Why government intervenes in market?

Income inequality

  • Price controls (maximum price, minimum price)
  • Minimum wage
  • Progressive taxation

The different kinds of taxation

  • Progressive taxation: when the taxpayer’s income rises, the proportion of his taxes increases.
  • Regressive taxation: when the taxpayer’s income rises, the proportion of his taxes decreases.
  • Proportional taxation: the taxpayer pays the same proportion of taxes whether his income falls or rises.

The four maxims of taxation by Adam Smith, The Wealth of Nations (Book 5, Chapter 2):

  1. The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.
  2. The tax which everyone is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person.
  3. Every tax ought to be levied at the time, or in the way it is most likely to be convenient for the contributor to pay it.
  4. Every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state.

Regulating the banks

Regulation:

  • Controls the type of loans the banks could grant
  • Sets rules on the assets that banks must hold
  • Sets limits on interest rates
  • Tackles the problem of asymmetric information

How government intervenes in market?

Taxation

  • Direct taxation
  • Indirect taxation (for example VAT: Value-Added Tax)

Subsidies

For example, government payment to a company to increase the consumption of a good.

Public provision

For example, government provides consumer education and health care.

Regulation and laws

Sometimes, government prohibits the production and consumption of certain goods (for example drugs).

Allocating property rights

Compensation for all external costs inflicted on third parties.