● Firms hire as long as the additional worker adds more to revenue. This
essentially means that MRP shows us the derived demand for labour.
● The profit-maximising output is where the highest level of additional units
meets the lowest level of workers needed.
● The equilibrium point of the highest additional unit for the lowest number of
labourers also helps us determine market wage.
The Supply Labour
● The supply of labour is the number of hours that labour is able and willing to
work for a particular wage rate.
● Factors affecting the supply of labour:
○ They are classified into wage and non-wage factors. Non-wage factors
consider job satisfaction. Individuals consider both of these factors, known
as net advantage.
■ Net advantage: sum of the utility derived from receiving a wage as
well as the utility derived from working in that certain occupation
■ The increase in net advantage will result in more labour being
supplied.
○ Wages Rates: The higher wages, the more willing workers are to trade in
their leisure time. The wage has a positive relationship with the supply
of labour.
■ Wage rates in different occupations affect the supply of labour
in each industry. For example, a salesperson gets paid more than
a production worker.
○ Income tax affects the percentage of real income workers receive;
the higher the income tax, the less incentive to join the workforce.
○ Skills and Qualifications: The higher the education and qualification
needed, the lower the supply.
○ Non-pecuniary benefits: These non-cash benefits by the government
can create a disincentive for employment in the population, reducing
the labour supply.
The Supply Curve for Labour:
● Above is the individual supply of labour, which shows the relationship between
wage rates and hours supplied.
● Workers don’t mind giving up more leisure time for more income as wage rates
rise.
● A positive relationship continues until wage rates reach an optimum point,
where consumers are satisfied with their income and wish to enjoy the
income with more leisure time.
● This is the supply of labour curve in the market. Movement along the supply
curve is due to changes in wage rates. Upward/rightward movement along the
supply curve is due to wage increases.
● Shifts in the supply curve are due to increased labour capacity in the market.
For example, stable growth and an higher birth rates will mean the size of the
population grows, meaning an increase in the working population
percentage.
○ Depending on how individuals view leisure time (either as an inferior or
normal good), an increase in income will lead to an increase in leisure
time if it is considered a normal good, in the case if it is considered an
inferior good, an increased income will lead to a decreased leisure.
This causes either a left shift (Normal good) or a right shift (Inferior good).
○ Changes in population, such as immigration rate, will increase the
market's supply level. An increase in retirement age would cause a
decrease/left shift in the curve.
Wage Determination in Perfect
and Imperfect Market
Wage Determination in a Perfect Market
● The equilibrium in the labour market is determined by market forces when supply
meets demand.
● Wages and level of employment are determined using that equilibrium.
● Any increase in demand will cause an increase in wages and employment.
● Any increase in supply will cause a decrease in wages and an increase in
employment.
Wage Determination in an Imperfect Market
● In an imperfect market, the equilibrium is influenced by many factors, which
result in either workers or employers determining wages.
● Government and trade union affect demand and supply through:
○ An imposed wage by the trade union will result in more labour supply,
but demand will decrease from the equilibrium of L to Lv. This can cause
unemployment in the market.
○ The government may try to set a minimum wage, which also affects
supply and demand, depending on the elasticity of labour. The more
elastic the demand is, the greater the fall in demand in response to the
introduction of minimum wage, causing significant loss in employment. On
the other hand, inelastic demand for labour will not cause a significant loss
of employment after imposing a minimum wage.
● Monopsony: where there is a single buyer in the market.
○ Wages are set based on marginal cost and marginal revenue product.
Since the employer holds all the power, they exploit workers and set
wages lower than the marginal revenue.
○ Monopsony can restrict employment, allowing them to employ fewer
workers at lower wages.
Wage Differentials
● Wage Differentials: the difference in pay between workers with different skills
and responsibilities
● This difference is a result of work ability and effort.
● The cause of wage differential:
○ Supply factors, such as:
■ Experience: The more job experience the individual has, the more
valuable he becomes. Hence, he earns a higher wage.
■ Education: The level of education determines the skills and
knowledge in the particular occupation, which is deemed a higher
wage.
○ Demand factors, such as:
■ Industry Type: Industries may have different values to the same
job title, e.g. a cashier in a fast food chain (responsible for financial
transactions) and an accountant in a company (also responsible for
financial transactions).
■ Demand for that occupation: As the industry progresses, certain
skills and occupations rise in demand, while others become
irrelevant. Technical skills are rising in demand, making them
valuable to the industry; hence, higher wages are needed to attract
those skills.
Transfer Earnings and Economic
Rent