O LevelEconomicsCambridge (CIE)Revision Notes2. The Allocation of Resources2.10 Market FailureGovernment Intervention to Address Market Failure

Government Intervention to Address Market Failure (Cambridge (CIE) O Level Economics)

Revision Note

Steve Vorster

Intervention to Address Market Failure

  • Four of the most commonly used methods to address market failure in markets are indirect taxation, subsidies, maximum prices, & minimum prices  

  • Additional methods of intervention include regulation, nationalisation, privatisation, & State provision of public goods

Examiner Tip

The material on this page is frequently examined in the Paper 2 structured questions. You will be asked to evaluate the effectiveness of taxes, subsidies, maximum & minimum prices. To do so:

1. Consider the advantages & disadvantages of each method of intervention

2. Explain that several methods of intervention are likely to be more effective than a single method e.g. smoking is taxed & highly regulated (age restrictions, packaging restrictions, display restrictions)

3. Consider different market segments and their responsiveness e.g. wealthy consumers will less responsive (inelastic demand) to tax increases than poorer consumers (elastic demand)

Maximum Prices

  • A maximum price is set by the government below the existing free market equilibrium price and sellers cannot legally sell the good/service at a higher price 

  • Governments will often use maximum prices in order to help consumers. Sometimes they are used for long periods of time e.g. housing rental markets. Other times they are short-term solutions to unusual price increases e.g. petrol 

Supply and demand graph showing excess demand. "S" and "D" curves intersect at equilibrium price (Pe) and quantity (Qe). Maximum price (Pmax) leads to shortage between Qs and Qd.
The maximum price (Pmax) sits below the free market price (Pe) & creates a condition of excess demand (shortage)

Diagram analysis

  • The initial market equilibrium is at PeQe

  • A maximum price is imposed at Pmax

    • The lower price reduces the incentive to supply and there is a contraction in QS from Qe → Qs

    • The lower price increases the incentive to consume and there is an extension in QD from Qe → Qd

    • This creates a condition of excess demand QsQd 
        

The Advantages and Disadvantages of Using Maximum Prices


Advantages


Disadvantages

  • Some consumers benefit as they purchase at lower prices

  • They can stabilise markets in the short-term during periods of intense disruption e.g. Covid supplies at the start of the pandemic

  •  Some consumers are unable to purchase due to the shortage

  • The unmet demand usually encourages the creation of illegal markets (black/grey markets) as desperate buyers turn to illegal bidding

  • Maximum prices distort market forces and therefore can result in an inefficient allocation of scarce resources e.g. maximum prices in rentals in the property market create a shortage

Minimum Prices

  • A minimum price is set by the government above the existing free market equilibrium price and sellers cannot legally sell the good/service at a lower price 

  • Governments will often use minimum prices in order to help producers or to decrease consumption of a demerit good e.g. alcohol 

Graph showing excess supply with price on the y-axis and quantity on the x-axis. Supply (S) and demand (D) intersect at equilibrium price (Pe) and quantity (Qe).
The imposition of a minimum price (Pmin) above the free market price (Pe) creates a condition of excess supply (surplus)

Diagram analysis

  • The initial market equilibrium is at PeQe

  • A minimum price is imposed at Pmin

    • The higher price increases the incentive to supply & there is an extension in QS from Qe → Qs

    • The higher price decreases the incentive to consume & there is a contraction in QD from Qe → Qd

    • This creates a condition of excess supply QdQs 
           

The Advantages & Disadvantages of Using Minimum Prices in Product Markets

Advantages

Disadvantages

  • In agricultural markets, producers benefit as they receive a higher price (Governments will often purchase the excess supply & store it or export it) 

  • When used in demerit markets, output falls (Governments will not purchase the excess supply of a demerit good) 

  • Producers usually lower their output in the market to match the QD at the minimum price & this helps to reduce the external costs

  • It costs the government to purchase the excess supply & an opportunity cost is involved

  • Farmers may become over-dependent on the Government's help

  • Producers lower output which may result in an increase in unemployment in the industry


 Minimum prices in labour markets  

  • Minimum prices are also used in the labour market to protect workers from wage exploitation

    • These are called national minimum wages 

  • A national minimum wage (NMW) is a legally imposed wage level that employers must pay their workers

    • It is set above the market rate

    • The minimum wage/hour varies based on age 

A national minimum wage (NMW1) is imposed above the market wage rate (We) at W1
A national minimum wage (NMW1) is imposed above the market wage rate (We) at W1

Diagram analysis

  • The demand for labour (DL) represents the demand for workers by firms

  • The supply of labour (SL) represents the supply of labour by workers

  • The market equilibrium wage & quantity for truck drivers in the UK is seen at WeQe

  • The UK government imposes a national minimum wage (NMW) at W1

  • Incentivised by higher wages, the supply of labour increases from Qe to Qs

  • Facing higher production costs, the demand for labour by firms decreases from Qe to Qd

  • This means that at a wage rate of W1 there is excess supply of labour & the potential for unemployment equal to QdQs

The Advantages and Disadvantages of a Minimum Wage in Labour Markets

Advantages

Disadvantages

  • Guarantees a minimum income for the lowest paid workers

  • Higher income levels help to increase consumption in the economy

  • May incentivise workers to be more productive

  • Raises the costs of production for firms who may respond by raising the price of goods/services

  • If firms are unable to raise their prices, the introduction of a minimum wage may force them to lay off some workers (increase unemployment)

Indirect Taxation

  • An indirect tax is paid on the consumption of goods/services

    • It is only paid if consumers make a purchase

    • It is usually levied by the government on demerit goods to reduce the quantity demanded (QD) and/or to raise government revenue

    • Government revenue is used to fund government provision of goods/services e.g education

  • Indirect taxes are levied by the government on producers. This is why the supply curve shifts 

  • Producers and consumers each pay a share (incidence) of the tax
      

The impact of an indirect tax is split between the consumer (A) & the producer (B)
The impact of an indirect tax is split between the consumer (A) & the producer (B)

Diagram analysis

  • The government places a specific tax on a demerit good

    • The supply curve shifts left from S1→S2 by the amount of the tax

  • The price the consumer pays has increased from P1 before the tax, to P2 after the tax

  • The price the producer receives has decreased from P1 before the tax to P3 after the tax

  • The government receives tax revenue = (P2-P3) x Q2

    • The consumer incidence (share) of the tax is equal to area A: (P2-P1) x Q2

    • The producer incidence (share) of the tax is equal to area B: (P1-P3) x Q2

  • The QD in this market has decreased from Q1→Q2

    • If the decrease in QD is significant enough, it may force producers to lay off some workers


The Advantages & Disadvantages of Indirect Taxes

Advantages

Disadvantages

  • Reduces the quantity demanded of demerit goods

  • Raises revenue for government programs

  • The effectiveness of the tax in reducing the use of demerit goods depends on the price elasticity of demand (PED)

    • Many consumers who purchase products that are price inelastic in demand will continue to do so

  • It may help create illegal markets as consumers seek to avoid paying the taxes

  • Producers may be forced to lay off some workers as output falls due to the higher prices

Examiner Tip

This further develops the exam tip mentioned above. When analysing the impact of taxes on a market it is worth highlighting the elasticity of the product as it influences who pays more of the tax (producer or consumer).

The more price inelastic the product, the greater the proportion of the tax will be passed on to consumers by producers as the QD will fall  less proportionately than the price increase. The more price elastic the product, the smaller the proportion of the tax will be passed on to consumers by producers as the QD will fall  more proportionately than the price increase. (See sub-topic 2.7.2 for more on PED)

Producer Subsidies

  • A producer subsidy is a per unit amount of money given to a firm by the government

    • To increase production

    • To increase the provision of a merit good

  • The way a subsidy is shared between producers & consumers is determined by the price elasticity of demand (PED) of the product

    • Producers keep some of the subsidy & pass the rest on to the consumers in the form of lower prices

Supply and demand graph with subsidies illustrating benefits and costs. Area A shows consumer benefit, area B shows producer benefit, and A+B represents government subsidy cost.
A diagram which demonstrates the cost of a subsidy to the government (A+B) and the share received by the consumer (A) & producer (B)

Diagram analysis

  • The original equilibrium is at P1Q1

  • The subsidy shifts the supply curve from S → S + subsidy:

    • This increases the QD in the market from Q1→Q2

    • The new market equilibrium is P2Q2

    • This is a lower price and higher QD in the market

  • Producers receive P2 from the consumer PLUS the subsidy per unit from the government 

    • Producer revenue is therefore P3 x Q2

    • Producer share of the subsidy is marked B in the diagram

  • The subsidy decreases the price that consumers pay from P1 → P2

    • Consumer share of the subsidy is marked A in the diagram

  • The total cost to the government of the subsidy is (P3 - P2) x Q2 represented by area A+B
      

The Advantages & Disadvantages of Producer Subsidies

Advantages

Disadvantages

  • Can be targeted to helping specific industries

  • Lowers prices & increases demand for merit goods

  • Helps to change destructive consumer behaviour over a longer period of time e.g. subsidising electric cars makes them affordable and helps motorists to see them as an option for the masses - & not just the elite

  • Distorts the allocation of resources in markets e.g. it often results in excess supply when used in agricultural markets

  • There is an opportunity cost associated with the government expenditure - could the money have been better used elsewhere?

  • Subsidies are prone to political pressure & lobbying by powerful business interests e.g. most oil companies receive subsidies from their respective governments (despite making $billions in profits each year)

Other Government Policy Measures to Address Market Failure

Other Methods Used To Address Market Failure

Method

Explanation

Advantages

Disadvantages

State Provision of Public Goods

  • Public goods are beneficial for society & are not provided by private firms due to the free rider problem

  • Examples include roads, parks, lighthouses, national defence

  • They are usually provided free at the point of consumption

  • Accessible to everyone regardless of income

  • Usually provide both private & external benefits to society

  • Paid for through general taxation

  • There is an opportunity cost associated with their provision

  • Products which are free may result in excess demand & long waiting times e.g. procedures at Public hospitals

Privatisation

  • Privatisation occurs when governments transfer ownership & control of firms/assets from the State (public sector) to the private sector (private firms)

  • Many State firms are monopolies. By privatising them it encourages more competition in those markets

  • This should result in more efficiency & lower prices for consumers

  • Increases government revenue in the year the asset is sold

  • Private firms may run the business more efficiently

  • The government no longer needs to manage the business or hire people to work for it - this reduces government expenditure

  • Government assets are often sold well below their actual market value

  • Private firms often provide a sub standard good/service as they cut quality to increase profits

  • The price of the good/service usually increases as firms seek to maximise their profit e.g. energy prices in the UK market

  • Many privatised companies still maintain considerable market power & have to be regulated, e.g. water companies

Nationalisation

  • Nationalisation occurs when the Government takes control & ownership of firms which were in the private sector

  • This can generate efficiencies, especially when delivering utilities (gas, water, electricity) to the national population

  • It creates more equity in society as all citizens have the same access to the same resource at the same price e.g. Norway nationalised much of the oil industry when oil was first discovered in 1972. The profits belong to the citizens

  • The business can generate significant revenue for government

  • Government firms can often run very inefficiently

  • There is an opportunity cost associated with the money required to run it

  • The Government may lack the expertise to run the business

Regulation

  • Governments create rules to limit harm from the external costs of consumption/production

  • They often create regulatory agencies to monitor that the rules are not broken

  • Individuals or firms may be fined/imprisoned for breaking the rules e.g. selling cigarettes to minors is a punishable offence

  • They help to reduce the external costs of demerit goods

  • Fines can generate extra government revenue

  • Enforcing laws requires the government to hire more people to work for the regulatory agencies

  • Enforcing laws can be difficult as it is a complex process to determine if firms/consumers are breaking the laws

  • The regulation may create underground (illegal) markets which could generate even higher external costs on society

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