1.3 Government intervention in markets

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1.3 Government intervention in markets
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1.3a Indirect taxes

• Indirect taxes are taxes that are not directly
  related to income. Examples include tariffs,
  sales taxes, and value-added taxes. Often these
  are ad valorem taxes or assessed as a of the
  sales price.
• Specific taxes are assessed as a specific flat
  rate tax on a good or service. For example, a 2
  per airline ticket in the U.S. to pay for airport
  administrative costs would be considered a
  specific tax.

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Indirect taxes are often used on goods that give
negative externalities (Unit 1.4b), reducing the
quantity demanded of those goods, and providing
government with funds to fight the external
costs. Pollution, for example, might result from
the exhaust from cars and trucks, so indirect
taxes are typical for gasoline.
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Consequences of indirect taxes

• Economists usually treat indirect taxes as extra
  costs, pushing supply curves up and to the left,
  normally reducing quantities and raising prices.
  The PED and the PES will play a large role in
  determining the effects of a tax. This shift
  will have three effects

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• 1. Incidence of tax - this explains who will
  actually pay the tax. This could be either the
  producer or the consumer. The more price
  inelastic of demand, the more the consumer will
  pay. The more elastic the good or service is,
  the more of the tax the producer will pay.

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• 2. Government revenues how much income the
  government will generate from the tax. This will
  vary with the elasticity for the item being
  taxed.
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• 3. Resource allocation - how the market
  reallocates resources after the change in price.

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What is the role of elasticity in taxes?

• Who pays the tax, how much money the government
  receives and the resource allocation are all
  factors, which will be impacted by the
  elasticities for the good or service being taxed.
  
• Lets look at a diagram

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• In the scenario above, the starting equilibrium
  price is 3. When an in direct tax is levied on
  the good in question, the supply curve will shift
  up to St by the amount of the tax. The new
  equilibrium price will rise to just below 4.

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1.3b Subsidies

• The incidence of tax will fall relatively equally
  on both producers (area b) and consumers (area a)
  due to the relative unit elastic PED and PES. The
  revenues accruing to the government is the
  combined areas of a and b. Resources will be
  reallocated with quantities supplied/demanded
  falling from Q to Q.

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• Notice the two small two triangles directly below
  the new equilibrium. These will combine to form
  a deadweight loss of efficiency.
•  
• This deadweight loss is due to the fact that
  consumers were willing to purchase more of the
  good in question yet could not due to the higher
  price.

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• This area represents a loss in societys net
  benefit due to reducing production and
  consumption below free market levels where
  marginal benefit is equal to marginal cost.
•  
• Finally, remember that taxes will diminish
  consumer surplus and producer surplus in varying
  degrees depending upon the elasticities of the
  good or service being taxed.

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1.3b Subsidies

• Subsidies are payments from the government given
  for the production of goods or provision of
  services that are thought good for society. This
  might be because of positive externalities (such
  as vaccinations) or because a product (food) is
  thought necessary for the well - being of certain
  people. A subsidy can also be used to even out
  income streams for farmers in high income
  countries.

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This payment can be made to either producers or
consumers or the government can directly provide
the product in question.   Economists typically
analyze the effects of subsidies as a reduction
in costs, shifting supply curves down and to the
right, lowering prices and increasing quantities
bought and sold.
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• In the diagram above, the government has
  subsidized a given product or service. This
  pushes the supply curve to the right from S to
  Ss.
• The result is a lower price for consumers at Ps
  and higher consumption at Qs. The area between
  the supply curves would represent the cost to the
  government of providing the subsidy to either
  producers or consumers.

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1.3c Price controls

• Policy makers sometimes attempt to prevent
  changes in price, preventing an equilibrium price
  and creating an artificial shortage or surplus.
• Setting a maximum price is called a price
  ceiling, an effort to keep prices below
  equilibrium.

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Price ceilings create incentives for people to
resell goods on a black market, allowing real
prices to be higher anyway. Laws that prohibit
the reselling of goods can be very difficult to
enforce. Examples of price ceilings are rent
control in cities like New York.
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Setting a minimum price is called a price floor,
an effort to keep prices above equilibrium, which
will usually benefit producers.
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Price controls are difficult to enforce and can
be quite expensive to implement. Price floors
are usually enforced through government purchase
of surplus stocks at a fixed price. This can be
quite expensive and has historically been a tool
in supporting agricultural prices so that farmers
have predictable incomes. Inefficiencies of
price floors can be the added cost of how the
government must dispose of the surplus output.
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Buffer stock schemes For some productsgoods
that can be stored cheaply for a long timea
buffer stock scheme can be used to keep prices
stable. These schemes combine price floors and
price ceilings in attempting to manage prices.
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Price stability is achieved by controlling the
supplies of a good on the market increasing
supplies when prices are high, decreasing
supplies when prices are low. Managers decrease
supplies by putting them in storage. Buffer
stock schemes are commonly seen in agricultural
markets, particularly with grains or
non-perishables like coffee, which can be stored
for a relatively long period of time.
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Many developing countries have attempted to
smooth volatility in their export revenues
through these schemes. In more developed
countries, the strategic oil reserve might
considered a variation of a buffer stock that
countries use to moderate wide swings in the
price of petroleum.