Government intervention in markets

Step 1. Find the equilibrium rent and quantity. Equilibrium is where quantity demanded equals quantity supplied. That happens at $1,200, where 4,000 flats are demanded and 4,000 are supplied.

Step 2. Check whether the maximum rent has any effect. $1,000 is below the equilibrium of $1,200, so the maximum rent binds. A maximum set above $1,200 would change nothing.

Step 3. Read the quantities at the maximum rent. At $1,000, 5,000 flats are demanded but only 3,000 are supplied.

Step 4. Calculate the shortage. Shortage = quantity demanded minus quantity supplied = 5,000 - 3,000 = 2,000 flats.

Step 5. State who gains and who loses. The 3,000 households who find a flat pay $200 a month less. But 1,000 fewer flats are rented than at equilibrium (3,000 against 4,000), and 2,000 households who want a flat at $1,000 cannot find one. The policy helps some tenants and harms others.

Step 5 is where the marks are. A maximum price does not make the good more available; it makes it cheaper for those who get it and less available overall. Say both halves.

Step 1. Calculate total tax revenue. Revenue = tax per unit x quantity sold after the tax = $1.00 x 800 = $800 a week.

Step 2. Find the consumer's share per unit. Consumers now pay $4.70 instead of $4.00, so they bear $0.70 of each $1.00 of tax.

Step 3. Find the producer's share per unit. The firm receives $4.70 but hands $1.00 to the government, so it keeps $3.70, which is $0.30 less than before. Producers bear $0.30 per unit.

Step 4. Convert to totals. Consumers pay $0.70 x 800 = $560 of the revenue. Producers pay $0.30 x 800 = $240. The two add up to the $800 collected, which is a useful check.

Step 5. Interpret. Consumers bear 70% of the tax. That means demand is less price elastic than supply in this market: buyers could not easily switch away, so sellers were able to pass most of the tax on.

Always check that the two shares add up to the tax per unit and the two totals add up to the revenue. It catches most arithmetic slips before the examiner does.

Step 1. Cost to the government. Cost = subsidy per unit x new quantity = $2.00 x 600 = $1,200 a week.

Step 2. Consumers' gain per unit. Consumers pay $8.80 instead of $10.00, a gain of $1.20 per unit.

Step 3. Producers' gain per unit. Producers receive $8.80 from the buyer plus $2.00 from the government, so $10.80 in total, which is $0.80 more than before.

Step 4. Check and interpret. $1.20 + $0.80 = $2.00, the full subsidy. Consumers receive 60% of the benefit and producers 40%. The subsidy has raised consumption by 100 units a week at a cost of $1,200, which is the figure a government would weigh against the benefit it wanted.

Step 1. Free market outcome. Set MPB = MPC: 40 - 0.02Q = 0.02Q, so 0.04Q = 40 and Q = 1,000. Price = 0.02 x 1,000 = $20.

Step 2. Social optimum. MSC = MPC + MEC = 6 + 0.02Q. Set MSB = MSC: 40 - 0.02Q = 6 + 0.02Q, so 0.04Q = 34 and Q = 850. Price = $23.

Step 3. Welfare loss in the free market. The triangle has a base of 1,000 - 850 = 150 units and a height of $6, the gap between MSC and MPB at Q = 1,000. Loss = 0.5 x 150 x 6 = $450.

Step 4. A correctly set tax of $6. The tax lifts MPC to 6 + 0.02Q, which is exactly MSC, so output falls to 850 and the welfare loss is eliminated. Consumers pay $23 and producers keep $17, so the $6 tax is split equally, which reflects equal slopes of the two curves here. Revenue = 6 x 850 = $5,100.

Step 5. Tax set at $10 by mistake. Output solves 40 - 0.02Q = 10 + 0.02Q, so Q = 750. Now output is 100 units below the optimum. At Q = 750, MSB = $25 and MSC = $21, a gap of $4. Loss = 0.5 x 100 x 4 = $200. Worse than a correct tax, but better than no tax.

Step 6. Tax set at $14 by mistake. Output solves 40 - 0.02Q = 14 + 0.02Q, so Q = 650, which is 200 units below the optimum. At Q = 650, MSB = $27 and MSC = $19, a gap of $8. Loss = 0.5 x 200 x 8 = $800, which is larger than the $450 loss with no intervention at all.

Step 6 is government failure in numbers. Overcorrecting an externality can do more harm than the externality did, and the error grows faster than the mistake in the estimate, because the triangle widens in both directions. This is the precise sense in which information problems limit intervention.

G, E, C, D, F, B, A

1. The government puts a specific tax on each unit sold, so the supply curve shifts vertically upwards by the amount of the tax.
2. At the old price there is now excess demand at the new cost of supply, so the market price rises.
3. As the price rises, consumers buy less, which is a movement along the demand curve.
4. 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.
5. 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.
6. The same logic runs on the supply side: producers who cannot easily reduce output bear more of the tax.
7. 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.

G, E, F, C, D, A, B

1. The government sets a maximum price below the equilibrium price.
2. At the lower price quantity demanded rises and quantity supplied falls, so there is a shortage.
3. Price can no longer ration the good, so some buyers who value it highly cannot obtain it legally.
4. Those buyers are willing to pay well above the maximum price to get it.
5. Some sellers, or buyers who obtained the good at the controlled price, resell it illegally at the higher price.
6. A black market develops, where the price may end up higher than the original equilibrium, since supply at the legal price has fallen.
7. 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.

D, A, F, C, B, G, E

1. A buffer stock agency sets a floor price and a ceiling price for a commodity such as coffee or grain.
2. After a good harvest, supply shifts right and the price falls towards the floor.
3. The agency buys the surplus, adding to its stock, which holds the price at the floor and protects farmers' incomes.
4. After a poor harvest, supply shifts left and the price rises towards the ceiling.
5. The agency sells from its stock, adding to supply, which holds the price at the ceiling and protects consumers.
6. The scheme only balances if good and bad harvests roughly cancel out over time.
7. 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.

E, F, A, G, D, C, B

1. A government subsidises a domestic industry to protect jobs, treating it as if it created external benefits.
2. The subsidy lowers the industry's costs, so output and employment are higher than the market would support.
3. Because the industry does not in fact create external benefits of that size, output is now above the social optimum.
4. Resources such as labour and capital are held in an industry where their value is lower than it would be elsewhere.
5. The subsidy must be funded by taxes, which distort other markets, or by borrowing.
6. Firms that depend on the subsidy lobby to keep it, so it continues long after any original justification has passed.
7. The result is a deadweight loss created by the intervention itself, which is government failure rather than market failure.

The key step is the third one: intervention improves allocation only if it is sized to a real external effect. The chain is a template for any question asking whether intervention always improves resource allocation.

Define and frame: Define market failure and allocative efficiency, and define government failure. Identify 'always' as the word under test: a single well-argued case of intervention making things worse defeats it. State that the answer depends on the type of failure, the tool chosen and the information the government has.

Analysis: when intervention improves allocation: Take one failure and run the full chain with a diagram. A negative externality corrected by a tax equal to the marginal external cost moves output to where MSB = MSC and removes the welfare loss. Add a second case where the market provides nothing, such as a public good, where direct provision is clearly better than no provision.

Analysis: when it does not: Use government failure properly, with mechanisms rather than a list. The external cost cannot be measured, so the tax is set at the wrong level. A maximum price creates a shortage and a black market. A subsidy protects an industry that creates no external benefit and keeps resources in low-value uses. Regulators may be captured.

Evaluation: Weigh the two sides. The comparison is between an imperfect market and an imperfect government, not between either and an ideal. Intervention is most likely to help where the failure is large, the harm can be measured, and the tool targets its cause. It is least likely to help where information is poor and the policy invites lobbying. Tool choice matters as much as the decision to intervene: the same aim can be pursued by a blunt tool or a well-designed one.

Judgement: Reject 'always'. Conclude that intervention improves allocation when the expected government failure is smaller than the market failure it corrects, and say what makes that likely: good information, a targeted tool, and independent regulation. A conclusion that names the conditions will outscore one that says intervention is sometimes good and sometimes bad.