OxfordAQA A-level Economics: Government intervention and government failure (9640) – Revision Notes

These notes condense sections 3.1.5.7 (government intervention in markets) and 3.1.5.8 (government failure) of the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2. Both sections are in section 3.1, which is International AS content. For full explanations and longer worked examples, use the study guide. Then try the practice questions. Course pages: OxfordAQA A-level Economics hub and checklist. All figures below are invented and illustrative. For elasticity revision, see the pages on demand elasticities and supply elasticity.

Key definitions

Term	Meaning
Market failure	A market misallocates resources
Public expenditure	Government spending on goods, services, transfers and subsidies
Indirect tax	A tax on spending; adds to firms’ costs and shifts supply up by the tax
Subsidy	A payment to producers that lowers costs and shifts supply down
Maximum price	A legal ceiling; binding when set below equilibrium
Minimum price	A legal floor; binding when set above equilibrium
Buffer stock	A store bought and sold to hold a price within a band
Tradable pollution permit	A right to emit a set amount, which can be bought and sold under a cap
Property rights	Enforceable ownership or use rights over a resource
Government failure	Intervention that leads to a worse allocation of resources and a fall in economic welfare

The tools at a glance

Tool	How it works	Main gains	Main risks
Indirect tax	Raises cost, cuts output	Corrects overproduction; raises revenue	Hard to set at the right level; regressive; weak if demand is inelastic
Subsidy	Lowers cost, raises output	Corrects underproduction	Costs taxpayers; may be set too high; waste
Maximum price	Holds price below equilibrium	Lower price for those who can buy	Shortage, queues, black market, lower quality
Minimum price	Holds price above equilibrium	Higher income for sellers	Surplus, cost of buying it, higher prices for buyers
Buffer stock	Buys when price is low, sells when high	Stabler prices	Storage cost; stock may run out or grow
Pollution permits	Cap on total pollution, tradable	Certain total pollution; lowest-cost cuts	Cap may be wrong; price uncertain; monitoring
Property rights	Owners protect what they own	Removes the cause of some externalities	Hard to define or enforce
State provision	Government funds or supplies	Overcomes free riding; wider access	Taxpayer cost; weak cost control
Regulation	Rules, limits and bans	Direct and certain	Costly to enforce; ignores firms’ cost differences

Method: tax or subsidy calculation

1. Find the original equilibrium by setting Qd = Qs.
2. Shift supply. For a tax t, write (P − t) wherever P appears in the supply equation; for a subsidy s, write (P + s).
3. Find the new price and quantity from the shifted equation.
4. Consumers’ burden (or gain) is the change in the market price. Producers’ share is the tax (or subsidy) minus that change.
5. Revenue (or cost) is the amount per unit times the new quantity.

Worked reminder (inelastic demand). Qd = 100 − 4P, Qs = 16P − 20, tax 5.

Before: 100 − 4P = 16P − 20  →  P = 6, Q = 76     PED = −4 × 6/76 = −0.32
Supply after tax: Qs = 16(P − 5) − 20 = 16P − 100
After:  100 − 4P = 16P − 100  →  P = 10, Q = 60
Consumers pay 4 of the 5 (80%). Revenue = 5 × 60 = 300. Quantity falls 21.1%.

Demand is inelastic, so consumers bear most of the tax and output falls proportionately less than price rises: good for revenue, weak for correcting an externality.

Rule for a small tax: consumers’ share = PES ÷ (PES + the size of PED). With PES 1.5 and PED −0.5, consumers bear 1.5/2.0 = 75%.

Method: evaluating any intervention

Use this chain: (1) name the failure; (2) explain how the tool works; (3) analyse effects on consumers, producers, taxpayers and third parties; (4) give a cost or risk, including a possible government failure; (5) judge, using size, elasticity, time and information as your reasons.

Useful evaluation words: depends on elasticity; depends on how accurately the failure is measured; short run versus long run; fairness (a value judgement); cost of administration; compared with a different tool.

Equity: taxes and spending

A progressive tax takes a larger share of income as income rises. Worked reminder. Tax is 0% up to 5,000 and 30% above.

Income 15,000: tax 30% × 10,000 = 3,000  (average rate 20%)   after tax 12,000
Income 45,000: tax 30% × 40,000 = 12,000 (average rate 26.7%)  after tax 33,000
Ratio before tax 3.0; after tax 33,000/12,000 = 2.75

Spending on benefits, health and education raises low incomes further. Evaluation: higher marginal rates may reduce incentives, and how much redistribution is fair is a value judgement.

Buffer stock rule

Set a floor and a ceiling. If the free-market price would fall below the floor, buy and add to stock. If it would rise above the ceiling, sell from stock. If the price is inside the band, do nothing. Check whether stock is enough: when it runs out, the ceiling cannot be defended. A floor above the long-run price makes stocks pile up and storage costs rise.

Permit rule

The cap fixes total pollution. The firms with the lowest abatement cost cut the most and sell permits to the firms with the highest cost. The permit price settles near the abatement cost of the marginal firm. If the permit price is 15, a firm whose cost is 12 per tonne cuts more and sells; a firm whose cost is 20 buys.

Government failure

Source	Chain of reasoning
Inadequate information	Government misjudges the external benefit or cost, so the policy overshoots or undershoots and creates a new welfare loss
Inappropriate or conflicting objectives	One aim (low prices, popularity) undermines another (the environment, budget); short-term focus
Administrative costs	Monitoring and enforcement use resources, which reduces the net benefit
Corruption	Resources go to the connected, not to the best use
Unintended consequences	Behaviour changes in ways the policy did not plan, such as black markets

Judge by comparing the size of the market failure with the likely size of the government failure. The specification wants you to see that intervention can raise welfare and that it can lower it.

Must-know distinctions

• Tax per unit versus change in price: the tax is the vertical gap between supply curves; the price rise is the consumers’ share.
• Maximum price (shortage) versus minimum price (surplus).
• Market failure (the reason to act) versus government failure (the risk of acting).
• Specific tax (fixed amount per unit) versus a percentage tax (the supply curve pivots).
• Progressive tax (rising average rate) versus regressive (falling average rate).

Quick self-test

1. A specific tax of 2 raises the market price from 10 to 11.5. How much do consumers bear, and what percentage is that?
2. After the tax in question 1 the quantity sold is 80. What is the tax revenue?
3. A subsidy of 3 per unit lowers the market price from 12 to 10.5. What price do producers effectively receive, and by how much have they gained?
4. Qd = 160 − 8P and Qs = 12P − 40. Find equilibrium, then the shortage if a maximum price of 8 is set.
5. In the same market a minimum price of 12 is set. Find the surplus and the cost of the government buying it all.
6. A buffer stock authority has a band of 20 to 30. What does it do if the price would be 15, and if it would be 35?
7. The permit price is 15. A firm’s abatement cost is 20 per tonne. Does it buy or sell permits?
8. State two sources of government failure.
9. A tax of 4 is added to a good priced at 20. Consumers bear 75%. What is the percentage rise in the price paid?
10. Give one unintended consequence of a binding price ceiling.

Answers

1. The price rose by 1.5, so consumers bear 1.5, which is 75% of the tax. Producers bear 0.5.
2. 2 × 80 = 160.
3. 10.5 + 3 = 13.5, up from 12 by 1.5.
4. 160 − 8P = 12P − 40, so P = 10, Q = 80. At 8: Qd = 96, Qs = 56, shortage 40.
5. At 12: Qd = 64, Qs = 104, surplus 40; cost 40 × 12 = 480.
6. At 15 it buys, because the price is below the floor of 20. At 35 it sells from stock, if it has any.
7. It buys, because buying at 15 is cheaper than cutting at 20.
8. Any two of: inadequate information; inappropriate or conflicting objectives; administrative costs; corruption.
9. Consumers bear 75% × 4 = 3, and 3/20 = 15%.
10. A black market, or reduced quality, or rationing by queue.

Where marks are usually lost

• Drawing the tax as a shift of demand, or labelling the gap between old and new price as the tax.
• Forgetting that a tax raises price by less than the tax unless supply is perfectly elastic or demand perfectly inelastic.
• Describing a policy without saying who gains and who loses.
• Giving a list of tools with no judgement about which suits this market and why.
• Using the phrase “government failure” without a source and a chain of reasoning.
• Treating the price ceiling as helping everyone, and ignoring the shortage.
• Quoting an elasticity without saying what it means for the outcome.
• Stating that inequality is unfair as fact; fairness is a value judgement.
• Dropping working in calculations, such as the shifted supply equation.

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Official syllabus

OxfordAQA International AS and A-level Economics (9640) specification, version 1.2, published by OxfordAQA: sections 3.1.5.7 and 3.1.5.8, with the quantitative skills in section 3.5.