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

This study guide is aligned to the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. It covers section 1.3.6 Government intervention in markets, items 1 and 2: the purpose and methods of intervention, and government failure. The specification labels Units 1 and 2 as International AS (IAS) and the extra content for the full International Advanced Level as International A2 (IA2). This topic is in Unit 1, so it is IAS content and also part of the full IAL.

Every figure below is invented. Countries, towns and firms are illustrative. Currency units are written “cu”. Do not quote any number as real data.

Related pages: the Edexcel economics hub, the printable checklist, the revision notes, the practice set, the wider Unit 1 guide and our free 10-minute diagnostics.

What the specification asks for

Reference	You must be able to
1a	Explain the purpose of intervention, with reference to market failure
1b	Explain and evaluate: indirect taxes (ad valorem and specific), subsidies, maximum and minimum (guaranteed) prices, tradeable pollution permits, extension of property rights, state provision, regulation, provision of information
1c	Apply these in health, housing, education, transport, environment, energy, agriculture and commodities
2a	Define government failure as intervention that results in a net welfare loss
2b	Explain its causes: information gaps, lack of incentives, unintended consequences, excessive administrative costs, moral hazard

1a: Why governments intervene

A market fails when its output is above or below the level that is best for society as a whole. The usual causes are external costs and benefits, public goods, imperfect information and moral hazard. Intervention aims to move output towards the social optimum, where marginal social benefit equals marginal social cost. Governments also intervene for fairness (for example, keeping essentials affordable), but your analysis should link each tool to a named failure.

A reliable chain: name the failure, name the tool, show the shift or new price, state who gains and loses, then judge size and side effects.

1b: Indirect taxes

An indirect tax is charged on spending. A specific tax takes the same amount from every unit sold. An ad valorem tax takes a set percentage of the selling price, so the amount per unit climbs as the price climbs.

Pre-tax price (cu)	Specific tax of 1 cu	Ad valorem tax of 25%
4	1.00	1.00
6	1.00	1.50
8	1.00	2.00

A tax adds to firms’ costs, so supply shifts left (or up by the tax). Demand does not move.

Worked example (Country A, fizzy drink, thousand litres). Demand: Qd = 120 - 20P. Private supply: Qs = 20P - 40. Each litre imposes an external cost of 1.5 cu, so marginal social cost is the supply curve plus 1.5.

1. Market equilibrium: 120 - 20P = 20P - 40, so P = 4 cu and Q = 40.
2. Social optimum: supply plus 1.5 is Qs = 20(P - 1.5) - 40 = 20P - 70. Then 120 - 20P = 20P - 70, so P = 4.75 and Q = 25.
3. Welfare loss at 40: a triangle with base (40 - 25) = 15 and height 1.5, so 0.5 x 15 x 1.5 = 11.25 (thousand cu).
4. A specific tax of 1.5 cu gives the same result. Consumers pay 4.75 (up 0.75). Producers keep 4.75 - 1.5 = 3.25 (down 0.75). Quantity falls to 25. Revenue is 25 x 1.5 = 37.5 (thousand cu).

The tax is set at the external cost per unit and removes the welfare loss. The incidence here is shared equally because supply and demand are equally steep.

To describe the diagram, put price up the side and quantity along the bottom. The supply curve shifts up by the tax. The new equilibrium is where it crosses demand. The gap between the price paid and the price kept is the tax per unit.

Evaluation points: the tax is only right if the government knows the external cost; demand for addictive or necessary goods is inelastic, so quantity may fall little; low-income households may pay a larger share of income; revenue can fund other policies.

1b: Subsidies

A subsidy is a grant paid to producers for each unit, which cuts their costs, so supply shifts right (or down by the grant). It suits goods with external benefits.

Worked example (Town C, bus journeys, thousand per week). Demand: Qd = 80 - 10P. Supply: Qs = 10P - 20. Each journey gives an external benefit of 1 cu.

1. Market equilibrium: 80 - 10P = 10P - 20, so P = 5 and Q = 30.
2. A subsidy of 1 cu per journey: supply becomes Qs = 10(P + 1) - 20. Then 80 - 10P = 10P - 10, so P = 4.5 and Q = 35.
3. Passengers pay 4.5 (down 0.5). Operators receive 4.5 + 1 = 5.5 (up 0.5). Cost to government: 35 x 1 = 35 (thousand cu).
4. Social optimum: marginal social benefit is demand plus 1, giving 90 - Q = Q + 20, so Q = 35. The subsidy reaches it.
5. Welfare gain: base (35 - 30) = 5, height 1 at Q = 30 (benefit 6, cost 5), so 0.5 x 5 x 1 = 2.5 (thousand cu).

The 35 spent is mostly a transfer from taxpayers; the net gain is the 2.5, less any cost of raising the funds. Evaluation: the subsidy must be funded, firms may pocket part of it, and withdrawing it later is politically hard.

1b: Maximum and minimum prices

Maximum price (price ceiling). Set below equilibrium to protect buyers, for example rents in housing.

Worked example (City B, flats to rent). Qd = 1,000 - 2R and Qs = 3R - 500, where R is monthly rent in cu.

1. Equilibrium: 1,500 = 5R, so R = 300 and Q = 400.
2. Cap at 250: Qd = 500, Qs = 250. Shortage = 250 flats.
3. Only 250 flats are supplied. The highest rent tenants would pay for the 250th flat is (1,000 - 250)/2 = 375. Suppliers need 250. A gap of 125 invites side payments or black markets.
4. Welfare loss: 0.5 x (400 - 250) x 125 = 9,375 cu per month.

Likely consequences: rationing by queue or connections, lower quality, less new building, tenants gain only if they keep a flat.

Minimum (guaranteed) price (price floor). Set above equilibrium to raise producer income, for example in agriculture or commodities.

Worked example (Country D, wheat, tonnes). Qd = 600 - 10P and Qs = 20P - 300.

1. Equilibrium: 900 = 30P, so P = 30 and Q = 300. Farmers’ revenue = 9,000.
2. Minimum price of 36: Qd = 240, Qs = 420. Surplus = 180 tonnes.
3. If the government buys the surplus: cost = 180 x 36 = 6,480. Farmers receive 420 x 36 = 15,120, made of consumer spending 240 x 36 = 8,640 plus the 6,480.
4. Consumers buy less and pay more. Taxpayers fund storage, or the surplus is dumped abroad, which can harm producers elsewhere.

Evaluation: the floor helps farmers who are efficient and those who are not; it keeps resources in a sector that may be oversized.

1b: Tradeable pollution permits

The government sets a cap on total emissions and issues permits. Firms can buy and sell them. Firms with low abatement costs cut more and sell spare permits; those with high costs buy.

Worked example. Firms J and K each emit 100 tonnes. The cap is 150, so each gets 75 permits. Assume constant abatement costs: J 20 cu per tonne, K 50 cu per tonne.

1. No trading: each cuts 25. Cost = 25 x 20 + 25 x 50 = 1,750.
2. With trading: J cuts 50 (cost 1,000), K cuts none. Total cost = 1,000, saving 750.
3. At a permit price of 35, J sells 25 permits for 875 and its net cost is 125. K pays 875 against 1,250 of abatement. Each gains 375. Any price between 20 and 50 benefits both.

The cap fixes the quantity of pollution; the permit price is found by the market. Evaluation: set the cap too high and the scheme achieves little; monitoring is needed; large firms may hold permits to block rivals.

1b: Property rights, state provision, regulation and information

Extension of property rights. Many failures arise because nobody owns a resource, so nobody pays for overuse. Giving legal ownership of a fishing ground, forest or river stretch means the owner bears the cost of damage and can charge users. Chain: ownership, owner gains from preserving the stock, overuse falls. Limits: some resources cannot be fenced (air), enforcement is costly, and ownership may be unfair to local users.

State provision. The government supplies the good, often free at the point of use, funded by taxes. It suits public goods such as street lighting, where private firms cannot exclude non-payers, and merit goods such as schooling. Limits: opportunity cost, long queues or fixed quality, and weak cost control.

Regulation. Laws set standards or ban actions: emission limits, building safety rules, bans on selling to minors. Regulation is clear and quick, but it ignores differences in compliance cost, needs inspection and fines, and gives no reward for doing better than the standard.

Provision of information. Labels, warnings, public campaigns and published quality scores reduce information gaps. Cheap and free of direct price effects, but people may ignore or misread the message, and results are slow.

1c: Contexts

Context	Typical failure	Typical tools
Health	Information gaps, external costs of disease	Information, taxes on harmful goods, state provision
Housing	Affordability, shortages	Rent caps, subsidies, state provision, planning regulation
Education	Under-consumption of a merit good	State provision, subsidies
Transport	Congestion, pollution	Taxes, subsidies, regulation
Environment	External costs, no property rights	Permits, taxes, regulation, property rights
Energy	External costs, security of supply	Taxes, subsidies, price caps, regulation
Agriculture	Unstable incomes and output	Guaranteed prices, subsidies
Commodities	Volatile prices	Guaranteed (minimum) prices, subsidies

2: Government failure

Government failure is intervention that results in a net welfare loss. The test is welfare after intervention against welfare before. Aiming at a problem is not enough.

Worked example (the fizzy drink again). Suppose the government mis-estimates the external cost at 3.5 cu, when the true value is 1.5, and sets a specific tax of 3.5.

1. Supply becomes Qs = 20(P - 3.5) - 40. Then 120 - 20P = 20P - 110, so P = 5.75 and Q = 5.
2. At Q = 5 the demand price is 5.75, while marginal social cost is (5 + 40)/20 + 1.5 = 3.75. The gap is 2.
3. The new welfare loss is 0.5 x (25 - 5) x 2 = 20, against 11.25 with no tax. Net welfare loss from intervening: 20 - 11.25 = 8.75 (thousand cu).

Even a correct tax can fail on cost. If the tax of 1.5 removes a welfare loss of 11.25 but costs 12 to collect and police, the net effect is 11.25 - 12 = -0.75.

Causes of government failure

• Information gaps: officials lack data on external costs, demand or true costs, so rates and caps are wrong (as above).
• Lack of incentives: state providers face no profit motive or rivals, so costs and quality may drift. Politicians may favour policies that win votes over those with the best net benefit.
• Unintended consequences: rent caps cut new building; guaranteed prices create surpluses; a tax on one good moves spending to an untaxed substitute.
• Excessive administrative costs: collecting, inspecting, enforcing and paying out use resources that could produce something else.
• Moral hazard: protection changes behaviour. If government covers all flood losses, farmers take less care or build on risky land, so claims rise.

Common errors

• Moving the demand curve to show a tax; it is the supply curve that moves.
• Using a welfare triangle with the wrong base: the base runs between the market and optimum quantities.
• Saying a subsidy “creates” welfare equal to its whole cost.
• Calling any policy that has side effects “government failure” without comparing welfare before and after.
• Evaluating with a list of side effects and no judgement about which matters most.

Official syllabus

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