In the middle of a housing shortage, a city caps rents so that ordinary families can afford a flat. Within a few years there are fewer flats to rent than before, waiting lists are longer, and the lucky tenants who hold a cheap lease never move. Nobody intended that outcome. Every tool a government uses to fix a market works by changing prices or quantities, and each one has side effects that follow as predictably as the effect it was meant to have. Knowing both is the whole of this topic.
Mixed economic system
An economy in which resources are allocated partly by the price mechanism and partly by the government, with both a private sector and a public sector.
A mixed economy tries to keep the strengths of markets while correcting their failures. Its advantages are that the private sector still responds to consumer demand and competition still pushes firms to be efficient, while the government can provide public goods, encourage merit goods, discourage demerit goods, deal with external costs and reduce inequality. Its disadvantages come from the government side: intervention can be costly to run, it needs taxes that may weaken incentives, officials may lack the information to intervene well, and a policy can create new problems of its own. Where the line between market and state is drawn differs from country to country, and that choice is what the rest of this note is about.
Price controls
Maximum price
A legal upper limit on the price of a good, set below the equilibrium price to make it more affordable.
A maximum price only has an effect if it is set below the equilibrium price. At the lower price more people want to buy the good and firms want to sell less of it, so quantity demanded exceeds quantity supplied and a shortage appears. Because price is no longer allowed to ration the good, something else has to: queues, waiting lists, first come first served, or sellers choosing their favourite customers. Some buyers who cannot get the good legally will pay more for it illegally, so a black market often grows alongside a maximum price. Governments use maximum prices on essentials such as rented housing, bread or fuel, where the aim is to protect people on low incomes.
Reading a shortage from a demand and supply schedule
The monthly rental market for flats in a city is shown below. Rent $800: quantity demanded 6,000, quantity supplied 2,000. Rent $1,000: quantity demanded 5,000, quantity supplied 3,000. Rent $1,200: quantity demanded 4,000, quantity supplied 4,000. Rent $1,400: quantity demanded 3,000, quantity supplied 5,000. The government sets a maximum rent of $1,000. Identify the equilibrium, then calculate the effect of the maximum rent.
Draw a demand and supply diagram for rented flats. Mark the equilibrium rent and quantity. Draw a horizontal line for a maximum rent below the equilibrium, and label the quantity demanded, the quantity supplied and the shortage.
The maximum price line must be drawn below equilibrium. Drawn above it, the control does nothing, and examiners mark the diagram as showing no understanding of when a maximum price binds.
Minimum price
A legal lower limit on the price of a good, set above the equilibrium price to raise producers' incomes or to discourage consumption.
A minimum price works the other way round. Set above equilibrium, it makes firms want to supply more and consumers want to buy less, so a surplus appears. Minimum prices are used to guarantee farmers a stable income, in which case the government usually has to buy the surplus and store or destroy it, and to discourage harmful goods, such as a minimum price per unit of alcohol, where the aim is to make the cheapest and strongest drinks dearer. A national minimum wage is a minimum price for labour, and the same diagram applies to it.
Candidates regularly put the lines on the wrong side. A maximum price is below equilibrium and causes a shortage. A minimum price is above equilibrium and causes a surplus. If your maximum price is above the equilibrium, your diagram shows a control that does nothing, and the explanation that follows it cannot earn the marks.
A government sets a minimum price for wheat above the equilibrium price. What is the most likely result?
Taxes and subsidies
Indirect tax
A tax on spending, collected from the seller, which raises firms' costs and therefore the price of the good.
An indirect tax raises the cost of supplying each unit, so the supply curve shifts to the left, the price rises and the quantity bought falls. Governments use indirect taxes on demerit goods such as cigarettes, alcohol and sugary drinks, and on goods with external costs such as petrol, to reduce consumption and raise revenue at the same time. The advantages are that the tax discourages the harmful activity, raises money that can be spent on the damage, and leaves consumers free to choose. The disadvantages are that it falls hardest on people with low incomes, that it changes consumption very little when demand is inelastic, and that a high tax can encourage smuggling.
Subsidy
A payment by the government to producers that lowers their costs, so that more of a good is supplied at a lower price.
A subsidy has the opposite effect to a tax: it lowers producers' costs, so the supply curve shifts to the right, the price falls and the quantity bought rises. Subsidies are used to encourage merit goods such as public transport, vaccinations and renewable energy, and to keep essentials such as food affordable. They make the good cheaper and increase its use, but they cost the government money that must be raised elsewhere, they can keep inefficient firms in business, and once a subsidy exists it is politically difficult to remove.
Draw two demand and supply diagrams side by side. On the first, show an indirect tax on cigarettes shifting supply to the left, and mark the old and new price and quantity. On the second, show a subsidy on bus travel shifting supply to the right, and mark the old and new price and quantity.
Always label the new supply curve (S + tax, or S + subsidy) and show both equilibrium points. A diagram with only the shifted curve and no change marked on the axes earns little.
Other ways governments intervene
Regulation is a set of rules backed by law: bans on smoking in public places, minimum safety standards, limits on pollution, age limits on buying alcohol. It is quick and certain in its effect, but it has to be enforced, which costs money, and a firm that can gain from breaking a rule may do so if the chance of being caught is low. Direct provision means the government supplies a good itself, usually free at the point of use, as with state schools, public hospitals, street lighting and defence. It guarantees that public goods and merit goods are available to everyone, but it is paid for through taxes and, without competition, may be run inefficiently.
Nationalisation is the transfer of a firm or industry from private to state ownership. It lets the government run the industry in the public interest, which is why it is used for natural monopolies such as water supply or rail networks, but state firms face no profit motive and can become inefficient. Privatisation is the reverse, the sale of a state-owned firm to the private sector. The profit motive and, where it exists, competition can push the firm to cut costs and improve service, but a privatised monopoly may simply charge higher prices unless it is regulated. Quotas are limits on the quantity that can be produced or used, such as fishing quotas or limits on the extraction of oil and minerals, which protect a natural resource from being used up too quickly.
Questions asking whether a government should use one of these measures reward answers that match the tool to the problem. A tax suits a demerit good because it makes the buyer face more of the cost. Direct provision suits a public good because the market would supply none. Regulation suits a harm so serious that any amount is too much. An answer that describes the tool without saying which market failure it corrects rarely gets beyond the middle marks.
Which measure is most suitable for making sure a public good such as street lighting is provided?
Who really pays: incidence
At AS the question is not only what a tax does to the price but who ends up paying it. A specific tax is a fixed amount per unit, such as $1 on every packet, so it shifts the supply curve vertically upwards by exactly that amount. The price consumers pay rises, but usually by less than the tax, because as the price rises some buyers drop out and firms have to absorb part of the tax to keep selling. The formal incidence of the tax falls on the firm that hands it to the government. The effective incidence, which is what matters, is shared between buyers and sellers, and the split depends on the price elasticities of demand and supply.
Why the less responsive side of the market pays more of a tax
- The government puts a specific tax on each unit sold, so the supply curve shifts vertically upwards by the amount of the tax.
- At the old price there is now excess demand at the new cost of supply, so the market price rises.
- As the price rises, consumers buy less, which is a movement along the demand curve.
- If demand is price inelastic, consumers keep buying almost the same quantity, so firms can pass most of the tax on in a higher price.
- If demand is price elastic, consumers cut back sharply, so firms cannot raise the price much and must absorb most of the tax out of the price they keep.
- The same logic runs on the supply side: producers who cannot easily reduce output bear more of the tax.
- The burden therefore falls mainly on whichever side of the market is less able to respond to the price change.
This is the reason governments tax cigarettes, alcohol and fuel so heavily. Demand is inelastic, so the tax raises a lot of revenue, most of it paid by consumers, and it reduces consumption by less than people expect.
Practise this chain →Calculating the incidence of a specific tax
Before a tax, a good sells at $4.00 and 1,000 units are sold each week. The government imposes a specific tax of $1.00 per unit. The new market price is $4.70 and weekly sales fall to 800 units. Calculate the tax revenue, the share paid by consumers and the share paid by producers, and state what this suggests about elasticity.
Draw a market with relatively inelastic demand. Impose a specific tax by drawing S + tax parallel to and above the original supply curve. Mark the price consumers pay, the price producers keep, and the new quantity. Shade the consumer's share of the tax revenue and the producer's share in different ways.
The tax revenue is the rectangle between the price consumers pay and the price producers keep, over the new quantity. The part above the old price is paid by consumers; the part below it by producers. Candidates often shade the whole area between the supply curves instead, which is wrong.
A subsidy is a tax in reverse and its incidence is analysed the same way. A specific subsidy shifts supply vertically downwards by the amount of the subsidy. The price consumers pay falls, but usually by less than the subsidy, so part of the benefit goes to consumers as a lower price and part to producers as a higher price received. The more inelastic demand is, the more of the subsidy goes to producers; the more elastic demand is, the more reaches consumers. The cost to the government is the subsidy per unit multiplied by the new, larger quantity, which is why subsidies on goods with elastic demand become expensive very quickly.
Who gains from a subsidy, and what it costs
A good sells at $10.00 and 500 units are bought each week. The government pays producers a subsidy of $2.00 per unit. The price falls to $8.80 and weekly sales rise to 600. Calculate the cost to the government and how the benefit is split.
Price controls in more depth
How a maximum price creates a black market
- The government sets a maximum price below the equilibrium price.
- At the lower price quantity demanded rises and quantity supplied falls, so there is a shortage.
- Price can no longer ration the good, so some buyers who value it highly cannot obtain it legally.
- Those buyers are willing to pay well above the maximum price to get it.
- Some sellers, or buyers who obtained the good at the controlled price, resell it illegally at the higher price.
- A black market develops, where the price may end up higher than the original equilibrium, since supply at the legal price has fallen.
- The policy intended to help poorer consumers can leave them facing either no supply or a black market price they cannot afford.
The last step is the evaluation. A maximum price is most likely to help the people it targets when it is set only a little below equilibrium, when supply is inelastic so little output is lost, and when it is combined with a way of allocating the good fairly, such as rationing coupons.
Practise this chain →A minimum price creates the mirror-image problem. The surplus has to be dealt with, and each way of dealing with it has a cost. If the government buys it, taxpayers pay for goods nobody wanted at that price, which must then be stored, destroyed or sold abroad cheaply, damaging farmers in other countries. If nobody buys it, producers are left with unsold stock and the scheme does not raise their incomes as intended. A minimum price used to discourage consumption, such as a minimum price for alcohol, avoids this because the government has no reason to buy the surplus: the whole point is that less is bought.
Buffer stock scheme
A scheme in which an agency buys a commodity when its price falls to a floor and sells from its stock when the price rises to a ceiling, to keep the price within a band.
How a buffer stock stabilises prices, and why it tends to fail
- A buffer stock agency sets a floor price and a ceiling price for a commodity such as coffee or grain.
- After a good harvest, supply shifts right and the price falls towards the floor.
- The agency buys the surplus, adding to its stock, which holds the price at the floor and protects farmers' incomes.
- After a poor harvest, supply shifts left and the price rises towards the ceiling.
- The agency sells from its stock, adding to supply, which holds the price at the ceiling and protects consumers.
- The scheme only balances if good and bad harvests roughly cancel out over time.
- If the floor is set too high, the agency buys far more than it ever sells, its stocks grow, and it eventually runs out of money to keep buying, at which point the scheme collapses.
The political temptation is always to set the floor high, because farmers lobby for it. That is why buffer stocks usually fail in the direction of oversupply rather than shortage.
Practise this chain →Provision of information tackles the cause of some market failures rather than the price. Merit goods are under-consumed and demerit goods over-consumed partly because people misjudge the private costs and benefits. Health warnings on cigarette packets, calorie labels on food, campaigns about the benefits of vaccination and published league tables for schools all try to correct that misjudgement. Information is cheap compared with taxes and subsidies and leaves people free to choose, but its effect is often small, it works slowly, and it does nothing for problems that are not caused by lack of information, such as externalities that fall on other people.
A government imposes a specific tax of $2 on a good whose demand is perfectly price inelastic. Who bears the tax?
Applied context
Two contrasting uses of price policy on alcohol and sugar are worth knowing. Scotland introduced a minimum price per unit of alcohol in 2018, aimed at the cheapest strong drinks bought most by heavy drinkers, rather than taxing all alcohol equally. The UK's Soft Drinks Industry Levy, introduced the same year, charged producers more for drinks with more sugar, in bands, and many manufacturers reformulated their drinks to fall into a lower band before the levy took effect. The levy therefore changed the product rather than only the price, which is a reminder that firms respond to the design of a tax, not just to its size.
Use these to make a point about design: a policy targeted at the specific cause of harm can achieve more than a blunt tax on the whole product. That is a stronger evaluative point than describing either policy.
Incidence questions are lost by candidates who say that a tax 'is passed on to consumers' as if all of it always is. Say how much, and why: the share passed on depends on the relative elasticities of demand and supply. Draw the diagram with the price consumers pay and the price producers keep marked separately, and the analysis follows from it.