IB DP Economics: Role of government in microeconomics

This study guide follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. Its subject is sub-topic 2.7, Role of government in microeconomics (Unit 2), taught at SL and HL. Two items are HL only: the calculation of effects on markets and stakeholders, and consumer nudges.

Every market in this guide is fictional and every figure is invented for practice. Course overview: IB DP Economics hub. Self-assessment: printable checklist. Also for this sub-topic: revision notes and a practice set. If you need equilibrium, shortage and surplus first, read demand, supply and market equilibrium. Our free 10-minute diagnostics can help you choose a starting point.

What the guide asks you to do

Part of 2.7	What you must be able to do	Level
Reasons for intervention	Explain why governments change market outcomes	SL and HL
Price ceiling and price floor	Draw and explain the diagram and its effects	SL and HL
Indirect tax and subsidy	Draw and explain the diagram and its effects	SL and HL
Direct provision, command and control	Describe as forms of intervention	SL and HL
Consumer nudges	Describe as a form of intervention	HL only
Consequences for markets and stakeholders	Weigh up the effects, not just list them	SL and HL
Calculations	Work out effects of ceilings, floors, taxes and subsidies	HL only

Calculating the shortages, surpluses and other figures in the worked examples below is HL only; at SL, show the same effects on the diagram. The guide gives the depth of the forms of intervention as application and diagram skills (AO2, AO4), and the depth of the consequences as synthesis and evaluation (AO3). So drawing the diagram is the start. You then judge who gains, who loses and how far the policy works.

Why governments intervene

The guide lists seven aims. Each one can be matched to a tool.

• Earn revenue. An indirect tax raises money for the budget.
• Support firms. A subsidy lowers costs, or a price floor raises the price a producer receives.
• Support low-income households. A price ceiling on a basic good or a subsidy on a necessity lowers what poorer households pay.
• Influence production. A subsidy encourages output; a tax discourages it.
• Influence consumption. A tax on a good lowers consumption; a subsidy raises it.
• Correct market failure (see externalities and common pool resources). A tax on a good with a negative externality, or a subsidy on one with a positive externality, moves output towards the socially best level.
• Promote equity. Policies aim at a fairer distribution of income or access.

Most real policies have more than one aim, and aims can conflict. A tax that raises revenue may also hurt low-income households.

Price ceilings (maximum prices)

A price ceiling is a legal maximum price. It only matters if it sits under the equilibrium price that the free market would reach. A ceiling above equilibrium changes nothing, because the market price never reaches it.

How to draw it

1. Draw demand (D) sloping down and supply (S) sloping up. Put price on the y-axis and quantity along the x-axis.
2. Mark the equilibrium price (Pe) and quantity (Qe).
3. Draw a horizontal line at the ceiling price (Pmax) below Pe.
4. Read across: the line meets S at the quantity supplied (Qs) and D at the quantity demanded (Qd). Qs is to the left of Qd.
5. Label the gap Qd − Qs as the shortage (excess demand).

Worked example (fictional). Tamora is an island. In its market for rented flats, price is the monthly rent in currency units (cu) and quantity is in thousands of flats.

• Demand: P = 240 − 2Q
• Supply: P = 60 + Q

Set equal: 240 − 2Q = 60 + Q, so 3Q = 180, Q = 60 and P = 120. The government sets a ceiling of 90 cu.

Demand at 90:  90 = 240 - 2Q  ->  Q = 75
Supply at 90:  90 = 60 + Q    ->  Q = 30
Shortage = 75 - 30 = 45 thousand flats

Only 30 thousand flats are offered, because that is all suppliers will offer at 90. At that quantity the demand curve shows a price of 240 − 2(30) = 180 cu. That is the most the last renter would pay, which is why informal payments or a black market can appear.

Consequences for stakeholders

• Renters who find a flat pay less than before. Renters who do not find one lose out completely.
• Landlords receive lower rent and may let properties decay or leave the market.
• The government may need to enforce the ceiling or ration supply, which costs money.
• Society loses welfare, because some trades that were worth more to renters than they cost landlords no longer happen.

HL only: calculation. Compare rents paid before and after: 120 × 60 = 7,200 cu before and 90 × 30 = 2,700 cu after. Landlord revenue falls by 4,500 cu. The welfare loss is a triangle with a base of the lost quantity (60 − 30 = 30) and a height of the gap between the demand price and the supply price at that quantity (180 − 90 = 90): ½ × 30 × 90 = 1,350 cu. This assumes the flats go to the renters who value them most.

Price floors (minimum prices)

A price floor is a legal minimum price. It only matters if it is set above equilibrium.

How to draw it. Draw D and S, mark Pe and Qe, then draw a horizontal line at the floor (Pmin) above Pe. The line meets D at Qd and S at Qs, and now Qs is to the right. The gap Qs − Qd is the surplus (excess supply).

Worked example (fictional). In the farming region of Veldmark, the market for barley has demand P = 120 − Q and supply P = 30 + 0.5Q. Quantity is in thousand tonnes and price is in cu per tonne. Equilibrium: 120 − Q = 30 + 0.5Q, so 1.5Q = 90, Q = 60 and P = 60. The government sets a floor of 75 cu.

Demand at 75:  75 = 120 - Q       ->  Q = 45
Supply at 75:  75 = 30 + 0.5Q     ->  Q = 90
Surplus = 90 - 45 = 45 thousand tonnes

If the government buys the surplus to keep the price at 75 cu, the cost is 45 × 75 = 3,375 cu. Farmers then sell 90 thousand tonnes at 75 cu, earning 6,750 cu instead of 3,600 cu. Buyers pay 75 cu a tonne for 45 thousand tonnes, which is 3,375 cu.

Consequences for stakeholders

• Farmers gain a higher price per tonne, and gain most if the government buys the surplus.
• Consumers face a higher price and buy fewer tonnes.
• Taxpayers pay for any purchases, and stored stock may be wasted or sold cheaply elsewhere.
• Resources are drawn into a product that the market does not need at that price.

Indirect taxes

An indirect tax is charged on a good or service, and the seller passes it on to the government. A per-unit tax is the simplest case to draw.

How to draw it

1. Draw D and S with Pe and Qe.
2. Shift S upwards by the amount of the tax. For any quantity, firms now need a price higher by the tax to keep the same take-home amount.
3. The new equilibrium has a higher price paid by the consumer (Pc) and a lower quantity (Qt).
4. The price the producer keeps is Pc minus the tax. Mark it on the original supply curve, directly below Pc at quantity Qt.
5. Shade the tax revenue: tax per unit × Qt.

Worked example (fictional). In the market for candles in the country of Orlen, demand is P = 150 − 2Q and supply is P = 30 + Q. Equilibrium: 150 − 2Q = 30 + Q, so Q = 40 and P = 70. The government adds a tax of 15 cu per candle.

New supply:  P = 30 + Q + 15 = 45 + Q
150 - 2Q = 45 + Q  ->  3Q = 105  ->  Q = 35
Price paid by consumers: 150 - 70 = 80
Price kept by producers: 80 - 15 = 65

Consumers pay 80 instead of 70, a rise of 10. Producers keep 65 instead of 70, a fall of 5. Consumers bear more of the tax because their demand is steeper (less responsive) than supply in this market.

HL only: calculation.

• Tax revenue: 15 × 35 = 525 cu.
• Consumer share: 10 × 35 = 350 cu. Producer share: 5 × 35 = 175 cu. The shares sum to 525 cu.
• Welfare loss: ½ × 15 × (40 − 35) = 37.5 cu.

Stakeholders. Consumers pay more, producers earn less and sell fewer candles, workers in the industry may lose hours, and the government gains revenue. The tax can also shift consumption away from a good the government wants people to buy less of.

Subsidies

A subsidy is money the state pays to a producer (or consumer) so that a good costs less to supply or buy.

How to draw it. Shift S downwards by the amount of the subsidy. The new equilibrium has a lower price paid by consumers and a higher quantity. The producer receives the consumer price plus the subsidy.

Worked example (fictional). In the city of Pellar, the market for monthly bus passes has demand P = 120 − Q and supply P = 30 + 2Q. Equilibrium: 3Q = 90, so Q = 30 and P = 90. The government pays a subsidy of 18 cu per pass.

New supply:  P = 30 + 2Q - 18 = 12 + 2Q
120 - Q = 12 + 2Q  ->  3Q = 108  ->  Q = 36
Price paid by consumers: 120 - 36 = 84
Price received by producers: 84 + 18 = 102

HL only: calculation.

• Cost to the government: 18 × 36 = 648 cu.
• Consumers gain 6 cu per pass: 6 × 36 = 216 cu. Producers gain 12 cu per pass: 12 × 36 = 432 cu. Together they equal 648 cu.
• Welfare loss from over-provision: ½ × 18 × (36 − 30) = 54 cu.

A subsidy only improves welfare if the market was producing too little in the first place, as with a positive externality. Without that, it pushes output beyond the efficient level.

Other forms of intervention

• Direct provision of services. The government supplies a service itself, such as a public clinic. This can help households that could not afford the service, but it is paid for by taxpayers.
• Command and control regulation and legislation. The government sets rules, such as a legal limit or a ban, and enforces them with penalties. It gives certainty but needs monitoring.
• Consumer nudges (HL only). A nudge changes how choices are presented without banning anything. A default option, such as automatic enrolment in a saving plan that people may leave, is an example.

Judging the consequences

The guide treats consequences for markets and stakeholders as an evaluation skill. Weigh these points.

• Size of the intervention. A ceiling set just below equilibrium causes a small shortage; one set far below causes a large one.
• Responsiveness. If demand and supply are inelastic, quantities change little but prices change a lot, and the reverse.
• Time. Supply is usually less responsive in the short run, so effects grow over time.
• Unintended effects. Black markets, falling quality, stockpiles and lost jobs.
• Who benefits. Check whether the intended group gains or someone else does.
• Cost. Subsidies and purchases need funding, and every cu spent has an opportunity cost.

Common errors

• Placing a ceiling over equilibrium or a floor under it, then claiming a shortage or surplus.
• Moving the demand curve when the policy acts on supply.
• Reading the producer’s price from the new curve rather than the original one.
• Forgetting that the tax per unit is the vertical gap between the two supply curves.
• Saying a tax “burden” is always shared equally. It depends on the slopes of the curves.
• Leaving labels off the axes, curves, and prices.
• Giving only a description when the question says “evaluate”.

Exam note

Paper 1 does not allow calculators; Paper 2 includes some quantitative questions; HL Paper 3 is a policy paper with quantitative and qualitative questions. In every case, show the steps. The command term “calculate” asks for the working to be shown.

Official syllabus

This page follows the IB Diploma Programme Economics guide, sub-topic 2.7 Role of government in microeconomics, first assessment 2022, published by the International Baccalaureate Organization in February 2020.