Sometimes a government will intervene if it believes the market is not providing the ideal outcome. In this short section we will consider some intervention methods it can use.

Minimum Wage

A government may feel that setting a minimum wage helps avoid people not earning sufficient to live a reasonable life. However this can also have negative consequences. In the diagram below, offering a minimum wage changes the wage rate from W* (the market equilibrium wage) to W_min:

Ld and Ls show how with the minimum wage the demand for labour is lower and the supply of labour is higher. This means that there is greater unemployment.

Maximum and minimum prices

Governments may seek to make certain goods readily available by setting a maximum price, e.g. for staples or merit goods. This price would be below the equilibrium price to be meaningful. Also they might set a minimum price, e.g. for demerit goods. What issues can you foresee occurring with such interventions!

The government may also choose to impose minimum price controls above the equilibrium price to support certain industries (e.g. agriculture).

Rent Controls

In order to ensure that sufficient cheap rental accommodation is available to people in certain places, a government could set a maximum rental price that landlords can charge. The below diagram shows the impact of this:

As this diagram shows, this leads to the demand for rental accommodation being higher and the supply of rental accommodation being lower, having the unwelcome effect of reducing the availability of rental accommodation.

Indirect taxes

Indirect taxation, like VAT, must be paid by the seller of a product to the government. If it is a fixed amount (a specific tax, such as excise duties on alcohol, cigarettes and petrol) it will shift the supply curve upwards by the amount of tax. As shown in the below diagram, this changes the equilibrium price and leads to a smaller quantity being traded. The increase in price is less than the amount of the tax though, so although the impact of the tax is entirely on the seller, the burden (the incidence of the tax) will be partly felt by the buyer:

If, instead of a fixed amount, the tax is a percentage of the price (as it is with VAT), called an ad valorem tax, then the effect is to make the supply curve steeper, as indicated below:

Subsidies

Governments can use subsidies to encourage producers to produce certain goods. The impact on the supply curve is shown below. Again, we notice that the drop in price is less than the amount of subsidy, so part of the benefit is felt by the buyer. So if the aim is to increase production, it is only partially successful (the level of success depending on the elasticity of demand:

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Canons of Taxation

These four “canons” are ideas of what criteria any good taxation should meet, based on Adam Smith’s suggestions:

1. Equity
   • Proportional to individuals’ means
2. Certainty
   • Not arbitrary
3. Convenience
   • Charged at the time when a person is most able to pay it
4. Economy
   • Arranged so as to minimise excess costs in collecting it.

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Redistribution of Income

There are many ways a government can achieve this. One is by paying benefits, or transfer payments, such as child benefit or incapacity benefit. Instead of cash, these can also be “benefits in kind”, such as free healthcare or education. Benefits can be means tested, meaning they are only received by people whose income is below a certain level, or they can be universal.

Taxation

Taxation can be direct taxation, paid on income, or indirect taxation, paid on expenditure.

Direct taxation (such as income tax, corporation tax, inheritance tax and capital gains tax) is typically progressive, being paid at a higher rate on higher levels of income (the marginal tax rate increases as income increases). This has an impact in reducing inequality in income distribution, sometimes complemented by tax credits, which reduce the tax liability of those on low incomes. Note that for an individual, the marginal rate of tax that they are subject to is genuinely more important in influencing their decisions than the average rate of tax.

Indirect ad valorem taxation can sometimes be regressive, impacting most heavily on lower-income households. If a tax is neither progressive nor regressive, we say that it is proportional.

Poverty trap

If benefits paid are too high in comparison with the net pay received in a low paid job, people can be disincentivized from working because working will lead to them receiving less. This is called a poverty trap.

Discouraging Goods

Governments will sometimes try to intervene in the market by discouraging demerit goods (as we have seen recently with cigarettes)

Direct provision of goods and services by government

Government can provide public goods like street lighting which the market doesn’t provided. By definition these goods should be non-rivalrous and non-excludable, however often this is not fully achievable (e.g a public road when it is busy is not fully available to all users).

Nationalisation and privatisation

A government may nationalise an industry so that its supply is ensured. But sometimes nationalised industries don’t operate efficiently due to a lack of accountability, so many countries prefer privatisation (an example being the British postal service, which was privatised in 2013).

Below are some of the advantages and disadvantages of nationalisation:

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Of course, there are intermediate levels between nationalisation and privatisation. Particularly with merit goods the government and private sectors can often work together (e.g. with a country’s national airline or health service)

Below are some of the advantages and disadvantages of privatising industries:

Final comment

With any government microeconomic intervention, the costs of the intervention should be considered. These include the costs of administering the intervention, and the costs of monitoring it to see that it is having the intended effect. Its marginal costs should not outweigh its marginal benefits.

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