Explain intervention
Show why public goods, information failure and socially unacceptable market outcomes may lead governments to intervene.
The government in the microeconomy
Markets can coordinate resources through prices, but they do not always produce outcomes that governments consider efficient or socially desirable. This chapter explains why governments intervene, the main intervention tools they use, and how policies can influence prices, output, inequality and the distribution of resources.
Market interventionTaxes & subsidiesPrice controlsBuffer stocksInequality & redistribution
What this chapter prepares you to do
Analyse policies
Use demand and supply diagrams to explain specific indirect taxes, subsidies, minimum prices and maximum prices.
Judge effectiveness
Explain why elasticity, administration costs, incentives and unintended consequences matter when evaluating intervention.
Analyse inequality
Distinguish income from wealth, interpret the Gini coefficient, and explain policies used to redistribute income and wealth.
High-grade habit: never stop at naming a policy. Trace the full chain: policy → curve or price change → new market outcome → who gains/loses → limitation or condition affecting effectiveness.
Chapter sections
5.1
Reasons for government intervention in markets
For a mixed economy to work effectively, government first provides the framework within which markets operate. This includes political stability and secure property rights, so households and firms can make decisions with confidence. Government may intervene more actively when free-market outcomes do not allocate resources effectively or are considered socially unacceptable.
Public goods and the free-rider problem
Public goodA good that is non-excludable, non-rival and non-rejectable once provided.
Free-rider problemBecause people cannot easily be excluded from consuming a public good, they have an incentive to benefit without paying for it.
A private firm may be unable to charge every user of a pure public good. If people expect to receive the benefit whether or not they pay, the firm may be unable to earn enough revenue to make provision profitable. Important services such as street lighting or national defence may therefore require government action to ensure provision.
Extension insight: for a public good, the benefit enjoyed by different consumers occurs simultaneously. The social benefit from an extra amount therefore reflects the combined willingness to pay of users. The difficulty is collecting payment when consumers can free-ride.
Easy book example — street lighting: Once a street has been lit, people walking along it benefit whether or not they personally paid for the lighting. Because non-payers cannot easily be excluded, each person has an incentive to wait for others to pay. That free-rider problem can leave a private market with too little or no provision.
Merit and demerit goods
Merit good
Consumers underestimate the benefits, so the good tends to be under-consumed in a free market. Education and vaccination are common examples.
Demerit good
Consumers underestimate costs or overvalue benefits, so the good tends to be over-consumed. Tobacco is a common example.
The central problem is information failure. If consumers do not fully understand the long-run consequences of their choices, too few resources may go to merit goods and too many to demerit goods. Government may intervene to change prices, provide the good, or improve information.
Market prices may be considered inappropriate
Government may also regard a market price as too high or too low. High rents may make housing unaffordable for low-income households, while very low agricultural prices may leave farmers with inadequate incomes. These concerns can lead to maximum or minimum price controls.
Exam warning: saying “the government intervenes because prices are high” is not enough. Explain the problem created by the market outcome and then connect it to the chosen policy.
5.2
Methods and effects of government intervention in markets
Specific indirect taxes
Indirect taxA tax on expenditure on a good or service rather than a tax charged directly on an individual's income.
Specific taxA fixed amount of tax charged per unit of a commodity.
A specific indirect tax raises the cost associated with supplying each unit. Firms are therefore willing to supply less at every market price. The supply curve shifts vertically upwards/left by the amount of the tax. The new equilibrium normally has a higher price paid by consumers and a lower quantity traded.
The effects of an indirect tax on cigarettes
A specific tax shifts the supply curve vertically upwards by the amount of the tax. The market quantity falls from Q₀ to Q₁. Consumers pay P₁, while producers receive P₁ − tax; the gap between these two prices is the tax per unit. Because the consumer price rises by less than the full tax, the burden is shared between buyers and sellers.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Tax incidence: who bears the burden?
Incidence of a taxThe way the burden of a sales tax is divided between buyers and sellers.
The seller may physically pay the tax to government, but that does not mean the seller bears all of its economic burden. Part can be passed to consumers through a higher market price.
| Demand condition | Likely incidence in the chapter's limiting case | Reason |
|---|---|---|
| Perfectly inelastic demand | Buyers bear the whole tax | Quantity demanded does not respond to price, so the tax can be passed on through price. |
| Perfectly elastic demand | Sellers bear the whole tax | A price rise would cause demand to fall to zero, so sellers cannot pass the tax on. |
| Normal case | Burden is shared | Price rises by less than the full tax, so consumers and producers each bear part. |
Subsidies
SubsidyA government grant to producers designed to encourage production of a good or service.
A subsidy works like a negative indirect tax. It reduces the effective cost of production and shifts supply down/right. The equilibrium price paid by consumers falls and the quantity traded rises. The benefit is shared between consumers and producers.
The effect of a subsidy
A subsidy reduces the effective cost of supplying the good, shifting supply downwards/right. The price paid by consumers falls from P₀ to P₁, while the quantity traded increases from Q₀ to Q₁. The gain from the subsidy is shared between consumers and producers.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Easy book example — a museum: If the government regards museum visits as a merit good, it can subsidise provision. The subsidy lowers the effective cost to suppliers, so the market price can fall and more people can visit. The size of the increase still depends on how responsive demand and supply are to the price change.
The effect of a subsidy depends on responsiveness. If demand is very inelastic, a lower price may generate only a small increase in consumption. If firms cannot expand output easily, an inelastic supply response can also limit the increase in production.
Direct government provision
Government may ensure that important public or merit goods are provided. This does not always mean the government must produce them itself: it can raise funds through taxation and contract a private organisation or local authority to provide the service.
Possible benefit
Ensures provision where the free-rider problem or information failure would otherwise cause under-provision.
Administrative cost
Policies must be organised, monitored and enforced, using scarce resources.
Policy test
The marginal benefit from intervention should be weighed against the marginal cost of implementing and monitoring it.
Minimum prices: the example of a minimum wage
Minimum wageA legally enforced wage below which firms are not allowed to pay workers.
If a minimum wage is set above the competitive equilibrium wage, firms demand less labour while more workers offer their labour. The result is excess supply of labour: unemployment. A minimum wage set below the equilibrium wage is non-binding and does not alter the market outcome.
A minimum wage
Without intervention, the labour market clears at W* and L*. A minimum wage at Wmin, set above equilibrium, reduces labour demanded to Ld and increases labour supplied to Ls. The gap Ls − Ld is excess supply of labour, shown as unemployment in the competitive-market model.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Evaluation point: this result assumes a competitive labour market. If employers possess market power and pay wages below the competitive level, the effect of a minimum wage can be different and employment may rise.
Maximum prices: the example of rent controls
A government may impose a maximum price below equilibrium to make an essential good more affordable. In a rental market, a binding rent ceiling reduces the rent landlords can charge. Quantity supplied falls while quantity demanded rises, creating excess demand.
Rent controls
The free-market rent is R*. A maximum rent at Rmax, set below equilibrium, makes rented accommodation cheaper but reduces the quantity landlords supply to Qs while increasing quantity demanded to Qd. The result is a shortage of Qd − Qs.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Price controls can create rationing problems, unofficial markets, losses for suppliers who cannot sell at a controlled price, and administrative costs. The intended objective may therefore be only partly achieved.
Buffer stock schemes
Buffer stockA scheme that aims to stabilise a commodity price by buying excess supply when supply is high and releasing stocks when supply is low.
Agricultural supply can vary sharply because of weather, disease and harvest conditions. Large price fluctuations make producers' future income uncertain and can discourage investment. A buffer stock authority sets a target price and intervenes in the market.
Good harvestSupply is high and market price tends to fall.
→Authority buys surplusExcess output is stored, supporting the target price.
→Poor harvestStocks are released to increase market supply and prevent a sharp price rise.
Limitation: if the target price is set too high relative to the market's average equilibrium price, the authority may repeatedly buy more than it sells. Stocks and storage costs then accumulate and the scheme can become unsustainable.
Provision of information
Where the underlying problem is information failure, government can try to improve consumers' knowledge. Campaigns about the health effects of smoking may reduce demand for a demerit good, while accurate information about vaccination may encourage consumption of a merit good. Effectiveness depends on whether people trust and act on the information; habits and addiction may weaken the response.
| Policy | Typical purpose | Main market effect / issue |
|---|---|---|
| Specific indirect tax | Discourage a demerit good | Supply shifts left/up; price rises and quantity falls. |
| Subsidy | Encourage production/consumption | Supply shifts right/down; price falls and quantity rises. |
| Direct provision | Ensure access to public or merit goods | Can overcome under-provision but creates fiscal and administrative costs. |
| Minimum price | Raise a price regarded as too low | If above equilibrium, can create excess supply. |
| Maximum price | Lower a price regarded as too high | If below equilibrium, can create excess demand. |
| Buffer stock | Stabilise volatile commodity prices | Authority buys in surplus periods and sells from stocks in shortage periods. |
| Information | Correct information failure | Attempts to change preferences and consumption decisions. |
5.3
Addressing income and wealth inequality
Income and wealth
Income
A flow of wages, salaries and earnings from other sources received over a period of time.
Wealth
A stock of accumulated assets, such as property and financial assets, owned at a point in time.
Income and wealth are linked but not identical. Saving part of income can build wealth, while wealth itself can generate income through rent, interest or dividends. Wealth may also be inherited, so differences in asset ownership can persist across generations.
Income distributionThe way national income is shared among the population.
Wealth distributionThe way a country's stock of wealth is shared among its population.
Measuring inequality: deciles, quintiles and quartiles
Households can be ranked from lowest to highest income and divided into equal-sized groups. Comparing the shares of total income received by these groups reveals how unevenly income is distributed.
| Grouping | Population divided into | Example |
|---|---|---|
| Deciles | 10 equal groups | The first decile is the poorest 10%; the top decile is the richest 10%. |
| Quintiles | 5 equal groups | The first quintile is the poorest 20%. |
| Quartiles | 4 equal groups | The first quartile is the poorest 25%. |
Reading distribution data: A quintile contains 20% of households. In the book’s data, Pakistan’s lowest quintile receives 8.9% of income while the highest quintile receives 42.8%. Comparing the shares received by the bottom and top groups gives a quick indication of the degree of inequality before using a summary measure such as the Gini coefficient.
The Gini coefficient
Gini coefficientA numerical measure of inequality. In published data it is often shown as a percentage: values closer to 0 indicate greater equality, while values closer to 100 indicate greater inequality.
The Gini coefficient allows comparisons between countries and over time. It summarises the overall distribution rather than focusing only on the richest and poorest groups. It is also commonly referred to as the Gini index.
Interpretation: do not say a country with a Gini of 40 is “40% unequal”. Use comparative language: a higher Gini indicates a more unequal distribution than a lower Gini.
Why income and wealth are unequal
Labour markets
Different skills, qualifications, occupations and sectors attract different wages. Technological change can raise demand for skilled labour and widen wage differences.
Ownership of wealth
Assets are unevenly owned. Wealth can be inherited, and assets can generate further income through rents and profits.
Demographic change
An ageing population can increase the proportion of people dependent on pensions while reducing the share of working-age contributors.
Changes in the strength of trade unions may also affect wage inequality. A decline in union power may reduce the bargaining protection available to some lower-paid workers, although greater labour-market flexibility may bring other benefits.
Policies to redistribute income and wealth
Minimum wage
A minimum wage can raise earnings for low-paid workers who remain employed. Its overall effect on inequality is uncertain if employment falls, if the legal minimum does not cover informal work, or if many workers already earn above the minimum.
Transfer payments
Transfer paymentA payment or benefit provided by government to households, transferring resources from taxpayers to recipients.
Transfers may be cash benefits or benefits in kind, including access to services such as health and education. They aim to protect households whose market income would otherwise be very low.
Taxation
Progressive direct taxation
Higher-income groups face a higher marginal tax rate. Examples of direct taxes include income tax and taxes on profits or gains.
Regressive indirect taxation
Taxes on spending can take a larger proportion of the income of poorer households, so their effect can be regressive.
Marginal tax rateThe tax paid on additional taxable income: the change in tax payments divided by the change in taxable income.
Taxes on property, capital gains or inheritance can also influence the distribution of wealth, depending on the design of the tax system.
State provision of essential goods and services
Government may provide, finance or arrange access to essential services such as health and education. This can support lower-income households even when their cash income remains low. The exact method differs between countries and may involve public or private providers.
Evaluation habit: redistribution creates trade-offs. A policy should be judged by who actually receives the benefit, whether behaviour changes, the administrative and fiscal cost, and whether there are unintended effects on employment, incentives or resource allocation.
Chapter 5 revision checklist
Explain why secure property rights and stability support markets.
Define public goods and explain the free-rider problem.
Explain why merit goods may be under-consumed.
Explain why demerit goods may be over-consumed.
Explain why governments may regard some market prices as inappropriate.
Show the effect of a specific indirect tax on supply, price and quantity.
Explain tax incidence and how PED affects the burden.
Show the effect of a subsidy on supply, price and quantity.
Evaluate why elasticity can limit the effectiveness of a subsidy.
Explain direct provision and why government need not produce the service itself.
Analyse a binding minimum wage and the possibility of unemployment.
Analyse a binding maximum price and the resulting shortage.
Explain how a buffer stock stabilises commodity prices.
Evaluate the storage and sustainability problem of buffer stocks.
Explain how information provision can address merit/demerit good problems.
Distinguish income (flow) from wealth (stock).
Interpret deciles, quintiles and quartiles.
Interpret a Gini coefficient correctly.
Explain labour-market, wealth and demographic causes of inequality.
Evaluate minimum wages, transfers, taxation and state provision as redistribution policies.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.