1The idea in one paragraph

A free market settles at the price where the quantity buyers want matches the quantity sellers offer. Governments intervene when they do not like that outcome: the price is too high for poor households, too low for farmers, the good is over-consumed, the good is under-produced, or the government simply needs revenue. The tools are price controls, indirect taxes, subsidies, direct provision and regulation. Each of them moves the market away from equilibrium, and the moment it does, the quantity traded is no longer the quantity that would have maximised the gains from trade. Somebody gains, somebody loses, and a slice of surplus goes to nobody at all. Naming those three groups every time is the whole skill of this subtopic.

2Why a government intervenes

The guide lists seven reasons. Learn them as a list, because a four-mark question asks for two of them and an evaluation question asks you to weigh one against another.

To earn government revenue. An indirect tax on a good raises money the government can spend elsewhere. Fuel, tobacco and alcohol are taxed for this reason in almost every country.

To support firms. A subsidy lowers producers' costs, keeps an industry alive through a bad year, or helps a new industry reach the size at which it can compete.

To support households on low incomes. A maximum rent, a subsidised staple food, or a service provided free at the point of use puts something within reach of people who could not otherwise pay for it.

To influence the level of production. A subsidy raises output; a tax or a regulation lowers it. A government may want more renewable electricity generated and less coal burned.

To influence the level of consumption. The same tools aimed at the buyer rather than the seller: a tax on sugary drinks to cut consumption, a subsidy on public transport to raise it.

To correct market failure. When a market left alone produces the wrong quantity — too much pollution, too little vaccination — the government steps in to move the quantity towards the one that suits society.

To promote equity. Equity is fairness in the distribution of income and opportunity, and it is not the same as equality. Progressive intervention takes from those with more and delivers to those with less, whether in money or in access to a service.

Two warnings for the exam. The reasons overlap, so a single policy usually serves more than one, and saying so is a good sentence. And the reasons can conflict: a tax that raises a lot of revenue is a tax that changed very little behaviour, so a government aiming at both is aiming at two targets with one arrow.

3Price ceilings

A price ceiling, or maximum price, is a legal limit on how high a price may go. It only does anything if it is set below the equilibrium price. A maximum set above equilibrium changes nothing, because the market is already trading below it, and drawing it there is a common way to lose every mark on the question.

Take a university town's market for student rooms. Rent settles at €400 a month, and 5,000 rooms are let. The city decides that €400 is too much and caps rent at €300.

Read Figure 1 across from the €300 line. At €300 landlords are willing to offer only 4,000 rooms, because some flats are no longer worth letting at that rent. At €300 students want 6,000 rooms, because it is now cheap. The gap of 2,000 rooms is a shortage: quantity demanded exceeds quantity supplied at the controlled price.

The quantity actually traded is the smaller of the two. Only 4,000 rooms exist to be let, so 4,000 are let, and 2,000 students who would happily pay €300 go without. Price can no longer do the rationing, so something else has to, and that something else is the list of consequences an examiner wants:

• queues and waiting lists, because rooms go to whoever asks first;
• first-come-first-served or favouritism, because the landlord now chooses among willing tenants;
• a black market — often called a parallel market — where rooms are re-let illegally above €300 to the students who are desperate enough to pay;
• falling quality, because a landlord who cannot raise the rent saves money by not repairing;
• under-investment, because nobody builds new rooms to rent at a capped price.

Now the stakeholders. Figure 2 shades what happened to the surplus.

Consumers who get a room gain. They pay €300 instead of €400 for a room they were willing to pay at least €400 for. The teal rectangle is that gain, and it is not new wealth: it is surplus transferred from landlords to tenants.

Consumers who do not get a room lose. There are 2,000 of them, and they had a room before the policy or would have had one. An answer that says "consumers gain" without splitting the group has missed half the point.

Producers lose twice. They lose the transferred rectangle, and they lose the surplus on the 1,000 rooms that are no longer let at all.

The government spends nothing, which is why a ceiling is attractive to a government with no money. It may spend later, on enforcement, or on subsidising supply to close the shortage.

Everybody loses the clay triangle. Those 1,000 rooms were worth more to the students who wanted them than they cost the landlords to provide. Now nobody has them. That lost surplus is welfare loss, sometimes called deadweight loss: the value of the trades the intervention prevented, which goes to no stakeholder at all.

The evaluation in one line: a price ceiling improves equity for the people it reaches and worsens efficiency for the market as a whole, and the size of the shortage depends on how elastic supply and demand are. The more elastic they are, the bigger the shortage the same ceiling produces.

4Price floors

A price floor, or minimum price, is a legal limit on how low a price may go. It only does anything if it is set above equilibrium. Governments use floors to raise the incomes of producers, usually farmers, and to make a harmful good less affordable.

Take a milk market. The price settles at €0.60 a litre and 40 million litres a week are traded. The government sets a minimum price of €0.80.

At €0.80 farmers want to sell 50m litres and buyers will take only 30m. The 20m litre gap is a surplus: quantity supplied exceeds quantity demanded at the controlled price. Again the quantity traded is the smaller of the two, so only 30m litres change hands, and 10m litres that used to be bought and drunk are not.

What happens to the unsold 20m litres is a policy choice, and the two answers have very different consequences. Figure 4 draws both.

If the surplus goes unsold, it is wasted, and the market simply trades less. Consumers pay more for less, farmers sell fewer litres at a higher price, and the clay triangle of surplus is destroyed.

If the government buys the surplus to keep the price up, it pays €0.80 for every one of the 20m unsold litres, so the shaded rectangle is a bill of €16 million a week that comes out of taxation. It must then store the milk, sell it abroad, or dispose of it, and each of those has a further cost.

The stakeholder list for a floor:

• Producers gain. They receive a higher price, and if the government buys the surplus they sell everything they produce. That is the point of the policy: their incomes become higher and more stable.
• Consumers lose. They pay a higher price and consume less of the good. A floor on a staple food is regressive, because it takes proportionately more from poor households.
• The government pays, if it buys the surplus, and pays again to store or dispose of it.
• Resources are misallocated. Land, labour and capital stay in milk production when the market was signalling that they were worth more somewhere else.
• Welfare loss appears again, as the clay triangle: trades worth making that no longer happen.

A minimum wage is the same diagram with labour on the horizontal axis and the wage on the vertical: a floor above the equilibrium wage raises pay for those who keep their jobs and creates a surplus of labour, which is unemployment. Use the same three questions on it and you will get the same three answers. The minimum wage itself is not part of this subtopic: it is taught and examined in 3.3 Macroeconomic objectives, under unemployment. It is here only to show that one diagram serves both.

5Indirect taxes

An indirect tax is a tax on a good or a service rather than on income or wealth. The seller hands the money to the government, and how much of it the seller recovers from the buyer is the question of section 6.

The tax raises the cost of supplying every unit, so at every price producers are willing to supply less. Supply shifts upward by the amount of the tax, measured vertically. That vertical measurement is the single most important thing in the diagram: the gap between the two supply curves is the tax per unit, not the change in the price.

The tax in Figure 5 is a specific tax: a fixed amount per unit, €0.50 a litre on sugary drinks, which is why the new supply curve sits parallel to the old one.

Before the tax the market traded 10m litres at €2.00. After it, the new equilibrium is at E₂: consumers pay €2.30 and only 9m litres are sold. Producers do not keep €2.30. They hand €0.50 of it to the government, so they keep €1.80, which is point F. Three prices on one diagram, and each one earns a mark: the old price, the price consumers now pay, and the price producers now receive.

Figure 6 turns those prices into areas.

Government revenue is the whole of the two shaded rectangles: the tax per unit times the quantity still traded, €0.50 × 9m = €4.5m.

Consumers pay part of it. The price they pay rose by €0.30, so €0.30 of every litre's tax comes out of their pocket: the teal rectangle, €2.7m. They also buy less and lose surplus on what they no longer buy.

Producers pay the rest. The price they keep fell by €0.20, so €0.20 of every litre's tax comes out of their revenue: the amber rectangle, €1.8m. Their total revenue falls from €20m to €16.2m, and some of them leave the industry.

The clay triangle is welfare loss, the surplus on the 1m litres that are no longer traded. It goes to nobody: not to consumers, not to producers, not to the government.

Evaluate it with the government's own aim. If the aim was revenue, the tax succeeded, and it succeeded because demand was fairly inelastic. If the aim was to cut consumption of sugar, a fall of one litre in ten is a modest result for the same reason. A tax on a good with inelastic demand is also regressive: poor households pay the same cash amount as rich ones, and it is a larger share of their income.

6Who really pays the tax

Tax incidence is the share of an indirect tax that each side actually bears. It is where more marks are lost in this subtopic than anywhere else, because students say "the producer pays it, because the producer sends the cheque". Who hands over the money is not the question. The question is whose pocket the money came out of, and the answer is decided by price elasticity of demand, from 2.5 Elasticities of demand, set against the price elasticity of supply.

The rule is short:

The side of the market that finds it harder to change its behaviour carries more of the tax. The more inelastic your side is, the bigger your share.

Figure 7 shows the same €0.50 tax on the same supply curve with two different demand curves.

In the left panel demand is price inelastic. Buyers have nowhere else to go, so they accept most of the price rise, the consumer price climbs a long way above P₁ and the producer price barely falls. Consumers carry most of the tax. In the right panel demand is elastic. Buyers walk away if the price rises much, so the producer has to absorb most of the tax to keep selling, and the producer price falls a long way below P₁.

Figure 8 pushes it to the two extremes, which is the fastest way to fix the rule in your head.

With perfectly inelastic demand the quantity cannot fall, the consumer price rises by the full €0.50 and consumers pay all of it. With perfectly elastic demand the consumer price cannot rise at all, so producers pay all of it, and the quantity falls sharply.

Three consequences worth writing in an evaluation.

• A government chasing revenue taxes inelastic goods, and by doing so it puts the burden on consumers.
• A government trying to change behaviour needs elastic demand, and then the tax collects little.
• The same logic runs on the supply side: the more inelastic supply is relative to demand, the more of the tax producers carry.

7Subsidies

A subsidy is a payment from the government to producers for each unit they produce. It lowers the cost of supplying every unit, so supply shifts downward by the amount of the subsidy, measured vertically. It is the tax diagram with the arrow reversed, and everything in it reverses too.

Before the subsidy, 5,000 bicycles a year sold at €200. With a €40 subsidy, the new equilibrium is 6,000 bicycles at €175, the price consumers pay. Producers receive that €175 plus the €40 from the government, which is €215 a bicycle, shown at point G. Once again there are three prices, and once again the vertical gap between the supply curves is the subsidy, not the fall in price.

The government pays the whole shaded rectangle: €40 × 6,000 = €240,000 a year, and that money has an opportunity cost, since it could have built something else.

Consumers gain the teal part. They pay €25 less per bicycle and they buy more of them.

Producers gain the amber part. They receive €15 more per bicycle than before and sell 1,000 more.

The clay triangle is welfare loss. The last 1,000 bicycles cost more to make than buyers valued them at; only the subsidy made them worth selling. Resources were pulled into this market that were worth more elsewhere.

Split the evaluation the way you split the tax. A subsidy raises output, lowers the price to consumers and supports producers' incomes, so it does what it was asked to do. Against that: it costs taxpayers money that has other uses, it can keep inefficient firms alive by removing the pressure to cut costs, it may be very hard to remove once producers depend on it, and it benefits producers of the subsidised good at the expense of everybody who pays tax. Whether the gain is worth the cost depends on why the good was being under-produced in the first place.

8Direct provision, regulation and legislation

Two more tools, neither of which needs a diagram in this subtopic.

Direct provision of services. Rather than change the price, the government produces the service itself and supplies it free or below cost at the point of use: state schools, public hospitals, roads, refuse collection, a public library. It is paid for out of taxation, so the price at the point of use no longer rations the good.

• It gains the most in equity: access no longer depends on ability to pay, which is why health and education are provided this way in most countries.
• It is expensive, and the opportunity cost falls on everything else the budget could have funded.
• With no price to ration demand, something else must, so queues and waiting lists appear.
• Without the pressure of competition, costs can drift upwards and quality can drift down, and there is no price signal to tell the provider what people actually want.

Command and control regulation and legislation. Rules backed by law, with a penalty for breaking them: a minimum legal age for buying alcohol, a limit on the emissions a factory may release, a ban on advertising a product to children, food safety standards, planning rules that stop building on certain land.

• It is direct and fast. Where the harm is severe, banning it works better than pricing it.
• It is easy for the public to understand, and it does not depend on estimating an elasticity.
• It costs money to monitor and enforce, and it raises no revenue, unlike a tax.
• It is blunt. A limit that applies equally to every firm makes the firm that could cut cheaply do the same as the firm that cannot.
• Set too tight, it pushes activity into black markets or abroad rather than stopping it.

In an evaluation, the useful move is to compare tools rather than praise one. A tax on sugary drinks raises revenue and lets people choose; a ban on selling them in schools changes behaviour where it is most needed but raises nothing and reaches only one place. Which is better depends on the aim, the elasticity and the cost of enforcement.