Chapter 3: Government microeconomic intervention

Government Intervention

Government throughout the world intervene in markets to different extent. The justification for intervention is usually where there is market failure.

Market failure is when free market fails to make best use of scarce resources.

Government uses financial tools such as taxes and subsidies to influence the market.

Government Failure – It is a situation where government intervention in the economy to correct a market failure creates inefficiency and leads to a misallocation of scarce resources.

Maximum and minimum Price Control

Maximum Price is that price which can be legally charged by the sellers; the market price must not exceed this price.

Minimum Price is a price that is fixed; the market price must not go below this price.

Taxes – Direct and Indirect Taxes

Taxes

Taxes are the charges that are imposed by the government on people and businesses to raise finance for government spending. The “good” tax is one that is equitable, economic, transparent and convenient. Taxes are designed to imit production of goods.

Direct Taxes

It is the one that taxes the income of people and firms that cannot be avoided such as income tax, corporation tax, etc.

Indirect Taxes

It is the one that is levied on goods and services such as value-added tax (VAT).

The effect of imposing indirect Tax

Indirect taxes are used to discourage the production and consumption of demerit goods.

The greater the PED or the smaller the PES, the greater the burden upon producers. Indirect tax tend to be passed down on to the consumers through the increased price in market although technically they are imposed upon product.

Ad valorem taxes, like VAT are of fixed percentage of the price of goods so the amount of tax increases with increase in price.

Other taxation

The relation between taxation and income varies for different type of tax such as:

  1. Proportional taxes: Those taxes that takes same percentage from all who have to pay tax.
  2. Progressive Taxes: Those taxes that take higher percentage form those with higher income.
  3. Regressive Taxes: Those taxes that takes greater percentage form those with lower income.

 

Subsidies

Subsidies has the opposite effect of an indirect tax. They encourage greater production of goods and results in rightward shift in the market supply curve.

Indirect tax increases the price while Subsidies decreases the price.

It is mainly goods with elastic PED which are subsidized as this ensures most of the cost saving is passed on to the producer.

Transfer Payments

Transfer payments are payments from tax revenue that are received by certain members of the community. They are not made through market. These payment include; old age pensions, unemployment benefits, child benefits, etc. Those who work or who have worked in informal sector are not covered by this.

Nationalization and Privatization

Nationalization is the process in which the government take over a private sector business and transfers it to the public sector. This particularly makes sense for railways, airports and water supply. Any profit made through nationalization will be returned to business and reinvested for the benefits of public.

Privatization is the process in which there is change in the ownership of public sector business into private sector business. It is a conscious decision to decrease government participation in the economy. Privatized company can be successful in raising capital, lowering prices and minimizing waste.

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