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A Level Economics A Edexcel Your notes

1.4 Government Intervention

Contents
1.4.1 Government Intervention in Markets
1.4.2 Government Failure

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1.4.1 Government Intervention in Markets

Your notes
Government Intervention in Markets
Nearly every economy in the world is a mixed economy and has varying degrees of government
intervention
Governments intervention is necessary for several reasons

A diagram showing several reasons for government intervention in mixed economic systems
Correct market failure: in many markets there is a less than optimal allocation of resources from
society's point of view
In maximising their self-interest, firms and individuals will not self-correct this allocation of
resources and there is a role for the government
They often achieve this by influencing the level of production or consumption
Earn government revenue: governments need money to provide essential services, public and
merit goods
Revenue is raised through intervention such as taxation, privatisation, sale of licenses (e.g. 5G
licenses), and sale of goods/services
Promote equity: to reduce the opportunity gap between the rich and poor
Support firms: in a global economy, governments choose to support key industries so as to
help them remain competitive
Support poorer households: poverty has multiple impacts on both the individual and the
economy
Intervention seeks to redistribute income (tax the rich and give to the poor) so as to reduce
the impact of poverty
Four of the most common methods used to intervene in markets are indirect taxation, use of
subsidies, maximum prices, and minimum prices

Indirect Taxation

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An indirect tax can be either ad valorem or specific

Ad Valorem Tax
Your notes
Value added tax (VAT) is 20% in the UK in 2022. The more goods/services consumed, the larger
the tax bill
This causes the second supply curve to diverge from the original supply curve
VAT raises significant government revenue

A diagram showing an ad valorem tax (VAT) and the tax incidence for producers and consumers
Diagram Analysis
Initial equilibrium is at P1Q 1
Supply shifts left due to the tax from S → S + tax
The two supply curves diverge as percentage tax means more tax is paid at higher prices
Consumer incidence of tax is (P2 - P1) x Q 2 - Area A
Producer incidence of tax is (P1 - P3) x Q 2 - Area B
New equilibrium is at P2 Q 2
Final price is higher (P2 ) and QD is lower (Q 2 )

Specific Tax on Negative Externality of Production

Governments frequently tax firms that pollute or create harmful external costs in production

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Your notes

A diagram that shows the impact of a tax on a product that is over-provided in society. The tax reduces
the welfare loss and moves production closer to the optimum level of production
Diagram Analysis
The free-market equilibrium is at Pe Q e - where MSB = MPC
Market failure exists as MSC > MSB at equilibrium
Optimum level of output is at Q opt
There is over-provision of this product
A specific tax shifts the supply curve left from S → S1
The tax does not completely eradicate the welfare loss but moves the market closer to the
optimum level of output (Q opt )
The welfare loss has been reduced as shown in the diagram
The new market equilibrium is at P1Q 1
This is a higher price and less output
There is less over-provision and so less market failure
The external costs have been reduced
Specific Tax on Negative Externality of Consumption
Governments frequently tax demerit goods such as cigarettes, alcohol, fatty foods, and
polluting vehicles

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Your notes

A diagram that shows the impact of a tax on a product that is over-consumed in society. The tax reduces
the welfare loss and moves consumption closer to the optimum level of production
Diagram Analysis
The free-market equilibrium is at Pe Q e - where MPB = MSC
Market failure exists as MSC > MSB at equilibrium
Optimum level of consumption is at Q opt
There is over-consumption of this product
A specific tax shifts the supply curve left from S → S1
The tax does not completely eradicate the welfare loss but moves the market closer to the
optimum level of output (Q opt )
The welfare loss has been reduced as shown in the diagram
The new market equilibrium is at P1Q 1
This is a higher price and lower output
There is less over-consumption and so less market failure
The external costs have been reduced

Subsidies
Governments frequently use subsidies to encourage production/consumption of merit goods
such as energy efficient products, electric vehicles, healthcare, and education

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Your notes

A diagram that shows the impact of a subsidy on a product that is under-consumed in society. The
subsidy reduces the potential welfare gain and moves consumption closer to the optimum level
Diagram Analysis
The free-market equilibrium is at Pe Q e - where MPB = MSC
Market failure exists as MSB > MSC at equilibrium
Optimum level of output is at Q opt
There is under-consumption of this product
A subsidy shifts the supply curve right from S → S1
It does not completely eradicate the potential welfare gain but moves the market closer to
the optimum level of output (Q opt )
The potential welfare gain has been reduced as shown in the diagram
The new market equilibrium is at P1Q 1
This is a lower price and higher output
There is less under-consumption and so less market failure
Some of the external benefits available have been realised

Maximum Prices
Governments will often use maximum prices in order to help consumers. Sometimes they are
used for long periods of time e.g. housing rental markets. Other times they are short-term
solutions to unusual price increases e.g. petrol
A maximum price is set by the government below the existing free market equilibrium price and
sellers cannot legally sell the good/service at a higher price

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Your notes

A diagram that shows the imposition of a maximum price (Pmax) which sits below the free market price
(Pe ) and creates a condition of excess demand (shortage)
Diagram Analysis
Initial market equilibrium is at Pe Q e
A maximum price is imposed at Pmax
The lower price reduces the incentive to supply and there is contraction in QS from Q e → Q s
The lower price increases the incentive to consume and there is an extension in QD from Q e
→ Qd
This creates a condition of excess demand Q s Q d
Some consumers benefit as they purchase at lower prices
Others are unable to purchase due to the shortage
This unmet demand usually encourages the creation of illegal markets (black/grey markets)

Minimum Prices
Governments will often use minimum prices in order to help producers or to decrease
consumption of a demerit good e.g. alcohol
A minimum price is set by the government above the existing free market equilibrium price and
sellers cannot legally sell the good/service at a lower price
Minimum prices are also used in the labour market to protect workers from wage exploitation.
These are called minimum wages

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Your notes

A diagram that shows the imposition of a minimum price (Pmin) which sits above the free market price (Pe )
and creates a condition of excess supply (surplus)
Diagram Analysis
Initial market equilibrium is at Pe Q e
A minimum price is imposed at Pmin
The higher price increases the incentive to supply and there is an extension in QS from Q e →
Qs
The higher price decreases the incentive to consume and there is a contraction in QD from
Qe → Qd
This creates a condition of excess supply Q d Q s

Differences in Government Responses to the Excess Supply

In agricultural markets, if a minimum price is set by the government producers benefit as they
receive a higher price
Governments will often purchase the excess supply and export it
In demerit markets, producers suffer as QD contracts
Governments will not purchase the excess supply
Producers usually lower their output in the market to match the QD at the minimum price

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Other Methods of Government Intervention

Trade Pollution Permits Your notes
Governments create a pollution permit market and issue permits to polluting firms
This helps to reduce negative externalities of production
Each permit is typically valid for the emission of one ton of pollutant
More polluting firms have to buy additional permits from less polluting firms
The price of the permit represents an additional cost of production
If the price of additional permits is more than the cost of investing in new pollution technology,
firms will be incentivised to switch to cleaner technology:
Firms can then sell their spare permits and gain additional revenue

State Provision of Public Goods

Public goods are beneficial for society and are not provided by private firms due to the free
rider problem
They are usually provided free at the point of consumption, but are paid for through general
taxation
Examples include roads, parks, lighthouses, national defence

Provision of Information
Information gaps cause market failure
Governments can set up information portals so as to reduce the asymmetric information
Examples include job centres, consumer rights websites, nutritional labels

Regulation
Governments create rules to limit harm from negative externalities of consumption/production
They create regulatory agencies to monitor that the rules are not broken
There are more than 90 regulators in the UK
Individuals or firms may be fined/imprisoned for breaking the rules
Examples of some industry regulators include the Environment Agency, Ofsted, and the Financial
Conduct Authority

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1.4.2 Government Failure

Your notes
Government Failure
Government failure occurs when the government intervenes in a market to correct market failure,
but the intervention results in a more inefficient allocation of resources from society's point of
view
This results in even greater welfare loss
Usually represents poor value for money
May have long term consequences

Causes of Government Failure

Distortion of Price Signals
The signaling function of the price mechanism is artificially altered
For example, a minimum price sends a signal to producers to supply more
In agricultural markets this has often resulted in an excess of perishable products
which end up going to waste i.e. inefficient allocation of resources
In demerit markets higher prices seem to be sending the message to increase supply
(e.g. minimum price on alcohol). if producers do that, they will make greater losses. They
often have to reduce supply
Price intervention may help solve one problem but creates others

Unintended Consequences
Producers and consumers aim to maximise their self interest
This often leads them to look for legal or illegal loop holes to bypass
government intervention
This result creates unintended consequences such as the creation of illegal markets and/or
illegal production/consumption

Excessive Administrative Costs

Regulation or administration costs can be expensive
The costs can sometimes be greater than the savings in social welfare

Information Gaps
Government decision making is subject to the same information gaps and cognitive biases
(e.g. anchoring) that consumers face
Decision makers do not have perfect information
Decision makers are subject to political pressure

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Government Failure in Various Markets

Environment Agency - Regulatory Failure Your notes
The Environment Agency is responsible for regulating major industry, waste, and treatment of
contaminated land. water quality and resources
According to the BBC, in 2021 there were more than 375,000 instances of raw sewage pumped
into England's rivers

UK Energy Market - Regulatory Failure

The UK energy market was privatised between 1986 and 1990
Ofgem, the energy market regulator in the UK sets a maximum price on energy costs
In 2021, British Gas (owned by Centrica) profits were £948m
In 2022, Ofgem raised the maximum price by 53%
Unable to afford the increased payments, some pensioners ride buses in the winter to stay
warm

Smoking Ban - Unintended Consequence

In July 2007 an indoor smoking ban was implemented in the UK
Unintended consequences of this policy included:
Congestion around office & restaurant doorways
Increased use of outdoor patio heaters, thus increasing CO 2 emissions
Increased cigarette stump littering
Illegal Markets
The introduction of minimum prices on alcohol in Scotland has increased the amount of cross-
border driving to Carlisle to purchase alcohol
In 2017, a report found that the illegal trade in drugs was worth £10bn.

Badly Executed Policies - Information Gaps

Defence Information Infrastructure, a secure military network owned by the United Kingdom's
Ministry of Defence (MOD), cost £7.1bn to create compared to the original budget of £2.8bn. (and
it did not meet most of the operational targets that the MOD had originally envisaged)
NHS National IT Program. Abandoned in 2013 after more than £10bn. was spent on it. It never
worked

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