Transcript Topic 3 2016

GOVERNMENT MICROECONOMIC
INTERVENTION
TOPIC OBJECTIVES;
To
Explain why governments
intervenes in the market
Describe the forms of government
intervention
Distinguish between privatization &
nationalization
Why government intervention?
• To correct market failure.
• Write down the meaning of
market failure.
• Practical examples:
• Provision of public utilities by the
government e.g…………..
• http://www.-cheap-sugarimports
Forms of intervention
1. Regulations
2. Financial intervention
3. Government provision
4. Transfer payments
5. Nationalization & privatization.
1.REGULATIONS
.
Regulations
Price
controls
Maximum
Minimum
laws
Laws
• Occurs through the use of legal
legislations formulated by the
parliament.
• They control the quality & quantity
of products produced and
consumed.
• E.g. green production laws to
promote environmental quality.
Price controls
• Refers to installation of minimum
and maximum prices both in the
product and labour market
(wages)
• Maximum prices-ceiling prices
• A maximum price is imposed below the
free market equilibrium price .
• Definition: page 68
• Show diagram: students to draw
on the board
Observations
• Pe Qe is the equilibrium price &
quantity.
• The ceiling price causes an excessive
dd (Q3-Q1) since the price is
affordable by many consumers.
• NB 
Maximum prices will not work when
fixed above the equilibrium price.
• It’s imposed on essential products to
help consumers.
• Government enforces maximum prices
for;
• Task: copy the bullet points from
page 69 at the top
Effects of the ceiling prices
• They cause a disequilibrium of excess
dd which may lead to shortages
• The excess demand causes the supply
to be allocated using other methods
like rationing & queuing.
• This may lead to occurrence of black
/informal/underground markets to
satisfy the excessive market dd.
Note:
• The govt may use price stabilization
policies especially in the Agricultural
sector to ensure shortages do not
affect farmers incomes negatively.
• This involves the buying of
buffer/excess stocks during a surplus
season.
• The buffer stocks are released
cheaply during a shortage season at a
predetermined price.
Minimum prices- floor prices
• They are set above the equilibrium
prices so as to help producers earn
reasonable incomes .
• Copy definition: page 69
• Show diagram: students to draw
on the board
Observations
• Pe Qe is the equilibrium price &
quantity.
• The floor price causes an excessive
supply of (Q2-Q1) units.
• The surplus is the buffer stock
bought by the government.
• NB  Minimum prices will not work
when fixed below the equilibrium
price.
• Governments enforces price floors
for:
• Copy the bullet points from page
69
Effects of floor prices
• They cause overproduction since
more will be supplied at higher
prices.
• May lead to wastages when the
surplus is not bought
• Leads to operation of buffer stocks
which may be expensive for the
govt.
• Informal/black markets may
thrive to supply at lower prices.
• C:\Users\pnduati\ price
floors and ceilings
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Q18/9708/13/s/2015
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2.Financial intervention:
Financial
intervention
taxes
Direct
Subsidies
Indirect
Advalorem
specific
Taxes
• A tax is a compulsory contribution
from firms & households to the
govt.
• They assist in raising revenue to
finance government spending
• Discuss: How does the govt spend
money?
• Tax revenue helps to reduce
inequalities in income distribution
• How does this happen?
• Adam Smith(father of economics)
devised the principles/canons of
taxation.
• Define canons of taxation page 70
Canons of taxation
• 1. Equity
• Equality of sacrifice where the rich
should pay more & the poor less.
• This is the basis for progressive tax.
• 2. Economy
• Tax collection & admin costs should
be less than revenue generated.
3.Convinience
• Time and modes of payment
should be easy and clear to
taxpayer.
• 4. Transparent
• Tax payers should know exactly
how much they are paying
Impact & incidence of tax
Impact:
• Refers to ‘on whom the tax is
imposed’
• Incidence:
• Refers to ‘who bears the final tax
burden’ or the final resting place
of the tax.
• Eg The govt may impose excise
duty on beer manufacturers who
passes the high cost to consumers
thru high prices.
• Identify the impact & incidence of
the excise duty
• Impact of the tax is on beer
manufacturers
• Incidence is on the final
consumers.
• NB:
how much tax is passed on
depends on the PED
• When PED is inelastic, more tax is
passed on & vice versa.
Types of taxes:
Direct taxes
• They are paid directly (at source)
by taxpayers from their incomes.
• E.g. Income tax/PAYE &
corporation tax
• Indirect taxes
• They are charged on prices of
goods and services
• E.g. VAT& excise duty
• NB: 
• Taxes raises production costs
causing less to be supplied.
• The supply curve shifts to the left.
Specific taxes:
• Charged as a fixed amount per
unit produced.
• E.g. Sin tax in Kenya (alcohol &
cigs)- per litre o r packet of cigs
• C:\Users\pnduati.PEPONISCHOOL
\Documents\Class notes 2014\A
2 Econ\Lecutre notes 201516\Basic econ ideas 2015-16
• Specific tax causes the ss curve to
shift upwards/leftwards parallel to
the initial curve
• Draw the diagram: page 71
• Observations:
• S and D are the initial supply and
demand curves.
• Vertical distance btn the 2 supply
curves is the tax per unit.
• Area A is the tax incidence on
consumers
• Area B is the incidence on
producers
• A+B= total tax revenue collected.
Top tip: 
• Tax incidence is high on producers
when PED is highly elastic- why?
• Tax incidence is high on consumers
when PED is highly inelastic- why?
• Example 2
• Assume that a specific tax of $1
per bottle is imposed upon wine
which reduces ss as shown on the
diagram below;
• Show diagram: page 70- Anderton
• the vertical distance btn So and S1
gives the value of the tax
• Ad valorem tax 
• It’s a percentage tax based on
price e.g. VAT.
• It causes the ss curve to
tilt/pivot upwards
Reason for the tilt
Extension task
• Worked example from page 70-
Anderton
• TAX VIDEO: 00:3:27
Other tax issues
• Average rate of taxation
• Average % of total income that is
paid in taxes
• According to the canon of equity,
the poor have a low average tax
rate
Marginal rate of taxation:
• Proportion of an increase in
income which is paid in taxes
• NB
the relationship btn taxes and
income occurs in 3 types:
• Progressive taxes:
• Structured in a way that as
income rises, more taxes are paid.
• The marginal rate of tax is thus
lower that the average rate of
taxation.
• This promotes equality of sacrifice.
E.g. income tax
• Show the diagram: tax rate vs
income
Proportional taxes
• The tax rate is constant such that
all people pay the same regardless
of their income. E.g. VAT
• Show diagram
• Regressive taxes
• It takes a greater % from those on
lower incomes.
• The average & marginal rates of
taxes are falling
Subsidies
• These are financial grants given to
firms by govts or other agents to
offset prodn costs.
• They work in the opposite way
compared to taxes ie they increase
supply.
• They are paid for products with
positive externalities eg merit goods
• Subsidies reduce firms production
costs and hence encourage more goods
and services to be produced
Reasons why subsidies are given
• Summarize the bullet points from
page 73.
• Problems with subsidies.
• They are expensive to sustain
• They have real opportunity costs.
• They interfere with the price
mechanism
• They cant be easily linked to
incomes & ability to pay
• NOTE
• The subsidy causes the ss curve to
shift downwards and price
reduces.
Observations
• S & D are initial ss and dd curves
• S1= S + subsidy
• Vertical distance A B is the
amount of subsidy per unit
• Total cost of subsidy = benefit to
producers + benefit to consumers.
Top Tip: 
• 1. How much of the subsidy
internalized by consumers &
producers depends on the PED
& PES.
• 2. When PED is elastic relative
to PES consumers enjoy a
relatively lower reduction on
price
• 3. When PED is inelastic relative to
PES consumers enjoy a relatively
large reduction on price
4. products that provide external
benefits are always subsidized so as to
increase the benefit to the entire
economy eg education
• Further reading: separate
handout!
• C:\Users\pnduati\Documents\Class
notes 2013\AS Econ\Govt
intervention topic 3
• \\pepserver\Teachers\PN\Class
notes 2013-14\AS Econ\Taxes
and subsidies video
Transfer payments
• Copy definition Page 74.
• These are means of redistributing
incomes from one income group to
another in the country.
• These transfers may come as social
security benefits and they help to
promote fairness and equity in the
society.
• They transfer incomes from
taxpayers to those unable to work
or in need of help e.g. unemployed,
elderly etc
• Examples of transfer payments:
• Copy bullets points from page 74
Effects of transfer payments
• They protect the most vulnerable
thru financial assistance.
• They lead to less poverty
• Provides a more equitable
distribution of income
• May act as a disincentive to work
hence increasing unemployment
rate & reducing output
Direct state provision
• Occurs when govt provides
important services free of charge.
• The poorest gain more hence
lowering inequality.
• Examples:
• Merit goods: education & health
care.
• The NHS in the UK is free to all
60+ year olds.
• They are provided for free since
they are subject to market
failures.
• They are also aimed to provide
equity i.e. fairness of access
regardless of income levels.
• They are provided for free since
they are subject to market
failures.
• They are also aimed to provide
equity i.e. fairness of access
regardless of income levels.
Issues with state provision
• Free provision may lead to
overprovision causing inefficient
resource allocation.
• They come at a huge opportunity
cost.
• They are costly to sustain & may
hurt tax payers
Nationalization
• Copy definition from page 75
• Occurred in the UK in the 1940’s
where manufacturing industries
were nationalized.
• https://youtu.be/HyAmqy8F8WE
Case for nationalization
Copy bullet points from page 75
Privatization
Copy definition from page 75.
Advocated my Margaret Thatcher
in the 1970’s as a means of
economic reform.
• C:\Users\pnduati.Margaret
Thatcher on Privatization
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Forms of privatization
• 1. Direct sale
• Refers to sale of govt owned/
nationalized businesses to the
private sector.
• Can be thru conversion in to a PLC
or a buy out
• e.g. the British airways , Kenya
railways to RVR.
2. Franchising:
• Occurs when a private sector
franchisee acquires the right to run
some govt enterprises
• 3. Deregulation
• It occurs thru removal of barriers to
entry that protects the public sector
from competition
• This leads to more firms entering the
market forming a contestable
market. Eg Kenya Bus Service in
Kenya.
4.Contracting out
• Involves provision of non core
services e.g. cleaning by the private
sector.
• This helps in creating more jobs for
the private sector
Reasons/advantages for privatization
• 1.To widen the shareholding of public
sector enterprises to the public since
they are converted in to public
limited companies
• 2.To reduce govt involvement in the
economy so as to allow the operation
of the invisible hands of the market
in the allocation of resources.
• 3. It generates income for the
government which can be used to
foster development projects.
• 4. It leads to wider choice for
consumers and better quality services
due to flexibility of private sector
enterprises.
• 5. Privatized firms are more efficient
and are more market oriented due to
minimal red tape
 The case against privatization 
• 1.A private sector monopoly may
replace a public sector monopoly
leading to same old results of the
nationalized business.
• 2. Its associated with some negative
externalities due to change of
ownership e.g. unemployment
• 3. Privatization must be followed by
setting up of regulators to ensure
fair competition in the industry.
• 4.For direct sale of public businesses
it provides govt finance which is ‘one
off stream’.
• i.e. privatization sales may not
generate future revenues
• 5. Privatization of public sectors
providing basic essentials may lead to
higher end user prices and lack of
distributive justice due to pursuit of
profit motive……..
• Prep task: Q1 page 77 [12
marks] Due on Thurs.
• THE END 
Plenary
• Summary page 79
• Data response prep page 79
• The end