2. Government Intervention: Fiscal Measures
Taxes and Subsidies
• The use of taxes and subsidies to correct
externalities
o Externalities occur when some of the costs or benefits associated with production or
consumption of goods and services spill over onto third parties.
– the optimum size of a tax
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3. Using taxes to correct a market distortion
MC = S
Costs and benefits
P D
O Q1
Quantity
4. Using taxes to correct a market distortion
MSC
MC = S
Costs and benefits
P D
External cost
O Q2 Q1
Social optimum
Quantity
5. Using taxes to correct a market distortion
MSC
MC = S
Optimum tax = MSC – MC
Costs and benefits
P D
MC
O Q2 Q1
Quantity
6. Government Intervention: Fiscal Measures
Taxes and Subsidies
• The use of taxes and subsidies to
correct externalities
– the optimum size of a tax
– the optimum size of a subsidy
7. Using subsidies to correct a market distortion
MC = S
Costs and benefits
P D
O Q1
Quantity
8. Using subsidies to correct a market distortion
MC = S MSC
Costs and benefits
External benefit
P D
O Q1 Q2
Social optimum
Quantity
9. Using subsidies to correct a market distortion
MC = S MSC
MC
Costs and benefits
Optimum subsidy
= MC – MSC
P D
O Q1 Q2
Quantity
10. Government Intervention: Fiscal Measures
Taxes and Subsidies
• The use of taxes and subsidies to correct for monopoly
– use of lump-sum taxes
• Advantages of taxes and subsidies
– Considered the most effective way of solving underconsumption as it
is easily implemented
– Leaves space for market forces to interact
– Provision of revenue for the government
• Disadvantages of taxes and subsidies
– infeasible to use different tax and subsidy rates
– lack of knowledge
11. Provision of Public Goods
A public good is a good/service which is
– Non-rivalrous – its benefits are not depleted by an additional user
• MC = 0, for allocative efficiency, P = MC = 0
• Public goods have to be provided at no charge
– Non-excludable – impossible (or difficult) to exclude people from its benefits
• ‘Free rider’ problem arises – no one will pay for what he can get free
• Private firms will not provide public goods (unable to charge for
consumption)
• Public goods, therefore, have to be provided by the government
• Examples of public goods include streetlamps and public libraries
• Note: a private good is one that is both rivalrous and excludable –
automobiles, clothing, food etc.
12. Provision of Public Goods
• Direct provision of goods and services
– the provision of public goods
– the need to evaluate costs and benefits of publicly provided goods
– there is a need to produce merit goods (which are naturally
underconsumed) at low prices or for free due to four reasons
• Social justice: they should be provided according to need and not ability to pay
• Large positive externalities, for example in the provision of free health services
helps to contain and combat the spread of disease
• Dependants are subject to their guardians decision which are not necessarily
the best, therefore the provision of services like free education and dental
treatment is needed to protect dependants from uninformed or bad decisions
• Ignorance: The problem of imperfect information makes consumers unaware of
the positive externalities and benefits that arise from consumption
13. Nationalization And Expansion
of public sector
• Nationalization refers to the public (governmental) ownership of certain
firms to provide goods or services sold in the market, that is, public
corporations engaged in commercial activities. Governments often take
over natural monopolies to prevent monopoly pricing and examples
include public utilities.
• Advantages:
– Consumers protected from high prices
– Ensuring social costs and benefits are taken into account when
production decisions are made
• Disadvantages:
– No profit motive may lead to nationalized enterprises being
allocatively inefficient
14. Promotion Of competition
Effective competition in properly regulated markets can deliver
lower prices, better quality goods and services and greater choice for
consumers.
Competition can create strong incentives for firms to be more
efficient and to invest in innovation, thereby helping raise productivity
growth.
Policy makers should aim to protect and promote competition in
markets in order to capture the benefits of markets for consumers and
society as a whole.
However, markets if not adequately regulated can potentially harm
consumers.
15. Promotion Of competition
Drives firms to improve their internal efficiency and reduce costs.
Cost minimisation allows firms to deliver the same goods and
services to consumers, but at lower prices. This will attract a greater number of
consumers and the firm will gain a larger market share.
Provides incentives to firms to adopt new technology.
• Early adoption of technology and/or new techniques and
processes helps firms minimise their costs.
Provides incentives to firms to invest in innovation.
• Investment in innovation allows firms to improve the quality of their existing
products and/or develop new products and services to better suit the changing
needs and preferences of consumers.
Reduces managerial inefficiency.
• Competitive pressures from other firms and new entrants lead firms to look for
better, more efficient ways to organise their business. Lack of effective competition
could lead firms and managers to operate with inefficient business models and
technology as firms are unlikely to lose profits.
16. Control of price and output
Government determines how Market outcomes are to be limited.
Output regulation:
Government sets quotas or Limits the amount of output that can be
provided by participants in a market.
Examples: prohibition of bogus cures
Price regulation:
Government sets price controls either as minimum or maximum
prices that can be charged in a market.
Examples: price controls on drugs
standards regulation:
Government sets limits on the characteristics of a product or service
Examples: FDA regulations on advertising & quality
17. More or Less Intervention?
• Drawbacks of government intervention
– shortages and surpluses
– poor information
– bureaucracy and inefficiency
– lack of market incentives
– shifts in government policy
– lack of freedom for the individual
