In a free market economic system, scarce resources are allocated through the price mechanism where the preferences and spending decisions of consumers and the supply decisions of businesses come together to determine equilibrium prices. The free market works through price signals. When demand is high, the potential profit from supplying to a market rises, leading to an expansion in supply to meet rising demand from consumers. Day by day, the free market mechanism remains a tremendously powerful device for determining how resources are allocated among competing ends.
Intervention in the market
The government may choose to intervene in the price mechanism largely on the grounds of wanting to change the allocation of resources and achieve what they perceive to be an improvement in economic and social welfare. All governments of every political persuasion intervene in the economy to influence the allocation of scarce resources among competing uses
What are the main reasons for government intervention?
The main reasons for policy intervention are:
To correct for market failure
To achieve a more equitable distribution of income and wealth
To improve the performance of the economy
Government may intervene the market by using price control, tax and subsidy. At the same time, government intervene the market will cause market distortion.
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.
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When a price ceiling is set, there will be a shortage. For the price that the ceiling is set at, there is more quantity demanded than quantity supplied. Inefficiency occurs since at the price ceiling quantity supplied the marginal benefit exceeds the marginal cost. This inefficiency is equal to the deadweight welfare loss.
If a price ceiling is set, then there must be a way to assign who gets the low supply of the product. Since there is a legal limit on the price, the price can’t simply be raised. There are several ways this is done without raising the price:
Lottery: One way to distribute a product for which there is a shortage is to draw names out of a hat. In some states there is a high demand to be able to hunt for moose, but the government has a limit on the amount of permits it gives out. Often these states have a lottery and if you are lucky enough to get drawn, you can try your luck at finding and shooting a moose during the season.
Black Market: For those lucky enough to get some of the short supply, they are often better off selling what they have obtained to the demanders that will get more benefit out of it. In some cities there have been ceilings put on the apartment rent. While the demand for apartments increases, the rent remains the same. When some renters are ready to move, they sublease their apartment instead of ending their contract. If they were renting for $500, but someone is willing to pay $1000, then the subleaser can continue paying $500 and pocket the extra $500 he gets from the subleasee.
Queue/First Come First Serve: Had they raised the price of tickets to $100 the opening night of Star Wars: Episode I, I wouldn’t have been willing to camp out two nights to get a ticket. Since they didn’t let the market determine the price, however, there was a huge line and those that were there first got to buy tickets. Of course, in this case they may have wanted the “buzz” that would come from having people camp out a week early just to get tickets, but there are other cases where a buzz isn’t useful.
Historical Use: Sometimes the government will allow the consumers that were already consuming to continue consuming. This would be hard to do since after the price ceiling there will be many more people claiming they have consumed in the past. Also, the quantity supplied is decreased which will even leave some of the historical consumers wanting.
In New York City, rent control operates under the Maximum Base Rent (MBR) system. A maximum base rent is established for each apartment and adjusted every two years to reflect changes in operating costs. Owners, who certify that they are providing essential services and have removed violations, are entitled to raise rents up to 7.5 percent each year until they reach the MBR. Tenants may challenge the proposed increase on the grounds that the building has violations or that the owner’s expenses do not warrant an increase. For New York City rent controlled apartments, rents can also be increased because of increases in fuel costs (passalongs) and in some cases, to cover higher labor costs. Outside New York City, the New York State Division of Housing and Community Renewal (DHCR) determines maximum allowable rates of rent increases under rent control. Owners may apply for these increases periodically.
Rents can also be increased in any one of three ways; both inside and outside of New York City:
with the written consent of the tenant in occupancy, if the owner increases services or equipment, or makes improvements to an apartment;
with DHCR approval, if the owner installs a building-wide-major capital improvement; or
In cases of hardship with DHCR approval.
For rent controlled apartments, complaints submitted by tenants will result in an order by DHCR that establishes the Maximum Collectible Rent and directs that any overcharge be refunded for a period of no greater than two years before the filing of the complaint. If the refund is not made, the tenant can proceed to court to calculate the overcharge and enforce the order.
A price floor is the lowest legal price a commodity can be sold at. Price floors are used by the government to prevent prices from being too low. The most common price floor is the minimum wage–the minimum price that can be cover for labor. Price floors are also used often in agriculture to try to protect farmers.
As you might have guessed, this creates a problem. There is less quantity demanded than quantity supplied. This is called a surplus. If the surplus is allowed to be in the market then the price would actually drop below the equilibrium. In order to prevent this, the government must involve. The government has a few options:
They can buy the surplus. For a while the US government bought grain surpluses in the US and then gave all the grain to Africa. This might have been nice for African consumers, but it destroyed African farmers.
They can strictly enforce the price floor and let the surplus go to waste. This means that the suppliers that are able to sell their goods are better off while those who can’t sell their will be worse off. Minimum wage laws, for example, mean that some workers who are willing to work at a lower wage don’t get to work at all. Such workers make up a portion of the unemployed.
The government can control how much is produced. To prevent too many suppliers from producing, the government can give out production rights or pay people not to produce. Giving out production rights will lead to lobbying for the lucrative rights or even bribery. If the government pays people not to produce, then suddenly more producers will show up and ask to be paid.
They can also subsidize consumption. To get demanders to purchase more of the surplus, the government can pay part of the costs. This would obviously get expensive really fast.
Malaysia’s government have spends US$14 billion in term of subsidizing of gasoline, diesel and gas each year. In 5 June 2008, gasoline prices had increased by 40% from RM1.92 per liter to RM2.70 per liter. Price of diesel had also increased by 67% from RM1.00 per liter to RM2.58 per liter. It was announced that increasing of price due to bring fuel prices in line with global market cost. The Malaysia government had announced yearly cash rebate of RM625 per year to Malaysian citizens who own cars with an engine power of 3000 cc or less than 3000 cc and RM200 tax rebate to cars with an engine power of 3000 cc or more than 3000 cc to compensate the increased costs. Besides of that, the government had also introduced a temporary ban on buying fuel within 50 km of the country border, but the ban was interrupted according the price increase on 7 of June 2008 for petrol of 41% and for diesel of 63%.
On 22 June 2008, the Malaysian government announced that to set up separate pumps at its border petrol stations to sell fuel to foreigners at market rates. So that locals only can get benefit from subsidy of petrol. The new pumps will target Singaporeans and Thailand who make day trips across the border to fill their tanks with cheaper fuel there. Although Singapore-registered cars must have at their tanks at least 75% before they will be permitted to leave Singapore in any case. Petrol stations within 50 km of the country’s northern border with Thailand and southern border with Singapore would be affected. Recently, the fuel price has fall until MYR 2.45 and it has dropped for the second time. A further reduction was made on 1 November 2008. RON97 petrol was reduced from RM2.30 per liter to RM2.15 per liter while RON92 petrol from RM2.20 per liter to RM2.05 per liter and diesel from RM2.20 per liter to RM2.05 per liter. The Government exposed that it had stopped subsidizing for petrol from 1 November 2008 when the price of oil immersed below US$65 per barrel. However subsidies were still being paid for diesel and natural gas.
On 18 November 2008 the Malaysian government made further reductions in the price of gasoline cut pump prices by seven per cent to RM2.00 ringgit per liter and diesel by 15 cent to RM1.90 per liter. The government said that at current prices they were making about 30 cent per liter in sales. Again on 3 December, petrol prices were reduce further. Gasoline prices were reduced 10 cent to RM 1.90 per liter and as for diesel were reduced 10 cent to RM 1.80 per liter. On 16 December 2008, the price of RON97 petrol was reduced further to RM1.80, while RON92 is selling at RM1.70 per liter. The pump price of diesel was reduced to RM1.70 per liter.
A subsidy is a form of financial assistance paid to a business or economic sector. Most subsidies are made by the government to producers or distributors in an industry to prevent the decline of that industry or an increase in the prices of its products or simply to encourage it to hire more labor.
The graph about illustrates the subsidy effect. From the graph we find that when government giving subsidy, the supply will shift right to the subsidy effect curve. The price will decrease and the quantity will increase.
Advantage of subsidy is they result in lower price for the consumer. Although government implements the price ceiling to set the minimum price, subsidy also have their value in the market. Price ceiling help consumers buy the good which their need, it is helpful for consumer get the goods. Nevertheless, some necessary product cannot set at the lower price because when the price is cheaper, the producer will reduce the quantity of the product even leave the industry. When that time the supply will less than demand, there will have a shortage. At the same time the price also will increase. When occur this situation, government adopt to give subsidy to the producer that producer will satisfy on the revenue and continue produce the product and consumer will allow buying it in the price. Cause win-win situation between producer and consumer.
On the other hand, when government giving subsidy, national will have to be paid from tax revenues and therefore result in higher tax.
Malaysia spent record subsidy in 2009 RM 74 billion. Subsidy bills in each category are enormous Social Fuel & Energy RM 42.4 billion RM 23.5 billion Infrastructure Food RM 4.8 billion RM 3.4 billion. Due to government subsidy, the price of cooking oil, sugar and flour in the cheaper in the region (Malaysia, Indonesia, Thailand, Brunei, and Singapore). But due to some reason, the price of sugar, flour and cooking oil will be increased by Sugar + 20 sen / kg (every 6 months until 2012) Flour + 20 sen /kg (2010) + 25 sen / kg (2011) Cooking oil (1 kg) +15% (2010) +15% (2011), thereafter 5% every year until Jan 2014. So Malaysians responded that it should reduce subsidies in 3-5 years by 61%~66% (Jala, 2010).
The beneficiaries of the subsidies have changed as agriculture in the United States has changed. In the 1930s, about 25% of the country’s population resided on the nation’s 6,000,000 small farms. By 1997, 157,000 large farms accounted for 72% of farm sales, with only 2% of the U.S. population residing on farms. In 2006, the top 3 states receiving subsidies were Texas (10.4%), Iowa (9.0%), and Illinois (7.6%). The Total USDA Subsidies from farms in Iowa totaled $1,212,000,000 in 2006. From 2003 to 2005 the top 1% of beneficiaries received 17% of subsidy payments. In Texas, 72% of farms do not receive government subsidies. Of the close to $1.4 Billion in subsidy payments to farms in Texas, roughly 18% of the farms receive a portion of the payments. In United State there also spend more money in the agriculture industry (Wikipedia, 2010).
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Accord the information above, we find that both countries spend a lot of money on the subsidy. There are certain degrees of effectiveness when government giving the subsidy. When the producer take subsidy, it will make producer got extra money to produce the product, cause the product price reduce. So the consumer will allow buying the product and mitigating consumer burden. Subsidy looks like useful but it only happen in short-run.
In long-run, only bulks of the farm subsidies are cornered by big farmers’, small farmers do not benefit from the huge agricultural support. It treats these subsidies as non trade-distorting and therefore excluded from any reduction commitments. But since these subsidies do not go to small farmers, the developing countries need to seek complete removal of these subsidies before providing any more market access.
Although subsidies have advantage to let consumer and producer satisfy, subsidy will not helps the economy. Free market economists argue that government subsidies distort the workings of the free market mechanism and can eventually lead to government failure where government intervention actually leads to a worse distribution of resources.
When Government giving subsidy, there will appear some problems on below,
Distortion of the Market
Subsidies will distort market prices -and lead to a misallocation of resources. Many economists believe that the free market mechanism works best. Export subsidies distort the free trade in goods and services and can severely curtail the ability to compete.
Decide which organizations will be subsidized. For example, in England if government support the tourism, why they will not subsidy the steel industry.
Subsidies can become expensive, note the opportunity cost. This is because every country spends a lot of money in subsidy. To have more subsidies, the consumer will pay more tax to the government.
Who pays and who benefits?
The final cost of a subsidy usually falls on consumers who may have derived no benefit from the subsidy.
Subsidy can protect a firm who need to restructure. So the firm will not work hardly because they government subsidy will become a part of profit of them.
Risk of Fraud
Allocate the subsidy always exist fraudulence risk.
There are alternatives.
To reduce the subsidy effect in economic, government can adjust the taxation and benefit system.
For giving more subsidies, consumers have to be paid form tax revenue and therefore result in higher taxes. So that subsidy is not help to the economic.
Indirect tax is a tax on the expenditure on goods. Indirect taxes included value added tax (VAT) and duties on tobacco, alcoholic drink and petrol. These taxes are not paid directly by the consumer, but indirectly via the sellers of the goods. Indirect taxes contrast with direct taxes (such as income tax) which are paid directly out of people’s incomes.
From the diagram, the Pc to Pe is pay by consumer and Pe to Pp is pay by consumer. The effect of the tax is to raise the price and reduce quantity. Price will not rise by the full amount of the tax, however, because the demand curve is downward sloping.
There have 4 types on incident of an indirect tax (inelastic demand, elastic demand, inelastic supply and elastic supply). In both incidents, the tax pay is same, when price rise to PC, quantity will fall to Qt. but the size of increase in price and decrease in quantity differs in each case, depending on the price and elasticity and demand and supply.
Nowadays, tobacco is charge higher tax. In UK 2004/2005, tobacco duties raise $8.1 billion or 1.9 percent of total tax revenue. This compares with 5.5 percent for fuel duties and 1.8 percent for alcohol tax that tobacco duties are a major source of revenue of the government. In China, government also increase their tobacco year by year, the tax revenue in China is over 11.6%. Although government charges higher tax on tobacco, the demand of tobacco is inelastic. It shows that tobacco is necessary for some person (David, Helen, John, 2010).
Government charges higher tax on tobacco to prevent their national smoking. In UK, smoking kills over 100,000 people/per year and In China near 3 billion people smoking and 673,000 person was killed by tobacco. To protect their national, government charge higher tax in those unhealthy products such as tobacco and alcohol.
In China by increase 1RMB per package, the elastic is -0.06. Prevalence rate of smoking would be reduced from 31% to 30.13% and a reduction of 3.42 million smokers. Specific excise tax increase would mean 1.14 million lives could be saved. At the same time, the total government cigarette tax revenue would increase by 129.4 billion (or US$17.25 billion) (David, Helen, 2010).
Charging tax on tobacco, the low-income smokers in China pay less per pack and smoke fewer cigarettes than high-income smokers. Furthermore, low-income smokers are more price responsive than high-income smokers. Low-incomes smokers saving money from tobacco expense and used for other household necessities such as clothing, food and other else to improve their live level.
By increase tax in tobacco, they will make unemployment in tobacco industry. In this time, government can giving subsidy to employees who work in tobacco industry. When this period government can give them training that they can find a new job in a new industry in the future. The farmer who are planted tobacco may change to plant another agriculture crop in their own land.
For some unhealthy product, government may changes higher tax on it to prevent their national using it. If the product is elastic product, government might reduce the tax because lower tax equal to higher economic growth. From 1990 to 1999, for example, more than 2,800,000 Americans moved from the 41 U.S. states that had income taxes to the nine states without state income taxes. People voted with their feet for smaller government and a lower tax burden. This movement says that people believe that the overall quality of life is higher in the states that did not tax their income. This migration says that people prefer to spend the money themselves than letting government doing it. People were fleeing Welfare State policies in order to pursue individual freedom without as much governmental interference (Belize Development Trust, 2002).
Sweden was one of the world richer countries in 1970. Today, is not in the top 15 richer countries because Sweden having a high tax. Per capita income is actually falling below the average of the European OECD countries. A crushing tax burden has led to a reduction in capital formation, a decline in hours worked, and general stagnation. It mean higher tax make the economic grow slowly (Belize Development Trust, 2002).
We remain neutral on government intervention the market. This is because government interventions the markets have both advantage and disadvantage.
Setting price ceiling and price floor is ensure producer and consumer would allow to earn profit or buy the goods. Although setting price control will make market distortions, government can analysis the market and utilize the price control effectively. When setting the price control, government must strengthening economic management to reduce the problem such as black market.
For subsidy, it only can support the industry in short run because in long run the small scale firm would get the benefit and it will become an extra profit for large scale firm. Beside this, subsidy in long run also will have corruption. So we feel that subsidy only suitable implement in short run.
Lastly, tax is an important income of each country. So government allows charging tax on every products or services. If government prevents their national to purchase some unhealthy product, they may charge higher tax on it. For other goods and services, government should charge lower tax on it because lower tax will have higher economic grow.