Chapter 8: Government microeconomic intervention

Deadweight loss

Deadweight loss is the welfare loss when due to market failure desirable consumption and production does not take place.

Deadweight loss can occur in a monopolistic market when comparing that market with a competitive market.

The measure for the loss of net consumer and producer surplus due to monopoly is given by shaded area. It is the deadweight due to monopoly.

Deadweight loss can also be seen when government imposes an indirect tax on a product.

Government intervention to correct externalities

Externalities occur when benefits or costs to society differs from benefits of individual responsible for them. They are:

  • Negative externalities in production
  • Negative externalities in consumption
  • Positive externalities in consumption
  • Positive externalities in production

Interventions to correct externalities may be of following:

  • Use of indirect tax
  • Various regulation
  • Pollution permits
  • Subsidies
  • Property rights

Negative Production Externalities

An example of this case is a firm that pollutes the environment as a result of production process. In such case an indirect tax would be imposed to the firm to correct negative externalities. Government use regulations to overcome market failures caused by production externalities such as restrict dumping of wastage by taking legal action. A third form of intervention would be pollution permits which would allow firms to pollute upto certain level only.

Negative Consumption Externalities

These externalities are the spillover cost caused by consumers. An example of this would be urban road traffic congestion. When there is traffic congestion there is over emission of exhaust in atmosphere. These negatively impact the residents and public. In these cases legislation is highly used. There are laws that prohibits people from smoking in public. There are also regulations that puts restriction on vehicles making noise.

Positive Production Externalities

These occurs when there is positive spillover benefits created by producers. Example of this is vaccines; they have been produced to combat serious medical conditions.

Positive Consumption Externalities

This occurs as a result of decisions taken that impact favorably on consumers. Provision of secondary education is an example of it. In education case, legislation is used in some countries to make state funded education system.

Behavioral insight and “nudge” theory

The basis of nudge theory lies in provision of information. Nudge theory is a way of achieving beneficial economic and social outcomes without the need for regulations. Nudge theory works only to a limited extent.

Equity and policies towards income and wealth redistribution

Equity is the condition where distribution of income or wealth is fair. There are two sides of equity and they are:

  • Horizontal equity: The consumers and other with same circumstances should pay the same level of taxation.
  • Vertical equity: The taxes should be fairly apportioned between rich and poor.

Income and wealth

It is important to distinguish between income and wealth.

Wealth is an accumulated stock of assets. Income is the reward for the service of production.

Measuring Inequality

A Lorenz curve is a simple, well used way of representing inequality.


The Gini Coefficient is the numerical measure of extent of inequality.

Government policies to redistribute Income and Wealth

There are three main policies and they are:

  • Providing benefits
  • Through tax system
  • Through other policies

Providing benefits

A simple way to redistribute income is to pay benefits out of government funding to those with low income.

  1. Means-tested benefits: benefits that are paid only to those whose income fall below poverty level.
  2. Universal benefits: benefits that are available to all irrespective of income and wealth.

Through the tax system

Tax system is used in order to reduce the inequality in income and wealth. Especially progressive tax is used in doing so that regressive tax.

Other policies

 Other ways of reducing inequalities in society is if the government provide certain facilities in the society free of cost. Such as providing health care facilities without any charge and free secondary education system.

Labour Market

Demand for labour

Labour is demanded not for its own sake but for the production of goods and services. Demand for labour is a deprived demand.

Supply of Labour

The supply of labour is the total number of hours the labour is able or willing to work at a particular wage rate.

Individual’s supply of labour

The wage is the important factor of the supply of labour. With the increase or decrease of the wage the individual’s interest to supply labour may vary.

Labour supply to firm or industry

This supply curve consist of the sum of individual supply curve of all workers employed in a firm or industry.


The long run supply of labour

These factors determine the long run supply of labour

  • Population size
  • Tax and benefit level
  • Immigration and emigration

Monopsony in Labour Market

Monopsony occurs when there is a single buyer in the market.

Government Failure in Microeconomic interventions

Government failures is where government interventions to correct market failure causes further inefficiencies.

The reason why government failures occurs are:

  1. Imperfect information
  2. Undesirable incentives
  3. Policy Conflict