Role of government in microeconomics

• State the seven reasons for government intervention in markets and match a suitable instrument to each.
• Draw and explain a price ceiling and a price floor, including a minimum wage and an agricultural price floor with government purchase of the surplus.
• Draw and explain an indirect tax and a subsidy, identifying the consumer and producer prices, the tax revenue or subsidy cost, and the welfare loss by their corner labels.
• Explain why price elasticities of demand and supply decide how a tax or a subsidy is shared between consumers and producers.
• Describe direct provision and command-and-control regulation, and evaluate each form of intervention by its effects on markets and stakeholders.

A competitive market left to itself settles at the price where quantity demanded equals quantity supplied (topic 2.3). Government intervention is any deliberate action by the state that changes that outcome: the price, the quantity, who pays or who can obtain the good. Governments intervene because the market outcome, even when it is efficient, may not be the one they want. It may raise no money for public services, leave some firms or households with very low incomes, involve too much of a harmful good or too little of a beneficial one, or distribute goods in a way that is judged unfair.

Governments have seven main reasons to intervene. Each is an aim, and each aim points to particular instruments.

• Earn government revenue. Indirect taxes on goods such as fuel, tobacco and alcohol raise money that pays for public spending. The revenue is largest and most reliable when demand for the taxed good is price inelastic, because the quantity sold falls only a little when the tax raises the price.
• Support firms. A subsidy lowers firms' costs and a price floor raises the price they receive. The aim is to keep an industry in business (farming, or a young industry such as renewable energy) or to protect the jobs it provides.
• Support households on low incomes. A price ceiling on a necessity such as rented housing, a subsidy on a staple food, or schooling and health care provided free of charge all reduce what a low-income household has to pay. A minimum wage raises what low-paid workers earn.
• Influence the level of production. A subsidy raises the output of a good the government wants more of. An indirect tax or a regulation lowers the output of a good it wants less of, such as one whose production pollutes.
• Influence the level of consumption. Indirect taxes, age limits and bans reduce the consumption of goods judged harmful (a Demerit good such as tobacco). Subsidies and free provision raise the consumption of goods judged beneficial (a Merit good such as vaccination).
• Correct Market failure. Where a market produces too much or too little because some costs or benefits fall on third parties, or does not supply a good at all, intervention aims to move output towards the level that is best for society. Topics 2.8 and 2.9 study these cases.
• Promote Equity. Equity means fairness. A market allocates goods to those able and willing to pay, so a government that judges the result unfair may tax luxuries more heavily than necessities, subsidise necessities, set a minimum wage, or provide education and health care regardless of income.

The instruments in this topic are price ceilings and price floors (together called price controls), subsidies and indirect taxes, laws and regulations of the command-and-control kind, and services that the government provides itself. One instrument can serve several aims, and the aims can pull against each other. A tax on tobacco both earns revenue and reduces consumption, but the more it succeeds in cutting consumption, the less revenue it earns.

Every instrument in this topic is judged in the same way. Does it achieve the aim it was chosen for? What does it cost, in lost efficiency and in public money that could have been spent on something else? Who gains and who loses? The sections that follow answer these three questions for each instrument.

A Price ceiling, or maximum price, is a legal upper limit on the price that sellers may charge. Governments use ceilings to keep necessities affordable for households on low incomes: rent controls, and caps on the prices of staple foods or energy. A ceiling changes the market only if it is binding, which means it is set below the equilibrium price. A ceiling above the equilibrium price has no effect, because the market price is already legal.

A binding ceiling works through two movements along the curves. At the lower price, quantity demanded extends along the demand curve, because the good is cheaper. Quantity supplied contracts along the supply curve, because selling is less profitable. Neither curve shifts. The result is Excess demand: a shortage equal to quantity demanded minus quantity supplied at the ceiling price. In a free market the shortage would push the price back up. The law prevents that, so the shortage persists, and the quantity actually traded is the quantity supplied, the smaller of the two.

Because price can no longer decide who gets the good, something else must. Non-price rationing takes over: queues and waiting lists, first come first served, sellers choosing the buyers they prefer, or ration coupons issued by the government. Some buyers are willing to pay more than the legal price (at Qs the demand curve is above Pmax), so a Parallel (underground) market tends to appear, in which the good is resold illegally at higher prices. With buyers queuing, sellers can also let quality fall without losing sales: a landlord with a waiting list has little reason to pay for repairs.

The ceiling also makes the market inefficient. At Qs the marginal benefit to consumers (the height of the demand curve) is greater than the marginal cost of production (the height of the supply curve), so society would gain from producing more, but the extra units are not supplied. Resources are under-allocated to the good, Allocative efficiency is lost, and the lost Social surplus is the Welfare loss triangle F, E, B.

• Consumers who obtain the good gain: they pay Pmax instead of Pe, and their Consumer surplus rises by the rectangle Pe, H, B, Pmax.
• Consumers who can no longer obtain the good lose. They would have bought the units between Qs and Qe at the equilibrium price, and they now spend time searching or pay more in a parallel market. Nothing in the policy ensures that the households who are left out are the better-off ones.
• Producers lose. They sell fewer units at a lower price, so revenue falls from Pe × Qe to Pmax × Qs and Producer surplus falls from the triangle Pe, E, K to the triangle Pmax, B, K.
• Workers in the industry may lose their jobs, because output falls from Qe to Qs.
• The government spends no money on the ceiling itself and may gain political support from those who pay less, but it must pay to monitor prices and enforce the law.

Time makes the shortage worse. In the short run supply is price inelastic: landlords cannot quickly do anything else with their flats, and farmers have already planted. In the long run supply is more price elastic: landlords sell to owner-occupiers or convert flats to other uses, and farmers switch to crops that are not controlled. The same ceiling therefore produces a larger fall in quantity supplied, and a larger shortage, the longer it stays in force.

A government can reduce the shortage only by increasing supply at the controlled price: by subsidising producers, by providing the good itself (public housing), or by releasing stocks it holds. Each of these costs public money, so a ceiling that looked free to the budget becomes a spending commitment.

A Price floor, or minimum price, is a legal lower limit on the price at which a good may be sold. It is binding only if it is set above the equilibrium price; a floor below the equilibrium price changes nothing. Governments set price floors for three reasons: to support producers' incomes (agricultural price floors), to protect low-paid workers (a minimum wage is a price floor in a labour market), and to reduce the consumption of a harmful good by making its cheapest versions dearer (a minimum price for alcohol).

At a price above equilibrium, quantity demanded contracts along the demand curve and quantity supplied extends along the supply curve. Neither curve shifts. The result is Excess supply: a surplus equal to quantity supplied minus quantity demanded at the floor price. In a free market unsold stock would push the price down. The law prevents that, so the surplus persists, and consumers buy only the quantity demanded.

What happens next turns on whether anyone buys the surplus. If no one does, producers sell only Qd. Their revenue changes from Pe × Qe to Pmin × Qd, which is a rise only if demand is price inelastic over that range, so that the higher price outweighs the smaller quantity sold (see price elasticity of demand, topic 2.5). Output that has been produced and cannot be sold earns nothing, so firms either cut production back to Qd or are tempted to sell the excess illegally below the floor. The units between Qd and Qe, which consumers value above their cost of production, are no longer traded: the welfare loss is the triangle B, E, F.

An agricultural price floor is usually backed by government purchase of the surplus, because the aim is to raise farmers' incomes and unsold crops would defeat it. The government promises to buy whatever consumers do not buy at the floor price. Farmers then sell their whole output Qs at Pmin: Qd to consumers and the rest to the government.

The government must then do something with the stock it has bought. It can store it, which is costly and impossible for perishable food. It can destroy it, which wastes the resources used to grow it. It can sell it abroad at a low price, which pushes down prices for farmers in other countries (topic 4.2), or give it away as aid. It cannot sell it at home, because that would add to supply and push the price below the floor.

• Farmers gain a higher price on a larger quantity: revenue rises from Pe × Qe to Pmin × Qs. Support is paid on every unit, so the largest farms receive the most and a small farmer with little to sell gains little.
• Consumers pay a higher price and buy less. When the product is a staple food, the burden is heaviest for low-income households, which spend a larger share of their income on food.
• Taxpayers pay for the purchase, Pmin × (Qs − Qd), and for storing or disposing of the stock. That money has an opportunity cost: it could have paid for other public services.
• Farmers in other countries lose if the surplus is sold on world markets below their costs.
• Society loses efficiency. Output Qs is above the efficient quantity Qe: for the units between Qe and Qs the cost of production is greater than the benefit to consumers, so resources are over-allocated to the good and high-cost producers are kept in business.

A Minimum wage applies the same model to a labour market. The price is the wage rate, firms are the buyers of labour and households are the sellers. A minimum wage above the equilibrium wage reduces the quantity of labour that firms demand and increases the quantity that households supply, so there is an excess supply of labour: unemployment.

Workers who keep their jobs gain a higher wage, which is the purpose of the policy. The model predicts three groups of losers: workers who lose their jobs or cannot find one, firms whose costs rise, and consumers if firms pass the higher cost on in prices. The size of the predicted unemployment is the key condition. It is small when the demand for labour is wage inelastic, for example because the work cannot easily be done by machines or moved abroad, and when the minimum is set only a little above the equilibrium wage. It is large when labour demand is wage elastic or the minimum is set far above the equilibrium.

An Indirect tax is a tax on spending on goods and services. It is collected from the firms that sell the good, which pass the money to the government, so for a firm it works like an increase in the cost of supplying each unit. Governments use indirect taxes to earn revenue, to reduce the consumption of goods judged harmful, and to make producers and consumers take account of costs that fall on third parties (topic 2.8).

Take a tax of a fixed amount on every unit sold. To supply any given quantity, firms now need the price they needed before plus the tax, so the supply curve shifts vertically upward by the amount of the tax, from S to S + tax. The demand curve does not shift, because nothing has changed consumers' willingness to pay. At the old price P1 firms would keep only P1 minus the tax, so they supply less and a shortage appears. The shortage pushes the market price up, and quantity demanded contracts along the demand curve, until the market clears at a new equilibrium E2 with a smaller quantity Q2.

After the tax there are two prices. Consumers pay Pc, the new market price, which is above P1. Producers keep Pp, which is Pc minus the tax and is below P1. The vertical gap between Pc and Pp is the tax per unit. The price paid by consumers rises by less than the tax, because a firm that tried to pass on the whole tax would lose too many sales.

The firm hands the tax to the government, but that does not decide who bears it. Consumers bear the part that reaches them as a higher price, (Pc − P1) on every unit. Producers bear the rest as a lower price kept, (P1 − Pp) on every unit. The way a tax is shared between buyers and sellers is called Tax incidence, and it is decided by the price elasticity of demand (PED) relative to the price elasticity of supply (PES).

The side of the market that responds less to a change in price bears more of the tax, because it has fewer ways of avoiding it. When demand is price inelastic relative to supply, buyers go on buying almost as much at a higher price, so firms can pass most of the tax on and consumers bear the larger share. When demand is price elastic relative to supply, a price rise would lose many sales, so firms absorb most of the tax and producers bear the larger share. In the two limiting cases, perfectly inelastic demand puts the whole tax on consumers, and perfectly elastic demand puts the whole tax on producers.

• Consumers pay a higher price and consume less, so consumer surplus falls. Lower-income households spend a larger share of their income on taxed goods such as fuel and tobacco, so an indirect tax takes a larger share of a low income than of a high one.
• Producers keep a lower price on a smaller quantity, so their revenue after tax falls from P1 × Q1 to Pp × Q2 and producer surplus falls.
• Workers in the industry may lose their jobs or hours, because output falls from Q1 to Q2.
• The government gains revenue equal to the tax per unit multiplied by Q2, the quantity sold after the tax. It can spend this on public services or use it to reduce other taxes.
• Society loses the surplus on the units between Q2 and Q1, which were worth more to consumers than they cost to produce and are no longer traded: the welfare loss triangle E2, E1, C. Where the good harms third parties, the fall in quantity is instead a gain for society (topic 2.8).

A Subsidy is a payment from the government to firms. In this topic it is paid for each unit produced, so it lowers the cost of supplying every unit. Governments subsidise goods to lower the price of necessities and of goods they want people to consume more of, to raise producers' revenue (farmers), to support the growth of an industry (renewable energy), and to help domestic firms compete with foreign ones (topic 4.2).

A subsidy of a fixed amount per unit means that firms can supply any given quantity for the price they needed before minus the subsidy, so the supply curve shifts vertically downward by the amount of the subsidy, from S to S + subsidy. The demand curve does not shift. At the old price P1 firms now want to sell more than consumers want to buy, so the market price falls and quantity demanded extends along the demand curve, until the market clears at a new equilibrium E2 with a larger quantity Q2.

Again there are two prices. Consumers pay Pc, the new market price, which is below P1. Producers receive Pp, which is Pc plus the subsidy and is above P1. The price paid by consumers falls by less than the subsidy, so the benefit is shared between consumers, who pay less, and producers, who receive more.

The subsidy is shared in the same way as a tax: the side of the market that responds less to price receives more of it. When demand is price inelastic relative to supply, the price must fall a long way to sell the extra output, so consumers receive most of the benefit. When supply is price inelastic relative to demand, output rises little and producers keep most of the subsidy as a higher price received.

Three money flows change, and they must be kept apart. Government spending is the subsidy per unit multiplied by Q2, the quantity sold after the subsidy. Producers' revenue rises from P1 × Q1 to Pp × Q2, because they receive more on a larger quantity. Consumers' spending changes from P1 × Q1 to Pc × Q2: it falls if demand is price inelastic, because the lower price outweighs the larger quantity, and it rises if demand is price elastic.

• Consumers gain a lower price and consume more, so consumer surplus rises by the area P1, E1, E2, Pc.
• Producers gain a higher price on a larger quantity, so producer surplus rises by the area Pp, C, E1, P1.
• Workers gain, because higher output needs more labour.
• Taxpayers pay for the subsidy, the rectangle Pp, C, E2, Pc. The money has an opportunity cost in other public spending or in higher taxes.
• Producers in other countries lose sales if subsidised output displaces theirs at home or abroad.
• Society loses efficiency. The gains to consumers and producers are smaller than the government's spending by the triangle E1, C, E2, the welfare loss: the units between Q1 and Q2 cost more to produce than consumers are willing to pay for them. This holds when the market was efficient before. Where the good benefits third parties, the extra output is instead a gain for society (topic 2.8).

Direct provision means that the government supplies a good or service itself and pays for it out of tax revenue, usually free of charge or below cost for the user. Health care, schooling, roads and street lighting are common examples. Governments provide services directly for three reasons: people would buy too little of a beneficial service such as education if they had to pay its full price; some goods would not be supplied by firms at all, because people who do not pay cannot be stopped from using them (public goods, topic 2.9); and access to essential services is judged a matter of fairness that should not turn on income.

• More of the service is consumed than the market would supply, and low-income households gain access to it. This is the aim.
• Taxpayers pay. Every unit of public money spent on one service has an opportunity cost: another service that is not provided, or higher taxes.
• At a zero price the quantity demanded can be greater than the capacity provided. The service is then rationed by waiting lists, not by price.
• A public provider does not face competition or need to earn a profit, so it has a weaker incentive to keep costs down or to respond to what users want. Private firms that would have supplied the service may be displaced.

Command-and-control regulation changes behaviour by law. A rule requires or forbids an action, and inspection and penalties enforce it. The main types are bans (smoking in enclosed public places), age limits (on buying alcohol or tobacco), compulsory use (seat belts, schooling up to a set age), standards (limits on emissions from vehicles and factories, building codes) and licences (permission to carry out an activity at all).

• Strengths: a rule is simple to understand, acts quickly and gives a predictable result. It works where a price signal would be too weak or too slow, for example where a substance is so dangerous that any use is unacceptable.
• Enforcement is costly. Inspectors, testing and courts must be paid for, and a rule that is not enforced changes little.
• A standard gives no incentive to do better than the standard. A firm that meets an emissions limit gains nothing from cutting emissions further.
• The same rule for every firm ignores differences in the cost of complying, so a given reduction is achieved at a higher total cost than if the firms that can change cheaply did more.
• A ban does not remove demand. A banned good moves to an illegal market, where there is no quality control and no tax revenue.
• Setting the right standard needs technical information that the government may not have, and the firms being regulated may influence the rule in their own favour.

Evaluating an intervention means setting its consequences for the market (price, quantity, shortages or surpluses, efficiency) beside its consequences for each group of stakeholders. Stakeholder impact is rarely the same for everyone: an instrument that helps one group does so at the expense of another, and the judgement lies in saying who gains, who loses, by how much and whether the stated aim was achieved.

Tax revenue, subsidy payments and the price cut under a ceiling are transfers: what one group loses another gains, and society as a whole is no worse off because of them. The welfare loss is different. It is Social surplus that nobody receives, because units that were worth producing are not traded, or units that were not worth producing are. In each diagram it is the triangle, never a rectangle.

1. Does the instrument achieve its aim? For taxes and subsidies the answer turns on price elasticity: quantity changes a great deal when demand is price elastic and very little when it is inelastic. For price controls and regulation it turns on enforcement: a ceiling or a ban that is evaded in a parallel market changes less than the law intends.
2. What does it cost? Count the welfare loss, the cost to the budget and the cost of administration. Price controls and regulation appear free to the budget, but they create shortages, surpluses or enforcement costs; subsidies and direct provision show their cost openly, and that money has an opportunity cost.
3. Who bears the cost? Indirect taxes on necessities and price floors on food take the largest share of income from the poorest households. Subsidies and direct provision are paid for by all taxpayers. Price ceilings are paid for by producers and by the buyers who are left without the good.

Time changes the answers. Demand and supply are both more price elastic in the long run, when buyers have found substitutes and sellers have changed what they produce. Shortages under a ceiling, surpluses under a floor and the fall in quantity after a tax all grow with time, and so do the cost of buying a surplus and the cost of a subsidy. An instrument that works as a short-term measure can become much more costly if it is left in place.

• Governments intervene to earn revenue, support firms, support low-income households, influence production, influence consumption, correct market failure and promote equity.
• A price ceiling binds only below the equilibrium price. It causes a shortage (Qd − Qs); the quantity traded is Qs; price no longer rations the good.
• A price floor binds only above the equilibrium price. It causes a surplus (Qs − Qd); consumers buy Qd; producers sell Qs only if the government buys the surplus, at a cost of Pmin × (Qs − Qd).
• A minimum wage is a price floor in a labour market: the predicted excess supply of labour is unemployment.
• An indirect tax shifts supply vertically up by the tax. Consumers pay Pc, producers keep Pp = Pc − tax, quantity falls to Q2 and revenue is the tax × Q2.
• A subsidy shifts supply vertically down by the subsidy. Consumers pay Pc, producers receive Pp = Pc + subsidy, quantity rises to Q2 and the cost is the subsidy × Q2.
• A tax or a subsidy is shared between consumers and producers, and the side that responds less to price takes the larger share.
• Direct provision supplies a service out of tax revenue; command-and-control regulation requires or forbids behaviour by law and must be enforced.
• Judge every instrument by three tests: whether it achieves its aim, what it costs, and who bears the cost.

This set has 9 parts worth 40 marks in all, and the whole set should take about 100 minutes. Every part uses the texts and data below. Answer each part in its writing workspace before you open the feedback under it.