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Government Intervention in Markets

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Economics

Sometimes the free market doesn’t work efficiently and effectively. What happens in this situation? Most of the time, the government will intervene to correct it and help the market operate smoothly again. This explanation is all about government intervention. You will learn why governments intervene, the different types of intervention, and both the advantages and disadvantages of their intervention.

What is government intervention in markets?

Sometimes the forces of demand and supply in the free market are unable to establish allocative and productive efficiency. When this happens, the government decides to step up and intervene.

Government intervention is when a government gets involved in the marketplace.

This is a regulatory action carried out by the government to try and overcome market failure. Its objective is to change the decisions made by individuals, groups, and organisations about social and economic matters to influence the free market equilibrium or outcome.

Why is there government intervention in markets?

There are four main reasons why governments need to intervene in the free market. They are:

  1. To correct market failure.
  2. To maximise social welfare.
  3. For macroeconomic factors.
  4. For socioeconomic factors.

To correct market failure

Market failure may manifest in different forms, such as the overproduction of demerit goods, negative externalities, and imperfect information access.

Market failure is when there is an inefficient distribution of goods and services in the free market.

Market failure results in a loss of net social welfare as it negatively impacts third parties and consumers. Without government intervention, the market would be stuck in this situation.

Thus, government intervention is important as it helps the market run more efficiently and effectively, which benefits all economic agents.

To maximise social welfare

In unregulated markets, there is a risk of organisations operating with monopoly power. This can result in the overpricing of products and a lack of healthy competition in the market. All of this ultimately leads to lower consumer surplus and deadweight welfare loss to society.

It's important that the government intervenes and directly tackles these social welfare issues by placing regulations that control the actions and consequences of markets. That way the government can improve and maximise the total welfare of society.

Macro-economic factors

To minimise the damage caused by naturally occurring economic events such as recession or inflation, the government would intervene to make sure the market economy is working efficiently.

The government uses subsidies and regulations to encourage the production, buying and selling of commodities in the economy to achieve growth in GDP.

Socio-economic factors

In situations where there is inequity and inequality, the government would intervene to promote general economic fairness. The government can reallocate financial resources by using means such as taxation and government spending on welfare programs.

Other factors

At times, the government may even decide to intervene in markets to promote national and government goals, such as advancement and national unity.

Types of government intervention

Government intervention can either affect the conditions of supply and demand or directly affect the market.

We will look at four different measures a government can introduce to correct market failure:

  1. Taxes
  2. Subsidies
  3. Price controls
  4. Regulation

Taxes

Taxes in the context of market intervention are used to influence the behaviours of producers and consumers in the market. Taxes can either be indirect or direct. In this explanation, we will focus on indirect taxation.

Ad Valorem (Indirect tax)

Indirect tax is a tax imposed on goods and services.

It has an indirect effect on the cost of production, which in turn affects the selling price.

The Value Added Tax, known as VAT, is an example of an indirect tax. This type of tax impacts the cost of production, which is usually trickled down to consumers through the selling price.

In the UK, VAT is a standard rate of 20%. It is a percentage of the unit cost of producing (supplying) the production, which causes a pivotal shift in the supply curve. You can see this in the diagram below.

Government Intervention in Markets Ad valorem tax StudySmarterFigure 1. Ad valorem tax - StudySmarter.

Indirect taxes are mainly used to correct negative externalities. As figure 1 shows, an indirect tax limits the supply of a particular good or service that creates negative externalities. The increase in price from P1 to P2 will further deter consumers from purchasing the good or service. This type of intervention is quite favourable because it generates tax revenues for the government. These can be further used to finance government spending to correct the market failure.

However, the effectiveness of the tax is dependent on the elasticity of the product. If the good is price elastic, the producer burden is significantly larger than the consumer burden. It will lead to a large fall in demand but generate less revenue for the government. If the good is price inelastic, the consumer burden is larger than the producer burden. It generates a lot of revenue for the government but has little impact on consumer demand.

Other factors the government will consider before introducing a tax is the size of the external cost. The government might not have all the information or the correct information to determine the external cost and thus how large or small the tax should be. This could lead to an ineffective intervention. Additionally, these taxes tend to be regressive in nature and affect lower-income households and consumers more.

Subsidies

Instead of taxing goods and services that result in lower net social welfare, governments can introduce subsidies that reward firms who produce goods and services that result in net social welfare gains.

Subsidies are benefits that remove some type of burden to promote social welfare. They can be direct (cash payments) or indirect (tax breaks).

Subsidies lower producers' costs, which causes an outward shift in supply. This is particularly helpful when there is underproduction of merit goods.

The government may give financial aid to businesses that produce and install solar panels. This reduces their costs and allows them to increase their supply of solar panels to consumers.

Government Intervention in Markets Subsidies graph StudySmarterFigure 2. Subsidy - StudySmarter.

Figure 2 illustrates the impact of a subsidy. Subsidies lower the cost of production for producers, thus the supply curve shifts from S1 to S2. This leads to lower market prices and higher demand for goods and services that benefit consumers or society as a whole.

The government may grant subsidies in the areas of public health care, research and development (R&D), education, raw materials, etc. This may result in positive spillovers, particularly for the consumers, as the subsidies lower the burden on households. This enables them to lower their expenditure on these goods/services.

Although this is highly beneficial for producers in terms of cutting down the cost of production and then selling at lower prices, some businesses might become dependent on state aid of financial grants, which isn’t ideal as the government still needs to allocate spending in other ways.

Price controls

The government uses price controls to impact supply and demand using the price of goods to correct market failures. This is done with the use of either maximum pricing or minimum pricing.

Maximum price

The maximum price is also known as the 'price ceiling'. Essentially, the government intervenes by setting a maximum price to prevent the market price from rising above a certain level. The government tends to use this when they want to help consumers if they feel the prices are too high.

Maximum prices are used in rent controls to make housing more affordable. This is particularly beneficial to those of lower-income households. In this case, the government sets a maximum price to protect tenants from landlords that would try to extort them.

For the maximum price to be effective it must be below the normal market equilibrium price, as only then it would be able to affect the price and output of the product.

As figure 3 illustrates, the maximum price is below the equilibrium price of Pe. This causes the quantity demanded by consumers to increase. However, producers have less of an incentive to supply and this creates excess demand.

Government Intervention in Markets Maximum price graph StudySmarterFigure 3. Maximum price - StudySmarter.

Minimum price (Price floor)

The minimum price is also known as the 'price floor'. Essentially, the government intervenes by setting a minimum price to prevent the market price from being sold below a certain price. The government tends to use this when the market is unfair to producers. However, it can also be used to help consumers.

The minimum wage is an example of a minimum price. In the labour market, it is the lowest possible wage an employer can pay. It is to prevent employers from underpaying workers and enabling people to maintain a certain standard of living.

Government Intervention in Markets Minimum Price StudySmarterFigure 4. Minimum price - StudySmarter.

Figure 4 illustrates a minimum price in the farming market, for example. In this market, prices are set at the minimum price, which is above the equilibrium price of Pe. This leads to excess supply as Qs is greater than Qd. Farmers benefit from having a steady and secure income, but the whole market is worse off as prices are above the optimal price and the excess supply of perishable food results in wastage of resources and products.

Regulations

The government might also intervene by passing regulations on the market to either encourage or discourage the consumption of goods and services.

The government makes it mandatory, through regulations, for people aged between 6-18 to attend some sort of schooling. This is because education is considered a merit good and it produces positive externalities. On the other hand, the government places regulations on illegal drugs and substances through bans. This prevents their consumption as they are known to be demerit goods and to produce negative externalities.

The purpose of government regulations is to promote social welfare. However, the government needs to be cautious when using regulations as it is possible for these to have unintended consequences.

Advantages and disadvantages of government intervention

Government intervention has some benefits and also negative unintended consequences despite good intentions. Interventionists are those who are in favour of government intervention. They tend to argue that government intervention is a good thing, even despite some of its drawbacks. Free market economists are against government intervention and tend to argue that government intervention is a bad thing.

Advantages

Some reasons why interventionists are in favour of government intervention are:

  • Prevents the formation of monopolies. Government intervention limits the monopoly power that would otherwise exist in the free market. With government intervention, the risk of increased inequality and deadweight welfare losses are reduced. Furthermore, by limiting mergers that can lead to monopoly power, there is an increased level of economic welfare.

  • Provision of public goods. Public goods are not provided by the free market as there is no profit incentive for the firms to provide them. Therefore, they are provided by the government. This includes national security, street lights, and so on, which are financed by tax revenues.

  • Correct negative externalities and demerit goods. If a particular good is deemed as damaging to both the individual and society, such as alcohol or tobacco, the government can reduce its production (supply) and purchase (demand), either through taxation, regulation, or minimum pricing (price floors).

  • Equality. Government intervention has been able to make adjustments to the market that reduces the rate and level of inequality and poverty in the economy. This has happened with the provision of unemployment benefits, which helps increase a person's economic welfare.

  • Environmental protection. The free market tends to ignore the external costs of business activities and also fails to consider long term possibilities. Therefore, the government can implement certain regulations to discourage activities that are unfavourable to the environment.

Market forces may lead to the burning of production wastes as it is the cheapest way to dispose of waste. However, due to the detrimental effect this has on the environment in terms of carbon emission, the government, through regulations, can control or limit the level of pollution permitted in production via pollution permits and fees. This would then have the effect of incentivising producers to devise ways to reduce their carbon footprint.

Disadvantages

Free market economists are against government intervention because:

  • Distorts signalling function. In the free market, the signalling function tells producers what to produce according to demand. Government intervention might distort signalling. This could lead to the misallocation of resources and thus to wastage.

  • Government failure. The government isn't immune to failure either. Government intervention can sometimes cause even more problems. This may occur when the intervention doesn't produce better outcomes and makes the market inefficient to allocate resources.

  • Lack of incentives. In the free market, firms have a lot of incentives to make profits, innovate, and find ways to cut costs, but in the public sector (where the government intervenes by means of state provision) there are no such incentives. This is particularly problematic as it can lead to inefficient production of goods and services.

  • Limited choice of products. Choice is an important element of economic freedom and the maximisation of individual welfare. However, some steps that the government takes might discourage manufacturers from producing some goods and services.

  • Political pressure groups. It is possible that government intervention could become intense and permanent, end up giving the government too much influence in the market, and putting citizens under pressure.

    If elections are coming up, the government might try to intervene in the market proposing tax breaks and subsidies in order to win over the votes of citizens.

  • Discrimination. Government intervention may be useful for some, but unfavourable for others.

    The government may support state-owned organizations more than private organizations.

Government Failure is another key concept in government intervention. Check out our explanation to learn all about it!

Government Intervention in Markets - Key takeaways

  • Government intervention is when a government is involved in the marketplace.

  • Its objective is to change the decisions made by individuals, groups, and organisations about social and economic matters to influence the free market equilibrium/outcome.

  • The types of government intervention are taxes, subsidies, minimum and maximum prices, regulations.

  • The advantages of government intervention are equality, prevention of monopolies, provision of public goods, correction of negative externalities and demerit goods, and environmental protection.

  • The disadvantages of government intervention are worsening the situation, limited choice of products, pressure, lack of incentives, and government failure.

  • Government failure is an economic inefficiency caused by government intervention.

Government Intervention in Markets

Government intervention is when a government is involved in the marketplace. It is a regulatory action carried out by the government to try and overcome market failure. Its objective is to change the decisions made by individuals, groups, and organisations about social and economic matters to influence the free market equilibrium/outcome.

Government intervention is sometimes needed

  • to correct market failure 

  • promote equality

  • prevent the formation of monopolies

  • to maximise social welfare

  • cause economic growth 

  • provide public goods

Government intervention can:

  • Change consumer behaviour 

  • Protect the environment

  • Reduce the rate of inequality and poverty

  • Offer more public goods

 

The negative effects are:

  • Distortion of market signals

  • Government failure

  • Lack of market incentive

  • Limits choice of products

  • Pressure form political groups

Final Government Intervention in Markets Quiz

Question

Define government intervention.

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Answer

Government intervention is when a government is involved in the marketplace.

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Question

Why do governments intervene in the marketplace?


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Answer

To overcome market failure.

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Question

What are the types of government intervention?


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Answer

Taxes 

Subsidies 

Minimum and maximum prices 

Regulations

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Question

What are subsidies?


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Answer

Subsidies are financial support to products with positive externalities.

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Question

What are minimum prices?


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Answer

Setting a lower limit for prices by the government.

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Question

What are the disadvantages of setting minimum prices?


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Answer

It can be costly for the government and force it to put tariffs on cheap imports – which damages the welfare of farmers in other countries.

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Question

Give an example of maximum prices.


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Answer

The price for bread cannot be higher than 80p/100g.

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Question

What can create a shortage?


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Answer

maximum prices

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Question

What are regulations?


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Answer

Regulations include non-market based ways of intervention in markets.

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Give an example of regulations.


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Answer

Minimum age laws on alcohol, maximum CO2 emissions for vehicles, ban on diesel cars.

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Question

What are the advantages of government intervention?


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Answer

The advantages of government intervention are equality, fighting monopolies, public goods, consumer behaviour and environmental protection.

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Question

What are the disadvantages of government intervention?


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Answer

The disadvantages of government intervention are worsening the situation, limited choice of products, pressure and dicrimination.

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Question

What are public goods?


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Answer

Some goods and services are not provided in a free market because they do not give any financial benefits. Instead, they can be provided by the government.

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Question

What is government failure?


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Answer

Government failure is an economic inefficiency caused by government intervention. It is when the government intervenes in the market with good intentions, but in result, creates even more problems by either deepening the market failure or causing a new failure.

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