Effect of a price ceiling set below equilibrium.

Quantity demanded exceeds quantity supplied: a shortage, non-price rationing (queues, waiting lists) and possible black markets.

Who bears more of an indirect tax?

The side of the market that is less price elastic. If demand is more inelastic than supply, consumers bear most of the burden.

How does a per-unit subsidy appear on a diagram?

Supply shifts vertically downward by the subsidy per unit; government cost = subsidy × new quantity.

Economics

2.7 Role of government in microeconomics

Governments intervene in markets with price controls, indirect taxes, subsidies, direct provision, regulation and nudges, each creating gains and losses for different stakeholders. Study guide, 4 practice questions with markschemes and 3 flashcards. Free.

Reasons for intervention · price ceilings and price floors · indirect taxes and subsidies · direct provision, regulation and command-and-control · consumer nudges · effects on stakeholders and welfare loss · (HL) calculating tax, subsidy and price-control effects from diagrams

Practise all 4 questions Study 3 flashcards

Study guide

Why governments intervene

To raise revenue (indirect taxes).
To support firms or industries (subsidies, price floors for farmers).
To support households on low incomes (price ceilings on rent or food).
To influence the level of production or consumption (taxing harmful goods, subsidising useful ones).
To correct market failure (see 2.8 and 2.9) and promote equity.

Price ceilings (maximum prices)

A legal maximum set below equilibrium. Diagram in words: D and S cross at Pe, Qe. A horizontal line Pc lies below Pe. At Pc quantity demanded (Qd) exceeds quantity supplied (Qs), creating a shortage equal to Qd minus Qs. Quantity actually traded falls to Qs.
Consequences: shortages, queues, rationing by waiting lists, parallel (black) markets, lower quality, and a welfare loss triangle between D and S from Qs to Qe. Consumers who obtain the good gain; producers and consumers who miss out lose.

Price floors (minimum prices)

A legal minimum set above equilibrium. At Pf, quantity supplied exceeds quantity demanded: a surplus. In agriculture, the government may buy the surplus, which costs taxpayers and needs storage or disposal. A minimum wage is a price floor in the labour market and may create unemployment. Producers gain; consumers pay more; resources are overallocated.

Indirect taxes

A tax on spending. A specific tax is a fixed amount per unit and shifts supply up in parallel by the tax; an ad valorem tax is a percentage of price, so the gap between the curves widens as price rises.
Diagram in words: S1 shifts up to S1 + tax. The new equilibrium has a higher consumer price Pc, a lower quantity Qt, and a lower price received by producers Pp, where Pc − Pp equals the tax. Government revenue is the rectangle (Pc − Pp) × Qt. The part of the rectangle above the original price is the consumer burden; the part below is the producer burden. A welfare loss triangle sits between Qt and Qe.
The more inelastic demand is relative to supply, the more of the tax consumers bear.

Subsidies

A payment per unit to producers that shifts supply down by the subsidy. Consumers pay less, producers receive more (price plus subsidy), and output rises. The cost to government is subsidy × new quantity. In a market without externalities, subsidies cause overallocation and a welfare loss.

Other tools

Direct provision: government supplies goods such as schools and roads.
Command-and-control regulation: laws, bans, standards and licences.
Consumer nudges: defaults and choice architecture (see 2.4).

(HL) Worked example: specific tax

$Q_d = 120 - 4P$, $Q_s = -30 + 6P$. Equilibrium: $150 = 10P$, so P = 15, Q = 60.
A USD 5 per unit tax: new supply $Q_s = -30 + 6(P - 5) = -60 + 6P$.

$120 - 4P = -60 + 6P \Rightarrow P = 18$, $Q = 48$. Producers keep 18 − 5 = USD 13.
Tax revenue $= 5 \times 48 =$ USD 240.
Consumer burden $= (18 - 15) \times 48 = 144$; producer burden $= (15 - 13) \times 48 = 96$.
Welfare loss $= \frac{1}{2} \times 5 \times (60 - 48) = 30$.

Price ceiling at USD 10: $Q_d = 80$, $Q_s = 30$, shortage = 50 units.
Price floor at USD 18 with government buying the surplus: $Q_d = 48$, $Q_s = 78$, surplus = 30, cost = 18 × 30 = USD 540.

Common mistakes

Drawing a price ceiling above equilibrium (it would have no effect).
Shifting demand instead of supply for a tax on producers.
Using the old quantity to calculate tax revenue.
Forgetting that the producer's price under a tax is the consumer price minus the tax.

Exam tips

10-mark questions: draw the diagram fully (both prices, both quantities, shortage or surplus, shaded revenue or cost) and explain effects on consumers, producers and government.
15-mark questions: evaluate with stakeholders, elasticities, short versus long run, unintended effects (black markets, dependence on subsidies) and alternatives.
HL: set out each calculation step and use units.

Cheat sheet

Tool	Shift / line	Key result	Calculation
Ceiling	line below Pe	shortage	$Q_d - Q_s$ at Pc
Floor	line above Pe	surplus	$Q_s - Q_d$; buy-up cost = Pf × surplus
Specific tax	S up by tax	P up, Q down	revenue = tax × new Q
Subsidy	S down by subsidy	P down, Q up	cost = subsidy × new Q

Tax: new $Q_s$ uses $(P - t)$; subsidy: new $Q_s$ uses $(P + s)$
Consumer burden = (new consumer P − old P) × new Q
Producer burden = (old P − producer P) × new Q
Welfare loss = $\frac{1}{2} \times$ tax (or subsidy) $\times$ change in Q
Inelastic demand → consumers pay most of the tax
Stakeholders: consumers, producers, workers, government, taxpayers, society

Key definitions

Price ceiling: A legal maximum price set below equilibrium, which creates a shortage.
Price floor: A legal minimum price set above equilibrium, which creates a surplus.
Parallel market: An illegal market where goods are sold at prices above a legal maximum.
Indirect tax: A tax on spending on goods and services, paid to the government by producers but partly passed on to consumers.
Specific tax: An indirect tax of a fixed amount per unit sold.
Ad valorem tax: An indirect tax charged as a percentage of the price of a good.
Subsidy: A payment from the government to producers per unit, lowering their costs and increasing supply.
Tax incidence: The way the burden of a tax is divided between consumers and producers.
Welfare loss: The loss of social surplus that results when output differs from the allocatively efficient level.
Command-and-control regulation: Laws and rules that directly require or forbid certain behaviour, enforced by penalties.

Practice questions

HLPaper 3Very hard

Question 1

The market for cans of energy drink in a city is described by $Q_d = 180 - 10P$ and $Q_s = -30 + 20P$, where $P$ is in dollars and $Q$ in thousands of cans per week.

(a) [2]

Calculate the equilibrium price and quantity before the tax.

Markscheme

1 $180 - 10P = -30 + 20P \Rightarrow P = 7$
1 $Q = 110$

(b) [1]

The government imposes a specific tax of $3 per unit on producers. Write down the new supply function.

Markscheme

1 $Q_s = -30 + 20(P - 3) = -90 + 20P$

(c) [2]

Calculate the new price paid by consumers and the new quantity.

Markscheme

1 $180 - 10P = -90 + 20P \Rightarrow P = 9$
1 $Q = 90$

(d) [1]

Calculate the government's tax revenue.

Markscheme

1 $3 \times 90 = 270$

(e) [2]

Calculate the tax burden on consumers and on producers.

Markscheme

1 Consumers: $(9 - 7) \times 90 = 180$
1 Producers receive $9 - 3 = 6$, so burden $(7 - 6) \times 90 = 90$

(f) [2]

Calculate the welfare loss caused by the tax.

Markscheme

1 Uses triangle with height equal to the tax and base equal to the fall in quantity
1 $\frac{1}{2} \times 3 \times (110 - 90) = 30$

SLPaper 2Standard

Question 2

Extract: Port Halden caps rents

Port Halden's council has capped monthly rents for two-bedroom apartments at $900, below the market rent of about $1,150. At $900, the council estimates that 12,000 households want to rent but only 8,500 apartments are offered. Some landlords have switched to short-term holiday lets.

(a) [2]

Define the term price ceiling (maximum price).

Markscheme

1 A legal maximum price set by the government
1 below the market equilibrium price

(b) [1]

Using the data, calculate the shortage of apartments created by the rent cap.

Markscheme

1 12,000 − 8,500 = 3,500 apartments

(c) [4]

Using a diagram, explain how the rent cap affects the market for rented apartments.

Markscheme

1 Diagram with rent and quantity of apartments, ceiling drawn below equilibrium
1 Quantity supplied (8,500) and quantity demanded (12,000) shown with shortage
1 Explains that landlords supply fewer apartments (some convert to owner-occupied or short-term lets)
1 Explains that more renters want apartments at the lower rent, so there is excess demand and non-price rationing (waiting lists)

SLPaper 1Challenging

Question 3

(a) [10]

Using a diagram, explain the effects of a government subsidy on producers of electric buses.

Markscheme

1 Defines the key economic terms used in the question accurately
2 Accurate diagram: supply shifts down/right by the subsidy per unit, new lower price and higher quantity, area of government spending shown
2 Explains that the subsidy lowers firms' costs, increasing supply
2 Explains effects on consumers (lower price, higher quantity) and producers (higher price received, more output)
2 Explains the cost to the government and the opportunity cost of that spending
1 Uses a real-world example

(b) [15]

Evaluate the use of minimum prices (price floors) to support farmers' incomes.

Markscheme

1 Defines a price floor
2 Diagram showing the floor above equilibrium, surplus and government purchase of the surplus
3 Explains how farmers who sell at the floor gain higher and more stable incomes
2 Uses a real-world example of an agricultural support scheme
2 Evaluates: consumers pay higher prices; the policy may be regressive
2 Evaluates: cost of buying and storing surpluses and its opportunity cost
2 Evaluates: inefficiency (overallocation of resources), possible dumping abroad; compare with alternatives such as direct income support
1 Reaches a supported conclusion

Key facts

Effect of a price ceiling set below equilibrium.: Quantity demanded exceeds quantity supplied: a shortage, non-price rationing (queues, waiting lists) and possible black markets.
Who bears more of an indirect tax?: The side of the market that is less price elastic. If demand is more inelastic than supply, consumers bear most of the burden.
How does a per-unit subsidy appear on a diagram?: Supply shifts vertically downward by the subsidy per unit; government cost = subsidy × new quantity.