Government Intervention in the Market

Types of Government Intervention on Different Market Structures

Depending on the type of government intervention, it can affect supply, demand, or the market as a whole. So, what are the types of government intervention in different market structures? They include taxes, subsidies, price controls, and market regulation.

Let's explain these types of government intervention one by one.

Taxes as a type of government intervention

Taxes as a type of government intervention is a way to influence how firms and consumers behave in the market. While there are direct and indirect taxes, direct taxes are beyond the scope of the current discussion, so we will only focus on indirect taxes (also known as Ad Valorem).

Indirect tax indirectly affects the production costs, affecting how much the firms sell their products.

The value-added tax (VAT) is a typical example of indirect tax. This is a tax added to purchases. This means that firms will pay VAT as they buy inputs, which will affect how much they sell the products to consumers. VAT is usually a percentage of the value of the product.

Indirect taxes are implemented to account for externalities or external costs.

How effective an indirect tax is, depends on the product's elasticity. A price elastic good with indirect tax will lead to a larger burden on producers than consumers. Consumers will just decide not to buy much of the product. Hence, demand will reduce, and less revenue will be generated for the government in indirect taxes. A price-inelastic good generates the opposite of this. Figure 1 helps explain the effect of indirect taxes.

Figure 1. Tax effect on market, StudySmarter Originals

Indirect tax increases the price for consumers to P2, while producers receive P1 in revenue. This causes the quantity demanded to reduce (from Q₁ to Q₂).

Subsidies as a type of government intervention

Subsidies can be considered the opposite of tax as it results in a reduction of production costs. Subsidies are pardons or rewards given to firms for producing goods that improve social welfare.

Direct subsidies are cash payments given to firms, whereas indirect subsidies are tax breaks.

The main effect of subsidies is that it reduces production costs. This then causes the market price to drop, which in turn causes demand to increase. Look at Figure 2.

Examples of subsidized products are education and healthcare since these are important for social welfare and must be made as affordable as possible for the people.

Figure 2. Subsidy, StudySmarter Originals

Supply increases (from S₁ to S₂), and the quantity demanded increases (from Q₁ to Q₂) since the price is lower now (P2).

Price controls as a type of government intervention

There are two types of price controls: maximum pricing (price ceilings) and minimum pricing (price floors). Price controls are a way for the government to control demand and supply by controlling the price of goods and services.

In price ceilings, the government sets a maximum price limit that cannot be exceeded for certain commodities. This is particularly helpful in a market where firms have too much control and want to set exorbitant prices.

Price floors, the government sets a minimum price limit that cannot be exceeded for certain commodities. Therefore, no matter how much competition, firms cannot price their products below a certain amount.

First, let's look at price ceilings. The main effect of price ceilings is that it keeps the prices of products below the market equilibrium price (Look at Figure 3). This is often used in rent control to ensure that consumers can afford rent. Otherwise, homeowners would price their homes absurdly, and there would be widespread homelessness.

Figure 3. Price ceiling, StudySmarter Originals

A price ceiling results in a shortage because the decreased price raises demand (from Q_e to Q_D). Meanwhile, supply decreases (from Q_e to Q_S).

Now, let's talk about the price floor. It's what the name says - a price floor. It stops the price from going into the dirt. The main effect is that it stops firms from paying workers too little of a salary. A typical example of this is the minimum wage requirements in the US. Look at Figure 4 to see what a price floor looks like.

Figure 4. Price floor, StudySmarter Originals

A price floor creates a surplus, as the increased price results in a higher quantity supplied (from Q_e to Q_S). This price increase lowers the demand (from Q_e to Q_D).

Market Regulation

The main effect of market regulations is better social welfare. For instance, as people under 21 years are prohibited from drinking alcohol, the government ensures that people only drink at a responsible age. Another example of mandatory education for children. This ensures that people in the country have gone through basic education. An example of market regulation is the regulation of quality standards when it comes to drugs and other pharmaceutical products. For instance, manufacturers of Covid-19 vaccines are required to go through a series of quality, safety, and efficacy tests before their products are approved for the market.

Effects of Government Intervention on Different Market Structures

Governments don't intervene in the market just because they can. They do this expecting very specific results. So what are the effects of the different government interventions? Let's find out.

Monopoly

In a monopoly, a government intervention such as taxes can worsen things. This is because the monopolist is not pressured by competition and can just increase the price of its product to make up for the taxes. Therefore, taxation without other interventions in a monopoly further reduces the consumer surplus.

A market regulation such as lowering the barriers to entry is used by governments to disrupt monopolies. Here, the government may provide loans and monitor the pricing of the existing monopoly to prevent predatory pricing. When this happens, other smaller companies can join the market more easily.

Oligopoly

In an oligopoly, the government can intervene with a price ceiling, ensuring that the few large companies do not charge absurdly high prices to consumers. Typically, the price ceiling will equal the marginal cost of these companies, ensuring that allocative efficiency is reached and consumers can enjoy reasonable prices.

Antitrust laws are also a market regulation that is aimed at correcting oligopolies. In an oligopoly, the few large firms exercise market power, and antitrust laws ensure that firms are not engaging in predatory business practices and creating unfair competition. This market regulation helps to establish fair competition and protect consumers.

Perfect competition

A subsidy receives a sharp response in perfect competition due to the high market pressure. Here, the market experiences an increase in the supply of the subsidized product since the firms in the market consider it more profitable. If only one good is subsidized, the supply of substitutes will drop drastically, and competitors will begin to supply the subsidized product.

Taxes in a perfect competition also receive a sharp response. The taxes increase the firms' production costs, threatening the market equilibrium where the marginal costs are equal to the marginal revenue. The resulting situation is that the firms will have to pass on all the taxes to consumers since the firms are already making zero profits in perfect competition. If the firms don't pass on the taxes, they begin to make losses until they leave the market.

Monopolistic competition

In monopolistic competition, even though there are several firms, none of these firms produce perfect substitutes for other products. Since the competitive pressure on the firms is low in the case of taxes, they will pass on the taxes to consumers by increasing their prices.

A market regulation such as the price ceiling ensures monopolistic firms do not exploit market power and increase their prices unreasonably. For instance, a price ceiling will ensure that monopolistic firms cannot pass on the taxes to consumers.

Advantages of Government Intervention on Different Market Structures

Government intervention in the right conditions can be very beneficial. Here are some of the advantages of government intervention.

1. Keeps companies from exercising monopoly power - Monopolies can have immense control in the market, setting absurdly higher prices than the equilibrium price and underproducing. This results in deadweight loss. Government interventions like price controls and market regulation can prevent such a situation.

2. Provides goods that promote social welfare - Tax revenues are used to provide public goods like street lights and roads. Subsidies also promote the production of goods that firms may find less profitable.

3. Controls or prevents negative externalities - Goods that harm social welfare, such as cigarettes and alcohol, are subject to high price floors to deter people from consuming them. In addition, companies may ignore the effect of their operations on the environment. For instance, market regulations can prevent companies from using harmful coal plants for their operations.

4. Promotes equality or fairness - A price floor like the minimum wage rules in the US promotes fairness. It prevents workers from being taken advantage of.

Disadvantages of Government Intervention on Different Market Structures

Government intervention comes with certain disadvantages. Let's discuss them.

1. Lack of incentives - In cases where the government regulates the market and prevents firms from exploiting some of the opportunities they see (such as a monopoly), the firms may not be incentivized enough to keep producing.

2. Poor signaling - Producers learn the market to determine what is in high demand and how much of it is demanded. As the government intervenes, producers may get the wrong impression and either overproduce or underproduce. They may also allocate resources poorly as they may produce too much of the wrong product, wasting resources.

3. Lack of variety - variety in the market is important to give consumers different choices. Government intervention may discourage the production of certain products, leaving consumers with limited choices.

4. Failure of the government - The government can simply get it wrong. Implementing the wrong intervention in response to market conditions can result in an even more rapid market failure.

You made it! You've reached the end of the article! Check out our article on Social Efficiency and Economic Inefficiency to understand why it is so important for governments to intervene sometimes.