This slide covers the chapter 3 Core (Economics- A'Level )

1. Government
Intervention in price
systems
Core
Kalaiyarasi Danabalan
A’ Level

2. Subtopic
 Externalities
 Social costs and social benefits
 Decision making using cost-benefit analysis
 Private and public goods
 Merit and demerit goods
 Examples of government intervention

4. Market Failure
 In a market where there is equilibrium, the resources are
allocated in the best possible manner and there is
'allocative efficiency'.
 Allocative efficiency is when situation where Marginal cost
is equal to Marginal revenue.
 Market failure exists when the resources are not allocated
efficiently. Community surplus is not maximized and thus
there is market failure. From a community's point of view,
producer surplus is not equal to consumer surplus.

5. Market failure is thus caused by
 Abuse of monopoly power
 Lack of public goods
 Under provision of merit goods
 Overprovision of demerit goods
 Environmental degradation
 Inequality in distribution of wealth
 Immobility of factors of production
 Problems of information
 Short termism

6. Externalities
 A loss or gain in the welfare of one party resulting from an
activity of another party, without there being any compensation
for the losing party.
 This activity can be due to consumption or production of a good
or service.
 If the third party suffers due to this activity then it is known as
negative externality. It’s the production or consumption
activity that creates an external cost.
 When the third party gains from this activity is it known as
positive externality. It’s the production or consumption
activity that creates an external benefit.

7.  Externalities occur when there is a divergence between social and private
costs and benefits.
 Private costs - costs involved in an action that accrue to the decision maker.
 Social costs - all costs that are associated with a particular action.
 Private benefits - benefits that accrue solely to the decision maker.
 Social benefits - all the benefits that accrue from a particular action. (
 The market demand and supply curves therefore reflect the MPB and MPC
accruing to buyers and sellers.
 MPC= MPB P & Q equilibrium reflected at this point are ‘socially optimum’.

8.  Social cost (SC) = Private costs (PC) + External costs (EC)
 In marginal terms (when each additional unit of good is produced),
Marginal Social Costs (MSC) = Marginal Private Costs (MPC) + Marginal External(MEC)
Net External benefit = External benefit – external cost
 External benefit arises when social benefit exceeds private benefit. It refers to the benefit from
production (consumption) experienced by people other than the producer (consumer).
Positive externality
 Social benefit- the full benefit to society from consumption and production of any good. From
the society's point of view, the price system must consider both private benefit and external
benefit.
 Social benefit (SB) = Private benefit (PB) + External benefit (EB)
In marginal terms (when each additional unit of good is produced),
 Marginal Social benefit (MSB) =Marginal Private benefit (MPB) + Marginal External benefit
(MEB)

9. How would net external benefit be calculated?
 A external benefit minus external cost
 B external benefit plus private benefit
 C private benefit plus social benefit
 D social benefit minus private cost

10. Negative Production Externalities
 Side effects of production activities.
 An individual / firm making a decision does not have
to pay the full cost of the decision.
 Pollution
 producers don't take responsibility for external costs
that exist--these are passed on to society.

11.  Producers have lower marginal costs
than they would otherwise have and the
supply curve is effectively shifted down
(to the right) of the supply curve that
society faces.
 Because the supply curve is increased,
more of the product is bought than the
efficient amount--that is, too much of
the product is produced and sold.
 Since marginal benefit is not equal to
marginal cost, a deadweight welfare
loss results.

12. How to reduce negative production
externalities?
 Legislation and regulation
Legislations will lower the quantity of goods produced and bring it closer to the optimal quantity
Q* by shifting the MPC curve upward towards the MSC curve. It might include legislations to
- Limit the emission of pollutants by setting limits to the extent of pollutants produced by a
firm.
- Limit the production to a certain level.
- Force polluting units to install technologies which reduce emissions.
 Taxes
- Government may impose a tax on the firm either on per unit of production or per unit of
pollutants emitted.
 Tradable permits
- Market-driven approach to reducing greenhouse gas emissions. A government must start by
deciding how many tons of a particular gas may be emitted each year.
- Tradable permits will result in firms to lower the quantity of goods produced so that it equals
Q* and to raise the price of the goods

13. Government impose Tax

14. Positive Production Externalities
 When firms train their employees which result in better manpower or invest
in research and development and succeed in developing new technologies
which benefits the society.
 Due to the fact that positive externality is produced, the MSC lies below the
MPC. The diagram below illustrates positive production externalities.

15. Corrective positive production
externalities
Subsidies can be provided to firms
which produce these goods. The
effect will be the lowering of MPC
and thus the MPC will more
downward to MSC.
This will increase the output to a
level Q2 near to the socially
optimal level Q*. The price will also
fall from P1 to P2.

16. Negative Consumption Externalities
 By smoking in public places, the consumer is creating
negative externalities, in the form of passive
smoking, for non-smokers. Other examples :- using
fossil fuels that pollute atmosphere, playing loud
music and disturbing neighbours, discarding garbage
in public places.
 MPB is not reflecting social benefit and thus MSB lies
below MPB. The vertical difference between MPB and
MSB is the negative externality. The optimal level of
consumption is where MSB=MSC i.e. Q*.
 However the negative externality is being ignored
and thus there is an over consumption of the goods at
Q1.

17. How to reduce negative consumption
externalities?
 Advertising
 Legislations and regulations
 Imposing indirect taxes

18. Positive Consumption Externalities
 consumption of education and health care. Both these will lead to more
productive workforce and hence high rate of economic growth for the society.
 The MSB lies above the MPB and the
difference between the two consists
of positive externality.
 The socially optimal level is where
MSB=MSC i.e Q*, however, due to
under-allocation of resources the
output/consumption is at Q1.

19. Corrective Positive
consumption externalities
 Subsidies
MSC curve shifting to MSC+subsidy which means high
output/consumption at socially optimal level Q* and at lower
prices from P1 to P*.
 Advertising
Consumers to increase their consumption and thus lead to a
shift of MPB to the right i.e. increase in demand. If the MPB
curve shifts enough, it will coincide with MSB and Q* will be
produced and consumed.

20. Goods
 Demerit Goods
goods which are deemed to be socially undesirable, and which are likely to be over-produced
and over-consumed through the market mechanism. Examples :-cigarettes,
alcohol and all other addictive drugs such as heroine and cocaine.
The consumption of demerit goods imposes considerable negative externalities on society
as a whole, such that the private costs incurred by the individual consumer are less than
the social costs experienced by society in general.
 Merit Goods
Benefits on society in excess of the benefits conferred on individual consumers; in other
words, there is a divergence between private and social costs and benefits, as the social
benefits accruing to society as a whole from the consumption of such goods tend to be
greater than the private benefits to the individual.
individual consumers and producers make their decisions on the basis of their own,
internal costs and benefits, but, from the standpoint of the welfare of society at large,
externalities must be considered.
 Private Goods and Public Goods

21. Demerit Goods Merit Goods

22. Consumer Surplus and Producer Surplus
 Consumer Surplus - difference between total benefit of consuming a given
quantity of output and the total expenditures consumers pay to obtain that
quantity.
 Producer Surplus - difference between the amount that a producer of a good
receives and the minimum amount that he or she would be willing to accept
for the good.
 Community Surplus - the welfare of society and it is made up of a consumer
surplus plus a producer surplus. It exists when it is impossible to make
someone better off without making someone else worse off.
When the consumer surplus is equal to producer surplus, it exists when the market is
in equilibrium, with no external influences and no external effects.
Market is said to be socially efficient and community surplus is at its maximum.

23. Consumer Surplus Producer Surplus

24. Community Surplus and Allocative Efficiency
(Let we draw)

25. Indirect Taxes
 tax collected by an intermediary i.e. seller, from the person who bears the ultimate
economic burden of the tax i.e. consumer.
 it is a tax which is imposed on goods and services sold. It is usually added to the cost of
the good or service and charged from the ultimate consumer. The seller will then file a
return to the government on all the taxes he has collected from the consumer.
 Example :- sales tax and excise duty

26. Reasons for imposing taxes
 To generate Government revenues: excise duties on beers, wines and spirits
are price inelastic in demand, so tax price increases by levying specific
alcohol and tobacco taxes raise consumer expenditures as a whole on these
categories and therefore taxation revenues.
 To discourage consumption: Government might use taxes to discourage
consumption of certain demerit goods such as cigarettes.
 To alter the pattern of consumption: Government might use direct taxes a a
mean to alter the consumption patter of its population. Certain goods can be
made more price attractive through lower taxes while goods which have high
marginal social cost can be made expensive through taxation.

27. Distinction between specific and ad valorem
taxes
 Specific tax is a flat rate of tax whereas ad valorem tax is a percentage tax.
 Ad valorem literally the term means “according to value.” It is imposed on
the basis of the monetary value of the taxed item.
Consequences of imposing indirect tax
 Imposition of tax results in three economic observations.
 Incidence: Incidence of tax means the party who actually pays the tax.
 Government revenue: the amount of tax government will receive as revenue
 Resource allocation: the amount of fall in quantity demanded and produced
created by the tax..

28. Incidence or tax burden
 When a tax imposed on a good or service increases the price by the amount of
the tax, the burden of the tax falls on consumers.
 If instead it lowers wages or lowers prices for some of the other factors of
production used in the production of the good or service taxed, the burden of
the tax falls on owners of these factors.

29. Tax incidence and price elasticity of
demand and supply
 Scenario 1: When PED is greater than PES
Where PED is greater than PES, it implies that consumers are more sensitive to
price changes as compared to suppliers. Thus the incidence of tax will be more
on the suppliers because if too much burden of tax is passed on to the consumers
then the demand will fall drastically.
 Scenario 2: When PES is greater than PED
When the supply curve is relatively elastic, the bulk of the tax burden is borne by
buyers. This is because PED as compared to PES is elastic, which means;
consumers are not that price sensitive and will not reduce their consumption
even if the prices rise. Because the PES is elastic, suppliers will stop the supply if
the cost of production goes up.
 Scenario 3 : PED is equal to PES

30. Subsidy and Elasticity
 A subsidy is a form of financial assistance paid by the government to a
business or economic sector.
Why subsidies are given?
 Subsidies might be given to
 Lower the cost of necessary goods which might affects a major part of population.
Example, subsidies given to essential food items and oil (in India).
 Guarantee the supply of merit goods, which the government thinks consumers
should consume.
 Help domestic firms become more competitive in the international market, also
known as protectionism.
Effect of subsidy
 Subsidy reduces the cost of production. Thus the supply curve for the product
shifts vertically downwards by the amount of subsidy provided.

31. Impacts of Subsidies on Producers
 Subsidies are monetary benefits provided to the producer
by the Government on account of production of certain
commodity. Subsidies lead to increase in producer
revenue. Due to subsidy the supply curve (S-subsidy) will
shift vertically downwards by the amount of subsidy. This
reduces the cost of production and more is now being
supplied at every price. Through the diagram, we can
see, initially the market was at equilibrium with Qe being
supplied & demanded at Price (Pe).
 Government provides subsidy WZ per unit.
 Producers lower their prices to P1 Increase output till a
new equilibrium is reached at Q1
 The producer will however not pass all the subsidy
benefit to the consumer.
 Initial producer revenue was OPeXQe which now
increases to ODWQ1.

32. Impacts of Subsidies on Consumers
 Consumers will now consume more of the product due to
lower prices. Consumers pay less as the prices fall from Pe to
P1.
 however, they end up consuming more from Qe to Q1. It is
difficult to say by how much the consumer expenditure will
increase or fall as it will depend on their relative saving and
extra expenditure.

33. Subsidies and elasticity
 Scenario 1: When PED is elastic relative to PES
The consumers do not benefit from a great fall but, because their demand is
relative elastic, they increase their consumption by a significant amount.
 Scenario 2: When PED is inelastic relative to PES
Consumption of the product is increased and so is the revenue of the producer.
The consumer benefit from a relatively large price fall, but their demand is
relative inelastic, their consumption does not increase by a great amount.

35. Government Intervention in Market
Prices
 Maximum Price or PRICE CEILINGS
In some markets, governments intervene to keep prices of certain items higher or lower
than what would result from the market finding its own equilibrium price.
A price ceiling occurs when the government puts a legal limit on how high the price of a
product can be. In order for a price ceiling to be effective, it must be set below the
natural market equilibrium.
 Minimum Prices or Price Floor
A minimum allowable price set above the equilibrium price is a price floor.
With a price floor, the government forbids a price below the minimum Price Floors are
minimum prices set by the government for certain commodities and services that it
believes are being sold in an unfair market with too low of a price and thus their
producers deserve some assistance.
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