Government
Microeconomic
Intervention
8.0
Ludovica Magni
, 8.1 – Government Intervention, Equity and
the Labour Market
why governments intervene
In a free market economy, prices are determined by the interaction of demand and supply.
In many cases, this leads to an efficient allocation of resources. However, markets do not
always work perfectly. When markets fail to allocate resources efficiently or fairly,
government intervention may be required to correct market failure, improve economic
welfare, and promote equity.
Government Policies to Achieve Efficient Resource Allocation
Government policies aim to correct market failure by influencing prices, quantities,
incentives, or information in markets.
Indirect Taxes (Specific and Ad Valorem)
Indirect taxes are imposed on spending and are commonly used to reduce the
consumption of demerit goods that create negative externalities.
- Specific taxes are fixed per unit.
- Ad valorem taxes are charged as a percentage of price.
By increasing price, taxes reduce consumption and internalise external costs. However,
their effectiveness depends on demand elasticity.
Subsidies
Subsidies reduce production costs and lower prices, encouraging greater consumption of
merit goods that generate positive externalities.
They aim to increase consumption to the socially optimal level where MSB = MSC.
However, subsidies can be expensive and may be poorly targeted.
Price Controls
Maximum prices are used to make essential goods affordable.
Minimum prices protect producers’ incomes.
Price controls can distort market signals and create shortages or surpluses if set away
from equilibrium.
Production Quotas
Production quotas limit output to reduce negative externalities or control supply. They are
often used in agriculture or environmental policy but may reduce competition and
efficiency.
Prohibitions and Licences
Governments may ban harmful activities or require licences to control entry into markets.
This can be effective but may encourage black markets if enforcement is weak.
Microeconomic
Intervention
8.0
Ludovica Magni
, 8.1 – Government Intervention, Equity and
the Labour Market
why governments intervene
In a free market economy, prices are determined by the interaction of demand and supply.
In many cases, this leads to an efficient allocation of resources. However, markets do not
always work perfectly. When markets fail to allocate resources efficiently or fairly,
government intervention may be required to correct market failure, improve economic
welfare, and promote equity.
Government Policies to Achieve Efficient Resource Allocation
Government policies aim to correct market failure by influencing prices, quantities,
incentives, or information in markets.
Indirect Taxes (Specific and Ad Valorem)
Indirect taxes are imposed on spending and are commonly used to reduce the
consumption of demerit goods that create negative externalities.
- Specific taxes are fixed per unit.
- Ad valorem taxes are charged as a percentage of price.
By increasing price, taxes reduce consumption and internalise external costs. However,
their effectiveness depends on demand elasticity.
Subsidies
Subsidies reduce production costs and lower prices, encouraging greater consumption of
merit goods that generate positive externalities.
They aim to increase consumption to the socially optimal level where MSB = MSC.
However, subsidies can be expensive and may be poorly targeted.
Price Controls
Maximum prices are used to make essential goods affordable.
Minimum prices protect producers’ incomes.
Price controls can distort market signals and create shortages or surpluses if set away
from equilibrium.
Production Quotas
Production quotas limit output to reduce negative externalities or control supply. They are
often used in agriculture or environmental policy but may reduce competition and
efficiency.
Prohibitions and Licences
Governments may ban harmful activities or require licences to control entry into markets.
This can be effective but may encourage black markets if enforcement is weak.
