Effects of Government Intervention

AS Economics

Aims and Objectives

Aim: To understand the effects of government intervention Objectives: Define price intervention Explain maximum and minimum prices Analyse the effects of these and buffer stocks Complete multiple choice questions

Starter
How could the government intervene to correct the following market failures? Externalities Public Goods Merit and Demerit Goods

Monopoly
Immobility of Labour Inequalities in the Distribution of Income and Wealth

Price Intervention Government can intervene in markets to legally impose a price in a market.

Maximum Prices
Government intervenes in a market to set a price ceiling (maximum price) for a product. The market price cannot rise above that level. To be effective the maximum price should be set below the market level. Example: a maximum price may be used when shortages of essential foodstuffs threatens large rises in the free market price. (e.g. after a natural disaster/drought/famine. May be applied to shortages of merit goods.

The Effect of Imposing a Maximum Price

Price S

P1 PMax

Q2

Q1

Q3

Quantity

Diagram Explained
Free market equilibrium is P1 Q1 Maximum price imposed Pmax

This maximum price results in excess demand Q3-Q2

Quantity Supplied is Q2

Quantity Demanded is Q3
Therefore excess demand is created.

Maximum price above market equilibrium would not work.

Minimum Prices
Government intervenes in a market to set a price above the market price. Price cannot fall to the market level. Example National Minimum Wage Intervention to raise wages of low paid workers

The Effect of Imposing a Minimum Price

Price PMin P1 S

Q2

Q1

Q3

Quantity

Diagram Explained
Free market equilibrium is P1 Q1 where workers are paid a lower wage rate. Minimum price imposed Pmin (minimum wage) This minimum price results in excess supply Q3-Q2 Quantity Supplied is Q3 Quantity Demanded is Q2 Therefore excess supply is created. Minimum price below market equilibrium would not work.

Buffer Stocks
Governments may intervene where markets suffer considerable volatility in price. Manipulate the free market price using buffer stock schemes. Agricultural markets are notorious for price instabilities due to unpredictable weather and inelastic supply and demand curves. Price instability can lead to unpredictable incomes for farmers and devastation of markets, especially in less developed countries. Because of this governments try to stabilise prices over time.

Buffer Stock Scheme

S3 Price S1 S2

P1

Q2

Q1

Q3

Quantity

Buffer Stocks
Government selects a target price to keep stable (P1) this is the average long term average equilibrium price. Following a supply shock (such as a bad harvest) supply decreases (S1-S3) the price would rise above P1 normally However the government intervenes and sells off some of its buffer stock to match the excess demand (Q1-Q2).

Buffer Stocks
Following a supply shock (such as a good harvest) supply increases (S1-S2) the price would fall below P1 normally. However the government intervenes and buys up the excess supply (Q3-Q1) and put this in its buffer stock.

1.D 2.B

1.B 2.A

1.C 2.B

1.D

1.A

Quick Draw