What’s it: Government intervention refers to the government’s deliberate actions to influence resource allocation and market mechanisms. It can take many forms, from regulations, taxes, subsidies, to monetary and fiscal policy. In some cases, the government also sets maximum and minimum price limits on the market.
Government intervention and the economic system
Broadly speaking, the significance of the intervention depends on the economic system adopted by a country.
Under a command economy system, government intervention is highly significant. The government determines what is best for the economy and society. It allocates resources and determines the production and distribution of goods.
The private sector’s role is minimal or even zero. Under a command economy system, the market mechanism does not work.
In contrast, a free-market economy operates in reverse compared to a command economy. The free market system emphasizes the minimization of intervention. The private sector plays a significant in the allocation of economic resources.
The market operates freely through a supply and demand mechanism. This mechanism directs the allocation of resources more efficiently than the command economy system. Under this system, the government’s role is usually limited to enforcing rules to recognize and protect private property ownership.
Furthermore, under a mixed economy system, interventions are more diverse than in a market economy, but not as extreme as a command economy. The government has a role, and so does the private sector.
The significance of the roles of the government and the private sector also varies between countries. Some countries, such as China and Cuba, are more inclined towards a command economy. The government plays a significant role. Meanwhile, in countries such as the United States and the United Kingdom, the private sector plays a more dominant role in managing economic resources.
Reasons for government intervention in the economy
The government intervenes in the economy with several objectives, such as:
Redistributing income and wealth. For example, the government launched various welfare programs such as unemployment insurance, health, and free education. It sustains the quality of life of those who are economically disadvantaged. Taxation is also another avenue for redistribution of income.
Providing public goods. Examples of public goods are public parks, infrastructure, and national defense. The private sector often does not want to provide it because it is unprofitable. Hence, the government took a role.
Promoting fair competition. Through antimonopoly regulations, the government prevents unfair competition practices such as collusion and predatory pricing.
Securing and spurring the domestic economy. For example, the government set trade barriers to protect domestic industries from competing imported products. So, they continue to grow and create more jobs.
Protecting people. For example, the government launched a consumer protection policy, quality requirements, occupational safety, and the environment.
Changing consumer behavior. Intervention is one way to reduce the impact of negative externalities. For example, the government could increase taxes on products such as alcoholic beverages and tobacco.
Preserving the environment. Without government regulations and policies, companies are more likely to ignore external costs to the environment. They overexploit natural resources or allow waste to flow into the environment without further treatment. Such practices certainly jeopardize the long-term sustainability of the economy.
Achieving macroeconomic goals. The four macroeconomic goals are sustainable economic growth, full employment, low inflation, and balance of payments equilibrium.
Ways of government intervention
Government intervention takes many forms, from the micro to the macro level. In this article, I try to group them into the following categories:
- Economic policy
- Price controls
The economic policy falls into two main categories:
- Supply-side policy
- Demand-side policy
The government designs supply-side policies to influence aggregate supply in the economy. Typically, these policies focus on increasing production efficiency, either in product markets or factor markets (e.g., labor market).
In the product market, the government promotes competition by launching antimonopoly, deregulation, and privatization policies. Competition forces producers to be more efficient and innovative to stay in the market and make a profit.
Furthermore, in the labor market, the government is trying to improve labor mobility and quality. That is through various programs such as education, training, and reduction of union power.
Demand-side policies consist of fiscal policy and monetary policy. The government is responsible for the fiscal policy through changes in its spending and taxes. Meanwhile, monetary policy is under the responsibility of the central bank or monetary authority. It seeks to influence the money supply in the economy. Both affect the economy through their effect on aggregate demand.
To stimulate economic growth, the government and the central bank adopted expansionary policies. That is usually during a weak economy, such as an economic recession. The options are to:
- Increase government spending
- Lower taxes
- Cut policy rates
- Open market operations through central bank purchases of government securities
- Lower the reserve requirement ratio
Meanwhile, to avoid high inflationary pressure, both implement a contractionary policy. High inflation endangers economic stability and can lead to hyperinflation. Among the options for implementing a contractionary policy are:
- Reducing government spending
- Lifting taxes
- Raising the policy rate
- Open market operations by selling government securities
- Raising the reserve requirement ratio
The government ensures that economic activities run healthily. Several regulations aim to encourage business activity. While others, to control business activities and avoid unwanted results or negative externalities.
There are many variations of government regulations, and each affects economic activity in different ways. The following are several categories of government regulations:
Employment. The government issues rules, regulations, and laws regarding wages, fair recruitment, and workforce health and safety.
Environment. For example, the government launches various regulations regarding the environmental impact of company operations on the surrounding environment, such as environmental safety standards and waste management.
Consumer protection. The focus is to protect consumers from unfair practices related to price rules, health and safety standards, and product descriptions.
Competition. It is in the government’s interest to promote fair competition. These types of rules and regulations include antitrust and merger and takeover regulations. This category includes deregulation, namely eliminating regulations or restrictions such as limits on foreign investors’ share ownership.
Information and reporting. An example of these rules and regulations are accounting standards and the security of consumers’ personal information.
Taxes are the main source of government revenue. The government uses it to finance several programs and to pay off debts. In addition to government operations, the government uses taxes to increase economic capital by providing public goods such as roads, bridges, trains, public parks, and national defense. This economic capital is vital for increasing the production capacity of the economy in the long run.
The government collects taxes from taxpayers, which come from the household and business sectors. The government can impose it directly on taxpayers, such as through income tax and profit tax. Or, it is indirectly as in sales tax and value-added tax.
Tax is a means of redistribution of income. Also, taxes affect the financial behavior of businesses and households. For example, an increase in taxes reduces household disposable income. Therefore, households tend to spend less on goods and services.
Under a price control policy, the government sets price limits for certain goods and services. The two forms of price control are:
- Price ceiling
- Price floor
Price ceilings limit the maximum prices for goods and services. Suppliers cannot charge a price higher than that price. The purpose of a price ceiling is to protect consumers by ensuring it is affordable to as many consumers as possible. An example is the rental price of residential property.
To be effective, the government sets a price ceiling below the free-market equilibrium price.
Setting a price ceiling has the following implications:
Bringing up the shortage. Due to lower prices, more consumers are asking for it. Conversely, lower prices make fewer producers willing to supply. Therefore, the market will experience excess demand (shortage), where the quantity demanded exceeds the quantity supplied.
Less efficient and decreasing economic surplus. Economic surplus is the sum of consumer surplus and producer surplus. Due to lower prices, the producer surplus will decrease. They get less profit. Meanwhile, even though consumers get lower prices, however, they face a shortage. Supply decreases because producers supply fewer goods.
Rationing. Because of the shortage, consumers have a more challenging time finding goods. Suppose it goes on for a long time. In that case, the government may need to ration goods to ensure their availability for as many consumers as possible.
Raising a black market. The black market thrives on shortages. The producer may sell at a higher than the ceiling on the black market. Likewise, some consumers who already own goods will sell back to other consumers at a higher price to profit.
It is the minimum price that can be charged for a good or service. Its purpose is to protect suppliers of goods or services.
The most quoted example of a price floor is the minimum wage. In this case, individuals act as suppliers of labor services, while companies are buyers. With the minimum wage, workers make enough money from their jobs to meet their basic needs.
To be effective, the government sets the price floor above the equilibrium price. Because prices are higher, more and more suppliers are willing to supply goods and services. On the other hand, the quantity demanded is less because the price becomes more expensive for consumers. As a result, the market will experience an excess supply, where the quantity supplied exceeds the quantity demanded.
The government also provides subsidies to households or companies. Examples include fuel oil, public health care, education, research and development, fertilizers, and raw materials subsidies. Soft loans also fall into this category.
The provision of subsidies reduces the burden on households. They spend less money on these goods and services, enabling a better standard of living.
For companies, subsidies reduce production costs. It stimulates them to produce more. Also, they can sell at a lower price, making the product more competitive in the market.
Disagreements among economists
Some economists view government intervention as necessary. However, they are still arguing about how much the government should intervene and how they should intervene. In macroeconomics, both gave rise to schools of thought: Keynesian economics and Neoclassical economics.
Keynesian views that the government should intervene. When there is a disequilibrium, the economy will not move towards the new equilibrium by itself.
Take the case when the economy is depressed. Among the solutions to getting out of the economic depression is stimulating government spending, which is a part of aggregate demand.
As we know, aggregate demand consists of household consumption, business investment, government spending, and net exports. Net exports are beyond the control of the domestic economy because they depend on global economic conditions. Thus, the main options for stimulating aggregate demand are through consumption, investment, and government spending.
But, during the economic depression, business profits worsen as demand falls. Likewise, household income drops due to high levels of unemployment. Therefore, it is almost impossible to increase consumption and investment during the depression.
Thus, a more sensible option would be to increase government spending. The budget depends more on discretionary government policies than on economic conditions.
In contrast, Neoclassical economists view government intervention should be minimal. The market mechanism will work and direct the economy towards equilibrium. According to Neoclassical economists, supply and demand are the main factors that determine goods, output, and income in an economy. So, government intervention will only make the economy no better.
Negative effects of government intervention
Although the aim is positive to build the economy and society’s prosperity, interventions often result in unintended consequences. The following are the opposing sides of government intervention in the economy:
Government failure. It happens when the intervention doesn’t produce better results. The market becomes inefficient in allocating resources. The government may also consider short-term effects rather than the long-term. For example, trade barriers protect domestic industries. But, it also disincentives producers to be more innovative and more efficient. Likewise, in the case of production subsidies.
Increased costs. For example, companies have to spend more money to meet product safety and health standards. They also bear the cost of further processing the production waste.
Fewer options. In an extreme case is the command economy. The government decides what to produce and how to distribute it.
Discrimination policy. Intervention may be beneficial for some, but detrimental for others. Take competition policy, for example. The government may favor state-owned companies over private companies. Likewise, in a bailout, the government used tax revenues to save the big banks instead of all the banks.