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Should the Government Interfere in the Economy?

06744 CC Trader Talk V2

(ARTICLE BY: Bernardo Serrano Vazquez, Investment Management Support Officer)

I am sure you heard it before; “If you let the economy do its job you will find yourself in equilibrium, where demand matches supply, and quantity matches price.” After hearing this it is logical to think that government should not interfere in the Economy. This is usually what they teach you in your first Economic class, but like you suspected this doesn’t usually work in the real world.

The reasons why it doesn’t work are infinite, but I am going to go over the most common. The first thing that we need to realize is that this model of economy, where the government doesn’t interfere only works in this manner when perfect competition is present, where there are infinite amount of firms making an identical product. In this case the producer or firm wouldn’t be able to set a price since the price will be already set by the market. Another interesting fact about this model is that in the long term the firms will not be able to make profit since the price will lower itself to adjust to the economy until prices match the total cost of making the product or service.

So there are already multiple obvious reasons why this model doesn’t work in our Economy. We never have an infinite amount of firms, the products are hardly ever identical, and firms are only working because they want to make profit.

What we usually see in the real world are models like monopolies, duopolies, oligopolies, monopolistic competition and contestable markets. I am not going to go through all of them, but I am going to use the first three for my explanation.

Imagine this: a consumer is with her friends and family during a nice evening in a restaurant with views at the sea, the waitress comes and ask the consumer:

Waiter: What would you like to drink?

The consumer: A Coke please

Waiter: Is Pepsi ok?

The consumer: No, I will better have a water.

For this consumer the Soda market is a Monopoly, and you will be surprise of how many other products have become monopolies as well, because of their marketing, location, or any other factor that could be involved in the production or distribution of the product.

The literate meaning of a Monopoly is when there is only one firm that produces the product. The problem arises when the firm sets the prices to maximize profit. This equation more than likely will end on having the product at a higher price and in lower quantity than in perfect competition. If the government doesn’t interfere, a lot of consumers wouldn’t be able to buy it.

A really good example of this is the pharmaceutical industry. If the government didn’t interfere they would sell their products at a really high rate where many consumers that need the medicine wouldn’t be able to get it. This challenge can happen on all the previous models.

Another reason that we need the government to interfere are externalities. Externalities are outcomes that come in the production of a good or service. If a firm is having a negative externality like contaminating the oceans, the government can impose fees, so they are encouraged to minimize the negative externality. At the same time the government can reward positives externalities like a firm that provides education to its employees. Education is going to help society in general, so the government can impose tax breaks or something similar.

The government can also help to reduce unemployment by creating jobs, and it can also help in a recessions by increasing aggregated demand. Additionally the government can also improve equality in the economy by redistributing the income and wealth.

As you can see the Government is an essential part of a country’s economy, and without its presence the economy would work in a way that will really put the consumer at a disadvantage.

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