AQA A-level Economics: Government intervention: tax, subsidy, price controls (7136)

This guide follows the AQA AS and A-level Economics specification (version 1.3, 29 June 2022) for the A-level, first taught from September 2015. It covers the sub-section Government intervention in markets, numbered 3.1.5.8 on the AQA website (the combined PDF prints the A-level version as 4.1.8.9). The specification gives no AS-only or A-level-only labels for this content. Every country, firm and number below is invented for illustration.

Use it with the revision notes and the practice questions. For the wider unit, see the overview of individuals, firms, markets and market failure, the AQA A-level Economics hub and the printable checklist. To find weak spots first, try the free 10-minute diagnostics.

What this unit covers

Outcome	What you must be able to do
Market failure as an argument for intervention	Link each tool to the failure it targets
Public expenditure, taxation, regulation; government objectives	Describe the ways governments influence allocation and how aims shape the choice
Indirect taxes, subsidies, price controls, state provision, regulation, property rights, permits	Analyse each and explain how it corrects market failure
Evaluation	Judge the case for and against intervention in a market, and compare methods

Other pages teach the causes of market failure, competition policy, public ownership and government failure. This one covers the tools.

Why intervene, and what governments want

A mixed economy relies mainly on markets but gives the government a role. Market failure means the free market gives a misallocation of resources, so the price signal is wrong or missing. That is the basic argument for intervention: price does not reflect full social cost or benefit, so output is too high, too low or absent.

Governments act in three broad ways.

• Public expenditure: spending on goods and services, and transfers such as subsidies.
• Taxation: changing prices and incomes, and raising revenue.
• Regulation: rules, standards, bans and limits backed by law.

Governments have objectives: efficient resource use, fairer incomes, growth, stable prices, a balanced budget and re-election. These conflict. A tax that cuts pollution may hurt low-income households, and a price control that helps tenants may cut the supply of homes. So the best tool depends on which objective the government weights most. Say which aim you judge a policy against. The market has strengths (price signals, incentives, choice) and weaknesses (market failure, unequal incomes), so ask where it does better than government.

Indirect taxes

An indirect tax is charged on spending and collected from sellers, who pass some of it on. A specific tax is a fixed sum per unit. An ad valorem tax is a percentage of the price, so the sum per unit rises with price. Either shifts the supply curve up. A specific tax gives a parallel shift. An ad valorem tax gives a steeper curve, because the gap between the old and new curve widens as price rises.

Worked example 1 (bottled juice in Country A). Demand is Qd = 400 − 20P and supply is Qs = −80 + 40P, with price P in currency units (cu).

1. Equilibrium: 400 − 20P = −80 + 40P, so 480 = 60P. P = 8 and Q = 240.
2. A specific tax of 3 cu: sellers need 3 more per unit, so Qs = −80 + 40(P − 3) = −200 + 40P.
3. New equilibrium: 400 − 20P = −200 + 40P gives P = 10 and Q = 200.
4. Buyers pay 10 (up 2). Sellers keep 10 − 3 = 7 (down 1).
5. Revenue: 3 × 200 = 600 cu. Buyers bear 2 × 200 = 400 and sellers bear 1 × 200 = 200. These add to 600.
6. Welfare loss: ½ × 3 × (240 − 200) = 60 cu.

Price
  10 |----- buyers pay        (S + tax)
   8 |----- old equilibrium
   7 |----- sellers receive  (S)
     +--------------------- Quantity: 240 falls to 200

Who pays depends on elasticity. Here PED at the original equilibrium is 20 × 8 ÷ 240 = 0.67 in size and PES is 40 × 8 ÷ 240 = 1.33. The buyer share and seller share are in the ratio PES : PED = 2 : 1, matching 400 : 200. The less elastic side bears more of the burden. Demand for a necessity is inelastic, so buyers bear most of a tax on it, and output barely falls.

Using a tax to correct a negative externality. Suppose each carton causes 3 cu of litter damage. The social cost curve is the supply curve shifted up by 3, so the tax in example 1 moves the market to the social optimum of 200. The 60 cu loss from producing the extra 40 units is removed.

Evaluation.

• The rate needs a reliable estimate of the external cost; a wrong estimate over- or under-corrects.
• If demand is inelastic, a tax raises revenue but changes behaviour little. That suits a revenue aim, not an environmental one.
• Taxes on necessities are regressive: they take a larger share of low incomes.
• High taxes can encourage avoidance or black markets.

Subsidies

A subsidy is a payment per unit that lowers costs and shifts supply down. It is used for goods with positive externalities or merit goods, where output is too low.

Worked example 2 (adult evening classes). Demand is Qd = 500 − 25P and supply is Qs = −100 + 50P.

1. Equilibrium: 600 = 75P, so P = 8 and Q = 300.
2. A subsidy of 3 cu per class: providers receive P + 3 for each class, so Qs = −100 + 50(P + 3) = 50 + 50P.
3. New equilibrium: 500 − 25P = 50 + 50P gives P = 6 and Q = 350.
4. Learners pay 6 (down 2). Providers receive 6 + 3 = 9 (up 1).
5. Cost to the government: 3 × 350 = 1,050 cu.
6. If each class gives an external benefit of 3 cu, the social benefit curve is demand plus 3: 23 − 0.04Q. Setting this equal to supply, 2 + 0.02Q, gives Q = 350. The subsidy hits the social optimum, and the gain over 300 to 350 is ½ × 3 × 50 = 75 cu.

Evaluation. A subsidy helps both sides and raises output, but it has an opportunity cost: the 1,050 cu could fund other things, and must come from taxes or borrowing. Providers may keep some as profit.

Price controls

A maximum price is a legal ceiling. To bind, it must be below equilibrium. A minimum price is a legal floor and must be above equilibrium.

Worked example 3 (a maximum rent in Country A). Demand for flats is Qd = 600 − 20P and supply is Qs = −120 + 40P, with rent P in cu.

1. Equilibrium: 720 = 60P, so P = 12 and Q = 360.
2. A maximum rent of 9: Qd = 420 and Qs = 240. Excess demand is 180 flats.
3. Only 240 flats are supplied. Tenants would pay up to (600 − 240) ÷ 20 = 18 for the 240th flat, so informal charges above 9 are likely.
4. Welfare loss: ½ × (360 − 240) × (18 − 9) = 540 cu.

The aim is affordability for those who get a flat. The costs are a shortage, lower quality and reduced supply over time.

Worked example 4 (a minimum price on a sugary drink). Demand is Qd = 420 − 10P and supply is Qs = −60 + 20P. Equilibrium: 480 = 30P, so P = 16 and Q = 260. A minimum price of 20 gives Qd = 220 and Qs = 340, so sellers have an unsold surplus of 120.

• Consumption falls by 40, which is 15.4% of 260. That meets a health aim.
• PED at the original equilibrium is 10 × 16 ÷ 260 = 0.62 in size, so demand is inelastic and spending rises from 4,160 to 4,400 cu.
• The extra revenue goes to sellers, not the government. Low-income buyers may pay the most as a share of income.

State provision and regulation

State provision means the government funds, and often runs, a good or service. It is used when private provision would be too little (for example where benefits spill over, or people cannot pay) or when the aim is equal access.

Worked example 5 (comparing two programmes). A government has funds for one programme. Programme A costs 12m and gives benefits worth 15m. Programme B costs 8m and gives benefits worth 11m.

• Net benefit: A = 3m and B = 3m.
• Benefit-cost ratio: A = 15 ÷ 12 = 1.25 and B = 11 ÷ 8 = 1.375.

Net benefit ties. B earns more per unit spent, so it is better if the budget is tight. Valuing benefits in money is itself uncertain. Provision that is free at the point of use can lead to overuse, and quality may suffer without competition. It also needs tax revenue.

Regulation sets rules by law. Examples are emission limits, age limits, safety standards and advertising bans. It is clear and works when harm is severe, because a ban or standard does not depend on price. But it treats all firms alike, so the total cost of a given result is often higher than with market-based tools. Monitoring costs money, and firms may lobby for weak rules.

Extending property rights and pollution permits

Some resources have no owner, so no one has a reason to protect them. Giving them an owner can fix this.

Worked example 6 (a lake in Country A). Total catch is T = 30n − n² tonnes with n boats. Each boat costs 10 tonnes-worth of fish to run, and fish are valued at 1 per tonne.

• Open access: boats join until the average catch equals the cost, 30 − n = 10, so n = 20. Catch = 600 − 400 = 200 and net gain = 200 − 200 = 0.
• Single owner: maximise T − 10n. Marginal catch 30 − 2n = 10 gives n = 10. Catch = 300 − 100 = 200 and net gain = 200 − 100 = 100.

The same catch is taken with half the boats, because the owner counts the cost of overcrowding. Evaluation: ownership is hard to define for air or open sea, and poor users may be excluded.

Pollution permits cap total emissions, issue permits that sum to the cap and let firms trade them.

Worked example 7 (three factories). Each emits 100 tonnes. The cap is 210, so each gets 70 permits and 90 tonnes must be cut. Cutting costs per tonne are 8 for X (up to 60 tonnes), 14 for Y (up to 50) and 25 for Z (up to 40).

• Without trading each cuts 30: cost = 240 + 420 + 750 = 1,410.
• With trading, the cheapest cuts happen: X cuts 60 and Y cuts 30. Cost = 480 + 420 = 900. The permit price is 14, set by Y, the marginal cutter.
• X sells 30 permits, Z buys 30. Z pays 30 × 14 = 420 instead of 750 to cut.
• Saving: 1,410 − 900 = 510, and the cap is still met.

Evaluation: the cap guarantees the quantity of pollution but not the price. The starting allocation decides who gains. Permits need monitoring, and a cap set too loose does nothing.

Choosing between methods

Tool	Strength	Weakness	Suits
Indirect tax	Uses the price signal, raises revenue	Hard to set the rate, regressive	Demerit goods, negative externalities
Subsidy	Raises output, lowers prices	Costs taxpayers, may be kept as profit	Merit goods, positive externalities
Maximum price	Helps buyers fast	Shortage, black market	Essentials with a clear fairness aim
Minimum price	Cuts demerit use, protects incomes	Surplus, costs consumers	Demerit goods, farm income
State provision	Equal access	Costly, quality risk	Essential services
Regulation	Certain effect	Enforcement cost, less flexible	Severe harm
Property rights	Self-policing	Hard to define	Resources like fisheries
Permits	Cheapest way to meet a cap	Cap setting, monitoring	Pollution with many firms

For any recommendation, ask: does it target the cause of the failure, how big is the effect given the elasticities, who gains and loses, and what does it cost? Then judge, for example: a tax is best here because demand is elastic and the cost is measurable, but a ban is safer if the harm is severe.

Common errors

• Moving the demand curve when a tax or subsidy changes costs.
• Saying the buyer always pays the whole tax. Incidence depends on elasticities.
• Drawing a maximum price above equilibrium. It would have no effect.

Official syllabus

AQA AS and A-level Economics, specification version 1.3 (29 June 2022), AQA. Sub-section covered: Government intervention in markets (3.1.5.8 on the AQA website; 4.1.8.9 in the combined PDF).