OxfordAQA International AS and A-level Economics: Government intervention and government failure (9640)

This guide follows the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2. It covers sections 3.1.5.7 (government intervention in markets) and 3.1.5.8 (government failure). Both sit inside section 3.1, which the specification lists as International AS content. All the figures are invented and the countries and markets are illustrative.

Why markets fail is taught in separate pages. Here you start from the idea that failure exists and ask what governments can do, and when they make things worse. The calculations use the quantitative skills in section 3.5, which can be assessed in any unit. Go to the revision notes for a short version and the practice questions to test yourself. Course pages: OxfordAQA A-level Economics hub and checklist. Find weak spots with a free diagnostic.

What you must be able to do

Section	Specification content	What it means in practice
3.1.5.7	Market failure is an argument for intervention	Link a failure to a justified response
3.1.5.7	Public expenditure, taxation, regulation; government objectives	Explain how each shifts resources and why aims differ
3.1.5.7	Indirect taxes, subsidies, price controls, buffer stocks, pollution permits, property rights, state provision, regulation	Explain each, show it on a diagram, analyse the winners and losers
3.1.5.7	Taxes and spending can reduce inequality	Show how with a worked calculation
3.1.5.7	Evaluate the case for and against, and compare methods	Reach a reasoned judgement
3.1.5.8	Government failure; its sources; unintended consequences	Explain how intervention can lower welfare

1. The case for intervening, and the tools

If a market leaves resources misallocated, there is an argument for intervening. It is only an argument: could the government do better than the market?

Governments influence resource allocation in three broad ways:

• Public expenditure: spending on goods, services and transfers, including subsidies and state provision.
• Taxation: changing prices and incomes through direct taxes (on income) and indirect taxes (on spending).
• Regulation: rules that require, limit or ban behaviour.

Governments have several objectives, such as efficiency, a fairer distribution of income, protecting the environment, stable prices and a balanced budget. A government that weights fairness heavily will favour progressive taxes and spending on health; one that weights low taxation heavily will prefer lighter rules. So the mix of market and state differs between mixed economies.

For any policy, name the consumers, producers and third parties affected, and say who gains and loses.

2. Indirect taxes

An indirect tax adds to firms’ costs. A specific tax is a fixed amount per unit. On a supply and demand diagram the supply curve moves up by a vertical distance equal to the tax.

Worked example (Country A, market for a good with a negative externality). Demand: Qd = 120 − 10P. Supply: Qs = 20P − 60. Quantity is in thousands of units. The tax is 3 per unit.

Before tax: 120 − 10P = 20P − 60  →  P = 6, Q = 60
Supply after tax: Qs = 20(P − 3) − 60 = 20P − 120
After tax:  120 − 10P = 20P − 120  →  P = 8, Q = 40
Consumers pay 8 − 6 = 2 more.  Producers keep 8 − 3 = 5, which is 1 less than 6.
Tax revenue = 3 × 40 = 120

Consumers bear 2 of the 3 (two thirds). This matches the elasticities at the original equilibrium: price elasticity of demand = −10 × 6/60 = −1, and price elasticity of supply = 20 × 6/60 = 2. The less elastic side bears more of the tax. Price rises 33.3% and quantity falls 33.3%.

Suppose each unit imposes an external cost of 3 on third parties. At Q = 60 the last unit is worth (120 − 60)/10 = 6 to buyers but costs society 6 + 3 = 9. The welfare loss from overproduction between 40 and 60 is ½ × 20 × 3 = 30. At Q = 40, buyers’ value is 8 and cost to society is 5 + 3 = 8, so the tax removes the loss.

Evaluation points. The tax works only if it matches the true external cost, which is hard to measure. If demand is inelastic, output barely falls, so the tax raises revenue but corrects little. It can also be regressive.

3. Subsidies

A subsidy lowers firms’ costs and shifts supply downward by the amount of the subsidy.

Worked example (a city, home insulation). Qd = 100 − 10P, Qs = 15P − 50, subsidy 2.5 per unit.

Before: 100 − 10P = 15P − 50  →  P = 6, Q = 40
Supply with subsidy: Qs = 15(P + 2.5) − 50 = 15P − 12.5
After:  100 − 10P = 15P − 12.5  →  P = 4.5, Q = 55
Consumers pay 1.5 less. Producers receive 4.5 + 2.5 = 7, which is 1 more.
Cost to government = 2.5 × 55 = 137.5

Buyers gain more because demand is less elastic than supply here (consumers’ share is 1.5/2.5 = 60%). If each unit gives a 2.5 external benefit, output of 55 is the socially best level and the subsidy corrects underproduction. Taxpayers fund the 137.5, and its opportunity cost is what the money could have done elsewhere.

4. Price controls

Maximum price (price ceiling). Set below equilibrium it creates excess demand. Take a staple food with Qd = 1000 − 100P and Qs = 150P − 250. Equilibrium is P = 5, Q = 500. A cap at 3.5 (30% below equilibrium) gives:

Qd = 1000 − 350 = 650     Qs = 525 − 250 = 275
Shortage = 650 − 275 = 375;  quantity traded falls by 45%

Consumers who can buy gain a lower price; those who cannot lose; producers sell less at a lower price. Queues, black markets and falling quality may follow.

Minimum price (price floor). Set above equilibrium it creates excess supply. In the same market a floor at 7 gives Qd = 300 and Qs = 800, a surplus of 500. If the government buys the surplus, it spends 7 × 500 = 3,500. Producers gain; consumers and taxpayers lose.

5. Buffer stocks

A buffer stock scheme tries to stabilise the price of a product with unpredictable supply, such as a crop. The authority sets a price band, buying when the price would fall below the floor and selling when it would exceed the ceiling.

Worked example (a crop in Country B). Demand is P = 20 − Q/10 (Q in tonnes, thousands). Floor 9, ceiling 11. At 9, buyers take 110; at 11, they take 90.

Year	Harvest	Price with no scheme	What the authority does	Stock after	Price
1	130	7	Buys 20 at 9 (spends 180)	20	9
2	100	10	Nothing	20	10
3	80	12	Sells 10	10	11
4	70	13	Wants to sell 20, has 10	0	12

In year 4 the stock runs out, so the price exceeds the ceiling. Storage costs money, goods may deteriorate, and the authority must judge the long-run price. If the band is set too high, stocks keep growing.

6. Pollution permits and property rights

Tradable permits. The government sets a cap on total pollution and issues permits. Firms can trade them. Three firms each emit 30 tonnes; the cap is 60, so 30 tonnes must be cut. Abatement costs per tonne are 8 (firm X), 14 (firm Y) and 30 (firm Z). X and Y can each cut at most 20 tonnes. Each firm gets 20 permits.

Equal cuts of 10 each: 10×8 + 10×14 + 10×30 = 520
Trading: X cuts 20 (160), Y cuts 10 (140), Z cuts none = 300

Z buys 10 permits. The price settles at 14, the cost of the marginal firm, and total cost falls by 220 (42.3%). Permits give certainty about the quantity of pollution, but the price is uncertain.

Extension of property rights. Many externalities arise because nobody owns a resource, such as an open fishing ground. Giving owners or users enforceable rights gives them a reason to protect the resource, and others have to pay to use it. It works poorly where rights cannot be defined or enforced, such as the air.

7. State provision and regulation

State provision means the government pays for, and may supply, a good such as street lighting. It overcomes free riding and can widen access, but taxpayers bear the cost and public suppliers may lack the incentive to cut costs.

Regulation sets rules, such as an emissions limit or a ban. It is direct and the result is certain if rules are obeyed. But firms differ in how cheaply they can comply, so it can cost more than a tax or permits, and it needs monitoring.

8. Using taxes and spending to reduce inequality

Taxes and spending can narrow gaps in income. Country C taxes income at 0% up to 12,000, 15% on the slice from 12,000 to 50,000 and 35% on the slice above 50,000.

	Income	Tax	Average rate	Income after tax
Household L	40,000	15% × 28,000 = 4,200	10.5%	35,800
Household H	120,000	5,700 + 35% × 70,000 = 30,200	25.2%	89,800

Before tax H earns 3 times L; after tax, 2.51 times. If L also receives a benefit of 2,500, L has 38,300 and the ratio is 2.34. A progressive tax takes a higher share as income rises. Benefits and free health or education raise low-income households’ living standards.

The trade-off is incentives: high marginal rates may reduce work effort.

9. Judging a policy

To assess relative merits, compare options on the same criteria: effectiveness (how large is the response, given the elasticities?), cost to government, firms and taxpayers, fairness (who pays and who gains?), the information needed, side effects and speed. Then say which method suits this case, and why. A tax suits a pollutant where firms’ abatement costs differ widely; a ban suits a hazard with severe, irreversible harm.

10. Government failure

Government failure is intervention that leaves resources worse allocated and economic welfare lower than before. The specification names four sources and one general outcome.

• Inadequate information. Governments do not know the true external cost or benefit, or demand and cost conditions. Worked example: using the insulation market, suppose the true external benefit is 1.0 rather than 2.5. The best subsidy is 1.0, giving Q = 46. Subsidising by 2.5 gives Q = 55. At 55, the value to society of the last unit is 4.5 + 1.0 = 5.5, but it costs 7.0 to produce, so there is a welfare loss of ½ × 9 × 1.5 = 6.75 from over-provision, plus the extra spending.
• Inappropriate or conflicting objectives. Cutting a fuel tax to protect living standards conflicts with reducing emissions. Election cycles can favour visible benefits now and costs later.
• Administrative costs. Monitoring, enforcement and running a scheme use resources. If a permit scheme gives an environmental benefit of 90 but costs 12 to run, the net gain is 78, below the headline figure.
• Corruption. Officials may allocate permits, contracts or licences in return for favours, so resources go to the best-connected firm and not the best use.
• Unintended consequences. A price ceiling can produce black markets; a floor can create surpluses and waste; a ban can push trade underground.

To evaluate, compare the size of the market failure with the size of the likely government failure. Intervention is justified when the first is larger and the second can be limited, for example by reviewing schemes and allocating permits transparently.

Common errors

• Shifting the wrong curve: taxes and subsidies move supply, not demand.
• Reading the tax from the price change. The gap between the supply curves is the tax; the price change is only the consumers’ share.
• Saying a maximum price lowers the price without mentioning the shortage.
• Treating government failure as a reason never to intervene. It is a reason to compare outcomes.

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.