Lecture Note 3 Rationale for government intervention in the economy PDF

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RATIONALE FOR GOVERNMENT INTERVENTION IN THE ECONOMY. One of the ten basic principles of economics as proposed by Gregory Mankiw is that markets are usually a good way to organize economic activity. Markets usually can work well to ensure an efficient allocation of resources between different consumption and investment activities, however, there are many circumstances in which market forces, left to themselves, will fail to maximise economic and social welfare and, as a consequence, will necessitate government intervention in the market. In general terms, there are three main arguments for Government intervention i.

Efficiency arguments for government intervention

There are market failures which result in inefficiencies in the allocation of resources. These inefficiencies mean the mix of goods and services produced across the economy as a whole diverges from the mix that would best meet consumers’ preferences (as expressed by their willingness and ability to pay). Efficiency in production occurs when production takes place on the PPC where resources are fully employed and put to their best possible use. On the PPC, allocation is Pareto efficient and it is impossible make somebody better off without making somebody else worse off. Allocative efficiency occurs when the economy operates on a point on the PPC that represents the combination of goods and services that best satisfies the needs of the consumers.

A

Point A for instance is efficient and Pareto Optimal while Point B is not because not all the resources are fully utilised

B

Conditions Necessary to Achieve Allocative Efficiency a. Perfect mobility of Resources It must be possible to shift factors of production into the activities that best represent the consumers wants and needs. b.

Perfect Competition

Firms must not exhibit monopolistic tendencies. c.

No market Power

Firms must be price takers and not price makers. In other words, they must not have market power. d. Perfect Information All consumers are well informed enabling them to make sensible decisions. This means there should be no case of information asymmetry. e. Fair income distribution This occurs when market forces set the wage rates for different professions. For instance, if there is high demand for doctors, but low supply, doctors get a high wage. f. No externalities An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect. Externalities occur when producers do not incur all costs of production or consumers don't derive all of the benefits of consumption. Since the market does not take account of these cost and benefit to others, externalities causes inefficiency. g. No public goods Public goods have unclear price signals and leads to inefficiency in the market. h. Consumer Sovereignty This means the consumer knows best and they are the best judge of what is good for them. When the conditions identified above do not hold, it leads to market failure. Market Failure occurs when there is a misallocation of resources, which results in distortions in the ma rket. This distortion creates an inefficiency in the market. Thus If perfectly competitive markets are left on their own they may fail to provide an efficient and fair allocation of resources so the government steps in for the following reasons: 1. Market Power When there is only one buyer or seller in the market, that firm can set the price of the product or the quantity supplied. Many countries have a limit on how much market share one firm can have or how big they can become. 2. The Negative Externalities Negative Externalities occur when the production or consumption of a good or service causes the social cost to exceed the private cost. For example, production of wood furniture does not take into account the effects of environmental pollution or deforestation.

3. The Positive Externalities Positive Externalities occur when the production or consumption of a good or service causes the social benefit to exceed the private benefit. For example, if the government provides vaccines to everyone for free then there is a social benefit that the country benefits. These benefits are not considered in production costs. 4. The need for Public Goods There may be a total absence of market arrangements for providing certain goods and services particularly when it is not possible to exclude people from its consumption once it has been provided, i.e., if it’s produced then anyone can consume it, and one person consuming the good doesn’t decrease the availability of the good for someone else. Such goods are non-excludable by price and they are non-rival thus the government usually ends up producing the good. The ‘freerider’ problem arises with public goods - when people refuse to contribute to the cost of providing a public good on the grounds that once it is provided no one can be excluded from using it. In this situation private producers will have no incentive to produce the goods as they have no way of charging for the product so they can’t make a profit. 5. Incomplete Information One party has material information that the other does not, or both parties lack material information that would affect whether or not the trade occurs, or for what price it occurs. This problem is known as asymmetric information. 6. Regulations Restrictions such as price floors or price ceilings can prevent the price mechanism from efficiently allocating resources. However, government sometimes imposes these regulations to maximise the well-being of the people. Y Price Ceiling is a maximum allowable price specified by law. It prevents sellers from charging more than a specified amount for a specified good and helps to control unwanted price hike. Thus price ceiling is often implemented to protect consumers. The effect of a price ceiling is illustrated below

The price ceiling causes a shortage in the economy and consumers might end up paying a price hig her (CPc) than the market established equilibrium to consume the good. The price regulation also leads to a loss of economic surplus or deadweight loss in the economy. Thus, though government intervention is often desirable, it can lead to inefficiency in resource allocation. Price Floor: This is a minimum allowable or legal price specified by law. It sets a limit to how low prices can fall. It is often intended to protect producers of perishable goods such as farmers and in the case of a minimum wage rate, it is used to protected labour from being unnecessarily exploited. The effect of a price floor is illustrated below

With an increase in price, supply becomes greater than demand leading to a surplus in the economy. If this surplus is not bought off by the government, then the producers might be forced to sell their products at a price (CPf) far lower than the market established equilibrium.

ii.

Equity Arguments for government Intervention

Economic efficiency arguments are not the only, or often the main, reason for government intervention. Equity considerations are also important, though to what extent involves a political judgement. Equity arguments for intervention take a number of forms: a.

vertical equity: This involves the redistribution of income from richer individuals and families to poorer individuals and families. This is often done through taxation and government transfer payments in the form of unemployment benefits and the likes.

b. horizontal equity: This proposes that individuals and families with similar needs should be treated similarly e.g. in terms of access services such as health care and education. c. social inclusion: This is closely linked to vertical and horizontal equity but implies everyone should have access to income, opportunities and services, which allow them to fully participate in the life of the society in which they live. For instance, public funded hospitals and schools can promote social inclusion. If individuals and However, with poor families, the solution may be the redistribution of income through cash benefits rather than benefits in kind such as health care and education. Cash benefits allow individuals and families to spend their income in the way that they judge is in their best interest. a. intergenerational equity: This has to do with balancing the needs of current and future generations. Government is considered to be more intentional in investment for future generations which greatly justifies their intervention in the economy

iii.

Ethical arguments for government intervention

Ethical arguments for government intervention arise where there are perceived to be boundaries to the role that markets should play. However economically efficient markets may be, there are some things that society may not wish to see bought and sold in that they believe it is wrong as a matter of principle. This will suggest the presence of merit and demerit goods. A merit good is a good that society or the government deems that people ought to have because it is considered to be good and consumption is encouraged. The government may encourage consumption by provide these goods free of direct charge, by providing a subsidy or by compulsion. A demerit good is a good that government or society deems to be harmful or bad for people. The government may prohibit consumption or impose taxes on such goods to make them expensive. Governments can tax demerit goods and subsidise merit goods....