Government policies to achieve efficient resource allocation and correct market failure

Economics A2 · Government microeconomic intervention. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

When a market fails, the government can step in to move output towards the social optimum. It can change prices with an indirect tax or a subsidy, or control the market directly with price controls, quotas, bans, licences and regulation. It can also provide a good itself, create property rights, sell pollution permits, give information or use a ‘nudge’ that makes the better choice easier without removing choice.

Each measure has limits. External costs are hard to measure, rules are costly to enforce, and bans can create illegal markets.

Government failure occurs when intervention leads to a less efficient allocation of resources than before, so net welfare falls.

Rules to remember

Specific tax: a fixed amount per unit, so supply shifts up parallel. Ad valorem tax: a percentage of price, so supply pivots and the gap widens as price rises.
Ideal tax per unit = marginal external cost at the socially optimal output. Ideal subsidy per unit = marginal external benefit.
A subsidy shifts supply to the right: price falls and quantity rises. Cost to the government = subsidy per unit × new quantity.
Maximum price below equilibrium: shortage. Minimum price above equilibrium: surplus.
Tradable pollution permits: total pollution is fixed. Firms that can cut pollution cheaply do so and sell permits to firms for which it is costly.
Privatisation: selling state-owned firms to the private sector. Nationalisation: the opposite. Deregulation: removing rules that restrict competition.
Causes of government failure: poor information, unintended consequences, administrative costs, political aims, regulatory capture.

Common mistake

Students think the consumer price changes by the full amount of a tax or subsidy. Unless demand is perfectly inelastic or supply perfectly elastic, the change is shared between buyers and sellers.

Worked example

Demand for a good with external benefits is Qd = 90 − 2P and supply is Qs = 4P − 30. The government pays producers a subsidy of $6 per unit. What happens to the price consumers pay, and what does the subsidy cost?

Before: 90 − 2P = 4P − 30, so 6P = 120, P = $20 and Q = 50.
With the subsidy producers receive P + 6: Qs = 4(P + 6) − 30 = 4P − 6.
New equilibrium: 90 − 2P = 4P − 6, so 6P = 96, P = $16 and Q = 90 − 32 = 58.
Cost of the subsidy = 6 × 58 = $348.

Answer: The consumer price falls by $4 (from $20 to $16), quantity rises from 50 to 58 and the subsidy costs $348.

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