Government in the Marketplace

A nation’s government has a power that businesses envy. It is the power to coerce payment, better known as taxation.

The opposite of a tax is a subsidy. A subsidy is a sum of money given by the government to an industry or business in order to help support it.

Government uses taxes and subsidies not only to raise revenue or redistribute income but also to shape people’s incentives and to change the marketplace.

How Taxation Shapes Markets

All effective governments have the power to tax. Taxes can be used as a tool of microeconomic policy.

For example, if the government wants to reduce the production of a certain good, they can tax the producer. This raises the cost of production for the producer and reduces the supply in the market.

The government can also use taxation to raise revenue without the intention of reducing production. For example, luxury taxes on expensive goods and services raise revenue without necessarily affecting the market.

If you’re going to buy an expensive automobile, whether you spend $500,000 or $501,000 doesn’t make a big difference in your purchasing decision.

So-called sin taxes (taxes on non-essential but popular products like alcohol and cigarettes) are intended to generate revenue but they are also intended to reduce consumption of products considered undesirable (although not illegal) by the government. High taxes on such goods can however lead to black markets.

How Subsidies Shape Markets

Subsidies are used by the government to encourage rather than discour­age the production of certain goods and services.

Subsidies have the effect of increasing the supply of the good or service and reducing its price. Many farmers and ranchers are subsidized by the govern­ment. Subsidizing farm goods ensures that there is always more than enough food and gives a nation’s farm exports a price advantage.

Sometimes subsidies are given to owners of farmland to encourage them not to produce, allowing an artificially lower production of agri­cultural goods to keep prices high (good for farmers, not so good for consumers). Critics of farm subsidies argue that it creates inefficiency and misallocates scarce resources.

Although a large number of government subsidies are agriculture related, not all of them are.

For example, export subsidies are used by governments to help domestic markets compete internationally. Redevelopment subsidies encourage producers to locate in certain geographical areas.

Some government subsidies are indirect (such as a tax break or low-interest loan guarantee) but are still used to implement economic policies and to affect the market.

Other subsidies are directed at consumers rather than producers (for example, a rent subsidy for a low-income earner). Consumer subsidies are often meant to protect the disadvantaged rather than to affect supply or demand, but such subsidies do affect the market.

There are times when the market fails to provide goods or properly assign costs. This calls for government intervention to either provide or redirect incentives in such a way that the market functions better.

Two approaches governments use are price ceilings and price floors.

Price Ceilings

A price ceiling is a legal maximum price for a good, service, or resource.

A price ceiling encourages consumers to purchase, but discourages producers from producing.

Assume that meat is currently selling for $5 per pound. Consumers feel that the price is too high, so they petition government for a price ceiling of $3 per pound. Representatives, senators, and presidents all like to get re-elected, so they cater to consumers and enact the price ceiling. The $3 price signals to consumers to purchase more, but signals to producers to produce less. The result of the price ceiling is a shortage of meat at the price of $3 per pound. At that price, more meat is demanded than is supplied. Consumers got a price ceiling of $3, but many consumers did not get any meat at all.

Thwarting Price Ceilings

When the government establishes a maximum price, shortages result for the good or service. This shortage is remedied by the market.

In New York City, a system of rent controls dating back to World War II is still in place. As a result, very desirable apartments can be rented at extremely low prices. But at the low prices, very few apartments are available.

People with significant income might be willing to rent some of these apartments, but are unable to do so legally. The market has responded with black market subletting. A renter benefiting from the rent control will turn around and sublet the apartment to a renter willing to pay a much higher rent (which is still lower than average).

Yet the city of New York actively pursues these illegal sublets. Every year, the city uses scarce resources to enforce this system of price controls. A solution would be to remove the rent controls and allow the market to determine the price of rent.

Sporting events also provide an example of the inefficient outcome created by price controls.

Who wants to see an event more, someone willing to pay $50 or someone willing to pay $1,000? When ticket prices are limited, those willing to pay more are forced to compete with those who would actually receive less utility from seeing the event.

Price Floors

Consumers are not the only ones who ignore the basics of supply and demand. Producers have at times called for price floors.

A price floor is a legal minimum price for a good, service, or resource. Prob­ably the best-known price floor is minimum wage. In the market for resources like labor, households supply and businesses demand.

Politicians representing areas with large populations of unskilled labor are often pressured by voters to increase minimum wage. It’s believed that an increase in the minimum wage is justified because employers will pay the higher wage and maintain the same number of workers. However, that does not always happen.

Thwarting Price Floors

Markets also develop to thwart price floors. Workers willing to work for less than minimum wage might resort to contract labor or receiving illegal cash payments.

Situations where workers are forced to accept low wages or face deportation are not mutually beneficial, nor are they voluntary. Exploitation occurs when one party to a transaction is unable to freely choose whether or not to engage in the transaction.

Assuming that the transaction is voluntary, both business and workers benefit. If the transaction were not mutually beneficial, then it would not occur.