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Chapter 3
The Role of Government in a
Market Economy
Copyright © 2008 Pearson Education Canada
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Chapter Objectives
1. Appreciate the advantage and shortcomings of the
free-market system.
2. Describe in your own words the concept behind Adam
Smith’s “invisible hand”.
3. Understand the rationale behind government
intervention in the free-market system.
4. Graph the impact of price ceilings, price floors, and
excise taxes on various markets.
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Government and the Free Market
Why do governments become involved in the operation of the
market.
The Writings of Adam Smith
He believed that the free-market system would channel
selfish, egoistic motives toward the betterment of society.
The term “invisible hand” was introduced to describe the effect
that a free-market economic system has on directing the selfinterests of individuals toward a common goal.
(Cont.)
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The Writings of Adam Smith (Continued)
And how the free-market will tend to allocate resources to
their most efficient use.
For example, if you start a business and you are not
successful than that means that not enough consumers want
your product.
If enough people buy your product you will earn a living, your
welfare increases and so does that of your customers.
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The Writings of Adam Smith (Continued)
If you are successful at your business this will attract
competition.
In order to continue to sell your product or service it will be
necessary that you make your good or service more attractive.
This can be done by lowering prices or improving the quality
of the product or service.
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Possible Shortcomings of the Free-Market
System
Deficiencies that lead to government intervention.
Market Imperfections
1. Consumers and suppliers may not have satisfactory
information with which to make decisions.
Advertising often helps to fill this gap although more often than
less it is meant to persuade rather than inform.
(Cont.)
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Market Imperfections (Continued)
Health standards, government building codes and Human
Resource Centres of Canada are designed to fill these gaps.
2. The marketplace does not always create sufficient
competition.
If new firms are prevented from entering the industry then
there would be higher prices and lower quantity of product.
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Market Imperfections (Continued)
Under the Competition Act it is illegal for firms to get together
and fix prices, or sell a product at a loss to eliminate
competitors, or for manufacturers to refuse to sell to retailers
who do not charge a set price for the product.
In situations where natural monopolies arise it is inefficient to
have more than one firm supply a product or service. The
government either provides the service or regulates the
company that provides the service.
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Third-Party Effects
A market transactions may affect someone other than the
buyer and seller, this third-party may be affected in a positive
or negative manner.
Government action, either in the form of a tax or the
requirement to install new equipment, may be implemented
when there is a negative third-party effect, such as polluting a
river during production of paper.
Such action would decrease the supply of paper and increase
the overall price. The higher price would correctly reflect the
total cost of providing this product.
(Cont.)
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Third-Party Effects (Continued)
Government that takes action with a negative third-party
effect.
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Third-Party Effects (Continued)
A product with a positive third-party effect is either subsidized
by the government thus increasing supply or paid for on behalf
of consumers thus increasing demand.
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Unmet Public Goods
The market may not be able to provide a number of goods and
services that are important to society – such as national
defense, policy protection or water supply.
The benefits from these services are spread over such a large
segment of the population that it is difficult to charge a fee for
their use based on the benefits received.
These unmet public goods are provided by the government or
contracted out to private companies.
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Distribution of Income
In the pursuit of earning an income, individuals compete with
each other for jobs.
If a person is unable to compete in a free-market system, he or
she will not be able to earn an income.
The government has intervened in the free market in order to
achieve a more equitable distribution of income.
Social welfare programs, such as assistance to the elderly and
disabled, and employment insurance, are financed with a
progressive income tax.
(Cont.)
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Distribution of Income (Continued)
Income differentials in Canada would not be a serious
problem if every Canadian earned enough money to meet his
or her basic needs.
Poverty is defined in terms of a minimum income necessary
for an individual or family.
Stats Canada prepares the lowest-income cut-off (LICO)
which is set at an income level where the family spends 64%
of its income on food, shelter and clothing.
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Distribution of Income (Continued)
The market basket measure introduced by HRDC sets an
income level that is too low to purchase a basket of goods by
a family of four with a 13-year old boy and a 9-year old girl.
The presence of regional income differences has prompted
the federal government to transfer tax dollars in the form of
equalization payments to the lower-income provinces and to
undertake economic development projects.
In Canada social-welfare spending accounts for the largest
portion of all federal government spending and approximately
one-fifth of all provincial and local government spending.
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Economic Stabilization
Classical economists believed that fluctuations in economic
growth, employment, and prices were temporary and the freemarket system would make adjustments to return to a period
of more stable economic activity.
The Great Depression in the 30’s shifted the focus to John
Maynard Keynes.
(Cont.)
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Economic Stabilization (Continued)
Keynes argued that in order to ensure stability in the
economy, governments had to intervene.
The adjustments of government spending and tax policy to
economic conditions is know as fiscal policy.
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Impact of Government Intervention
Price Ceilings
A price ceiling is a government imposed maximum price.
It is used when the government believes that the equilibrium
price established in the market is too high and many people
feel that they cannot afford to buy the product.
(Cont.)
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Price Ceilings (Continued)
It is illegal to set a price above a price ceiling, as a result a
shortage occurs.
A subsidy may be offered to the seller or the product must be
rationed to eliminate the shortage.
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Price Floors
A price floor is a government imposed minimum price.
It is illegal to set a price below a price floor, as a result a
surplus occurs.
A limit on the quantity produce is one method used to
eliminate a surplus.
Another method is to shift the demand to the right through
advertising.
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Excise Taxes
An excise tax is one levied by government on the suppliers of
certain products.
Excise tax on liquor and tobacco is a source of revenue for
the government.
Excise tax on air conditioners in automobiles is meant to
reduce the sales of air conditioners for environmental
reasons.
(Cont.)
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Excise Taxes (Continued)
Price elasticity of demand and supply determine the incidence
of tax, or who bears the larger burden of the tax.
If the demand is more inelastic than supply than the
consumer bears the larger burden of the tax, and vice versa.
If the government wants to raise tax revenue it will tax a
product which has an inelastic demand.
If the government wants to reduce consumption than it will tax
a product which has an elastic demand.
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