Edexcel IAL Economics: Government intervention and government failure in markets (YEC11) – Revision Notes

These notes condense section 1.3.6 Government intervention in markets, items 1 and 2, of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. The specification labels Units 1 and 2 as International AS (IAS) and the extra content for the full IAL as International A2 (IA2); this topic is in Unit 1, so it is IAS content and also part of the full IAL. For full explanations and worked diagrams, use the study guide.

All figures are invented and illustrative. Currency units are “cu”. Also see the practice set, the Edexcel economics hub, the printable checklist and the free 10-minute diagnostics.

Key definitions

Term	Meaning
Market failure	Too much or too little produced or consumed compared with the socially optimal level
Intervention	Government action to change the market outcome
Specific tax	Fixed sum per unit
Ad valorem tax	Percentage of the price
Subsidy	Payment per unit (or lump sum) that lowers firms’ costs
Maximum price	Legal ceiling; effective only below equilibrium
Minimum (guaranteed) price	Legal floor; effective only above equilibrium
Tradeable permit	Right to emit a set amount; can be bought and sold under a cap
Property right	Legal ownership that lets the owner exclude others and gain or lose from use
Government failure	Intervention that results in a net welfare loss
Moral hazard	Taking more risk because someone else bears the cost

Method at a glance (1b)

Method	What moves	Main gain	Main risk
Specific tax	Supply shifts up by the tax	Cuts output with external costs; raises revenue	Wrong rate; regressive; avoidance
Ad valorem tax	Supply pivots; gap widens at higher prices	Revenue grows with price	Harder to set for external cost per unit
Subsidy	Supply shifts down by the subsidy	Raises output with external benefits	Cost; firms keep part; hard to remove
Maximum price	Price fixed below equilibrium	Cheaper for those who buy	Shortage, queues, black markets, lower quality
Minimum price	Price fixed above equilibrium	Higher producer income	Surplus, storage, dumping, higher prices
Tradeable permits	Cap on total pollution	Cuts abatement cost at fixed total	Cap set wrongly; monitoring
Property rights	Creates owner who bears cost	Ends overuse of unowned resources	Hard to enforce or fence
State provision	Government supplies	Public and merit goods are provided	Cost, weak incentives
Regulation	Legal limits or bans	Clear and quick	Enforcement cost; no reward beyond standard
Information	Reduces information gaps	Cheap	May be ignored

Method in steps: a tax or subsidy diagram

1. Name the failure (external cost or benefit, information gap).
2. Label price up the side and quantity along the bottom, then sketch demand and supply.
3. Shift supply by the tax (up or left) or subsidy (down or right).
4. Read the new price paid by buyers and price received by sellers.
5. Incidence: buyers bear the rise in price paid; sellers bear the fall in price received.
6. Revenue or cost = quantity after intervention x rate per unit.
7. Compare with the social optimum and judge.

Small worked reminders

Ad valorem: a 20% tax on a good with a pre-tax price of 50 cu adds 10 cu, so buyers pay 60 cu if the whole tax is passed on.

Specific tax incidence. A tax of 2 cu per unit moves the market price from 10 to 11.2, and quantity from 100 to 88.

• Buyers bear 11.2 - 10 = 1.2 per unit, which is 60% of the tax.
• Sellers bear 2 - 1.2 = 0.8 per unit, which is 40%.
• Revenue = 88 x 2 = 176, split into 88 x 1.2 = 105.6 (buyers) and 88 x 0.8 = 70.4 (sellers).

Price controls. A price control bites only on the right side of equilibrium. With Qd = 400 - 8P and Qs = 12P - 200, equilibrium is 30 cu and 160 units. A cap at 36 changes nothing, because buyers and sellers already trade at 30. A cap at 25 creates a shortage; a floor at 36 creates a surplus.

Welfare triangle. Area = 0.5 x base x height. The base is the gap between market quantity and optimum quantity; the height is the gap between marginal social benefit and marginal social cost at the market quantity. For example, a base of 20 units and a height of 3 cu give 0.5 x 20 x 3 = 30 cu.

Permit rule: the firm with the lowest abatement cost sells permits; the firm with the highest cost buys. Both gain at any price between the two costs.

Contexts (1c) in one line each

• Health: information and taxes on harmful goods; state provision where private insurance fails.
• Housing: rent caps, subsidies, state-built homes, planning rules.
• Education: state provision and subsidies for a merit good.
• Transport: taxes on road use or fuel, subsidies for public transport, safety regulation.
• Environment: permits, taxes, regulation, property rights.
• Energy: taxes and subsidies, price caps for households, efficiency standards.
• Agriculture: guaranteed prices and subsidies to stabilise incomes.
• Commodities: minimum (guaranteed) prices to support producers when prices are volatile.

Evaluation toolkit

Use these to turn description into judgement.

• Size: is the failure large enough to justify the cost of acting?
• Elasticity: inelastic demand means a tax raises revenue but cuts quantity little; a price floor on inelastic demand raises farmers’ revenue.
• Time: effects of information campaigns and property rights are slow; taxes and caps act faster.
• Information: can the government measure the external cost or benefit well enough to set the rate?
• Fairness: who pays, and do low-income households lose most?
• Alternatives: would a different tool reach the same aim at lower cost?
• Conclusion: state which tool you prefer in this context and the condition under which you would change your mind.

Government failure (item 2)

Test: welfare after intervention is lower than welfare before.

Cause	Chain	Example
Information gaps	Wrong data, wrong rate or cap	Tax set on a mistaken estimate of external cost
Lack of incentives	No profit motive or rivals, costs drift	State provider with no pressure to cut waste
Unintended consequences	Side effects outweigh the gain	Rent cap cuts new building
Excessive administrative costs	Collecting and policing uses resources	A scheme whose running cost exceeds its welfare gain
Moral hazard	Protection leads to riskier behaviour	Full government cover of losses

Must-know distinctions

• Transfer versus welfare change: tax revenue and subsidy payments move money between groups; welfare changes only through the triangles.
• Shift versus movement: a tax shifts supply; the new equilibrium is a movement along demand.
• Price paid versus price received: they differ by the tax, or by the subsidy.
• Cap-and-trade fixes the quantity of pollution and lets price adjust; a tax fixes the price and lets quantity adjust.
• Intervention is not the same as government failure: failure needs a net welfare loss.

Quick self-test

1. A 20% ad valorem tax is placed on a good with a pre-tax price of 50 cu. State the tax per unit and the price paid by buyers.
2. A specific tax of 2 cu per unit raises the price from 10 to 11.2 cu. What share of the tax do buyers bear?
3. A subsidy of 5 cu per unit lowers the price buyers pay from 40 to 37.5 cu and raises quantity from 200 to 250. Calculate the cost to the government and the share of the subsidy that goes to buyers.
4. Demand is Qd = 400 - 8P and supply is Qs = 12P - 200. Find the shortage if a maximum price of 25 is set.
5. With the same market, a minimum price of 36 is set. Find the surplus and the cost to the government of buying all of it at 36.
6. Which firm sells permits in a trading scheme?
7. Define government failure.
8. A government guarantees all deposits of a bank, whatever risks it takes. Which cause of government failure is this?
9. Why is the cost of a subsidy not the same as the welfare loss of a subsidy?
10. Why does an ad valorem tax pivot, rather than shift in parallel?

Answers

1. Tax = 20% x 50 = 10 cu; buyers pay 60 cu.
2. Buyers pay 1.2 of the 2 cu: 60%.
3. Cost = 250 x 5 = 1,250 cu. Buyers gain 40 - 37.5 = 2.5 per unit, which is 50% of the 5 cu.
4. Equilibrium: 600 = 20P gives P = 30 and Q = 160. At 25: Qd = 200, Qs = 100, so shortage = 100.
5. At 36: Qd = 112, Qs = 232, so surplus = 120; cost = 120 x 36 = 4,320 cu.
6. The firm with the lower abatement cost.
7. Intervention that results in a net welfare loss.
8. Moral hazard (the bank can take risk because losses fall elsewhere).
9. Most of the payment is a transfer from taxpayers; the welfare effect is the triangle gained, less the cost of raising the funds.
10. The tax per unit is a fixed percentage of price, so it is larger at higher prices.

Where marks are usually lost

• Writing “demand shifts” when a tax or subsidy shifts supply.
• Shading the welfare triangle between the wrong quantities.
• Quoting the cost of a subsidy as if it were the welfare gain.
• Drawing a ceiling that sits over the equilibrium price, or a floor that sits under it; neither would bite.
• Listing side effects without weighing which matter more in the context given.
• Treating every unintended consequence as government failure without saying welfare falls overall.
• Using general words such as “expensive” instead of quantities, prices and who pays.
• Forgetting that permits fix the amount of pollution rather than its price.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, Pearson Education Limited. These notes cover section 1.3.6 items 1 and 2 of Unit 1.