Cambridge A Level Economics: Market-failure policies: taxes, subsidies, controls and quotas (9708)

This guide covers the first group of measures in section 8.1.1 of the Cambridge International AS & A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028: specific and ad valorem indirect taxes, subsidies, price controls, production quotas, prohibitions and licences, regulation and deregulation, and direct provision. Topics 1 to 6 are AS Level content and topics 7 to 11 are A Level content. Topic 8 is A Level only, so it is not examined at AS. A Level candidates meet it on Papers 3 and 4, with the AS content assumed.

Every market, firm and number below is invented for illustration. Prices are in currency units (cu). The AS treatment of taxes, subsidies and price controls is in methods and effects of microeconomic intervention; this page assumes it and adds the A Level application. See the revision notes, the practice questions, the course hub, the printable checklist and the free diagnostics. For the reasons for intervention, read reasons for government intervention in markets.

What you must be able to do

Measure	Application and effectiveness
Specific and ad valorem taxes	Shift or pivot supply; split the burden; price in an external cost
Subsidies	Raise output of a merit good; weigh cost against benefit
Price controls	Maximum and minimum prices and their side effects
Production quotas	Cap output; compare with a tax
Prohibitions and licences	Ban or limit supply; enforcement and black markets
Regulation and deregulation	Price caps, standards, and opening markets to entry
Direct provision	State supply of public and merit goods

For each one, give the mechanism, a number or table where you can, and an evaluation: who gains, who loses, how well it targets the failure, and what it costs to run.

Specific and ad valorem indirect taxes

A specific tax takes a fixed sum from each unit sold. An ad valorem tax takes a fixed share of the value of each sale. A specific tax shifts supply up in parallel. An ad valorem tax pivots supply, because the tax per unit grows as the price rises.

Seller price (cu)	Specific tax of 6	Ad valorem tax of 20%
20	6	4
30	6	6
40	6	8

Worked example 1 (a fictional market for plastic crates). Demand is Qd = 400 − 5P and supply is Qs = −80 + 10P. A 20% ad valorem tax is added to the seller’s price Ps, so buyers pay 1.2 × Ps.

1. No tax: 400 − 5P = −80 + 10P, so P = 32 and Q = 240.
2. With the tax, buyers pay 1.2Ps, so 400 − 5(1.2Ps) = −80 + 10Ps. That gives 480 = 16Ps, so Ps = 30.
3. Buyers pay 1.2 × 30 = 36. Quantity = −80 + 300 = 220.
4. Tax per unit = 36 − 30 = 6. Revenue = 6 × 220 = 1,320 cu.
5. Consumer burden = (36 − 32) × 220 = 880 cu. Producer burden = (32 − 30) × 220 = 440 cu. Total = 1,320 cu.
6. Welfare loss = ½ × 6 × (240 − 220) = 60 cu.

Demand elasticity at the start is −5 × 32 ÷ 240 = −0.67 and supply elasticity is 10 × 32 ÷ 240 = 1.33. Demand is less elastic, so consumers bear two thirds of the tax.

Using a tax to correct an externality. A tax set equal to the marginal external cost (MEC) makes the producer face the full social cost.

Worked example 2 (a fictional market for diesel generators). Marginal private benefit is P = 90 − 0.25Q and marginal private cost is P = 10 + 0.15Q. Each unit imposes an external cost of 16 cu.

1. Market: 90 − 0.25Q = 10 + 0.15Q, so Q = 200 and P = 40.
2. Social optimum: marginal social cost is 26 + 0.15Q. Setting 90 − 0.25Q = 26 + 0.15Q gives Q = 160.
3. A specific tax of 16 cu moves the market there. Buyers pay 90 − 40 = 50 (up 10). Sellers keep 10 + 24 = 34 (down 6).
4. Revenue = 16 × 160 = 2,560 cu. Welfare gain = ½ × 16 × (200 − 160) = 320 cu.

Evaluation: external cost is difficult to put a value on, so the rate chosen may be wrong. If demand is inelastic, quantity barely falls and the tax mostly raises revenue. The tax may be regressive, and revenue may fund other policies. Producers may pass the tax on, or avoid it by illegal sales.

Subsidies

A subsidy is a payment per unit that shifts supply down. It is used to raise output of a merit good, or of a good with positive externalities.

Worked example 3 (fictional child dental check-ups). Marginal private benefit is P = 70 − 0.1Q and marginal cost is P = 10 + 0.05Q. Each check-up gives an external benefit of 15 cu.

1. Market: 70 − 0.1Q = 10 + 0.05Q, so Q = 400 and P = 30.
2. Marginal social benefit is 85 − 0.1Q. Setting 85 − 0.1Q = 10 + 0.05Q gives Q = 500.
3. A subsidy of 15 cu per check-up gives Q = 500. Families pay 70 − 50 = 20 (down 10). Providers receive 20 + 15 = 35 (up 5).
4. Cost = 15 × 500 = 7,500 cu. Welfare gain = ½ × 15 × (500 − 400) = 750 cu.

The subsidy costs ten times the net welfare gain, because most of the money goes on units that would have been bought anyway. Evaluation: it needs taxes to fund it, providers may keep the money as profit, the external benefit is hard to value, and it can create dependence. It also lowers the price for poorer households, which helps equity.

Price controls

A maximum price below equilibrium creates a shortage. A minimum price above equilibrium creates a surplus.

Worked example 4 (a maximum price on a fictional essential medicine). Demand is Qd = 600 − 6P and supply is Qs = −120 + 12P.

1. Equilibrium: P = 40 and Q = 360.
2. Maximum price of 30: Qd = 420 and Qs = 240. Shortage = 180.
3. Only 240 units are sold. Buyers would pay (600 − 240) ÷ 6 = 60 for the 240th unit, which invites black markets.
4. Welfare loss = ½ × (360 − 240) × (60 − 30) = 1,800 cu.

Worked example 5 (a minimum price on a fictional cheap strong drink). Demand is Qd = 800 − 10P and supply is Qs = −160 + 20P. Equilibrium: P = 32 and Q = 480. A minimum price of 40 is set to cut consumption of a demerit good.

1. Qd = 400. Consumption falls by 80, which is 16.7%.
2. Price rises by 8 ÷ 32 = 25%. PED = −16.7 ÷ 25 = −0.67.
3. Spending rises from 480 × 32 = 15,360 cu to 400 × 40 = 16,000 cu, and the extra goes to the sellers who manage to sell, not to the government.

Evaluation: with inelastic demand, consumption falls by less than the price rise. Heavy users may cut other spending. Cross-border or illegal buying can leak. A tax would transfer the extra revenue to the state.

Production quotas

A quota sets a maximum output. Supply becomes vertical at the quota, so price rises.

Worked example 6 (a fictional fish stock). Demand is Qd = 1,200 − 8P and supply is Qs = −240 + 10P. Equilibrium: P = 80 and Q = 560. Each tonne caught imposes 27 cu of external cost on the stock, so the social optimum solves 150 − 0.125Q = 24 + 0.1Q + 27 and is Q = 440.

1. Quota of 440: price = (1,200 − 440) ÷ 8 = 95.
2. Sellers would supply 440 at (440 + 240) ÷ 10 = 68. The gap of 27 per tonne is a quota rent: 27 × 440 = 11,880 cu, kept by quota holders.
3. A specific tax of 27 gives the same price (95) and output. Sellers keep 68 and the government collects 11,880 cu.

So a quota and a tax can reach the same output. The difference is who gets the rent. A quota gives certainty about quantity, which suits a limited stock. Evaluation: it is hard to allocate fairly, people may cheat, and it protects existing producers. A tax adjusts more easily.

Prohibitions and licences

A prohibition bans a product or activity, as with an unsafe additive. It removes the harm if enforced, but demand may move to a black market with no quality control, and enforcement costs are high.

A licence limits who can supply. Worked example 7. A city issues 150 street-trading licences at 400 cu each, raising 60,000 cu. Inspection costs 45,000 cu, so net revenue is 15,000 cu. Licences can enforce standards and limit numbers, but they restrict entry and can raise prices.

Regulation and deregulation

Regulation covers legal standards and controls on price, quality or entry. Take a natural monopoly.

Worked example 8 (a fictional water network). Demand is P = 120 − Q. Marginal cost is 20 cu and fixed cost is 1,600 cu, so AC = 20 + 1,600 ÷ Q.

1. Unregulated: MR = 120 − 2Q = 20, so Q = 50 and P = 70. AC = 52, so profit = (70 − 52) × 50 = 900 cu.
2. Price cap at average cost: 120 − Q = 20 + 1,600 ÷ Q gives Q² − 100Q + 1,600 = 0, so Q = 80 (or 20). P = 40 and AC = 40, so profit is zero and output is higher.
3. Price cap at marginal cost: P = 20 and Q = 100, but the loss is 1,600 cu, which needs a subsidy.

Evaluation: the regulator lacks cost information, firms may cut quality, and regulators can be captured by the industry. Deregulation removes entry barriers or rules to add competition. If entry forces the price down towards average cost, consumers gain. But it can reduce safety or quality and cause service cuts to unprofitable users.

Direct provision

The state supplies public goods, which are non-excludable, so private firms cannot charge. Worked example 9. Flood defences protect 4,000 households, each worth 150 cu a year. Benefit = 600,000 cu and cost = 480,000 cu, so the ratio is 1.25 and net benefit is 120,000 cu. Evaluation: it ignores the market, may be wasteful, depends on tax revenue, and free supply can lead to over-use of merit goods.

Common errors

• Showing an ad valorem tax as a parallel shift.
• Using the market price as the producer’s share of a tax.
• Setting a price control on the wrong side of equilibrium.
• Calling a quota revenue for the government.
• Evaluating without numbers, time or elasticity.

Official syllabus

Cambridge International AS & A Level Economics (9708), syllabus for examination in 2026, 2027 and 2028, published by Cambridge International, section 8.1.1.