Government Intervention
Government Intervention
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Governments intervene when a market produces too much or too little of a good, so that society loses welfare.
Osira is a small country. Its national government may step into a market that, left alone, produces the wrong quantity.
Market failure: Too much or too little of a good being produced and/or consumed compared with the socially optimal level of output.
Put simply, the market leaves society with the wrong amount: more smoke than people would choose, or fewer vaccinations than keep a town healthy.
Burning coal in Osira does $15 of harm a tonne to people who neither buy nor sell it. This harm is an external cost: a cost that falls on people outside the deal. Buyers and sellers ignore it, because they do not pay it. Supply shows the cost to sellers of producing each extra tonne, the marginal private cost (MPC). Marginal social cost (MSC) adds the external cost to it (MSC = MPC + external cost), so MSC is $15 above supply at every quantity. Demand shows the marginal private benefit (MPB) to buyers. Coal gives no benefit to anyone outside the deal, so marginal social benefit (MSB) is the same as demand.
The free market settles where demand meets supply: 60 tonnes a day at $60. The social optimum counts every cost and benefit to society, so it is where MSB meets MSC. Demand meets MSC at 50 tonnes and $70.
Welfare loss: The net loss to society from producing or consuming units whose marginal social cost is greater than their marginal social benefit.
Put simply, welfare is how well off society is, counting every benefit and every cost. Society would be better off without those units, because each uses up more than it is worth.
Why is each tonne from 50 to 60 a loss? MSC shows what each of these tonnes costs society, and demand shows what buyers will pay for it. For every tonne from 50 to 60, the cost to society is higher than the price buyers will pay. The gap grows from $0 at 50 tonnes to $15 at 60.
On the diagram, E is the free-market equilibrium, where demand meets supply (60 tonnes, $60). F is the social optimum, where demand meets MSC (50 tonnes, $70). G is on MSC at 60 tonnes ($75). An area is named by its corner letters, so the welfare loss is triangle FGE.
So Osira loses $75 of welfare a day: the most any intervention here can gain. The purpose of intervening is to move the quantity towards 50 tonnes.
Exam Matters: When you draw a welfare loss, label MSC above supply and mark both quantities. Shade only the triangle between MSC and demand, from the social optimum to the free-market quantity.
A government may intervene to correct a market failure, to make outcomes fairer, or to keep prices stable.
Correcting a market failure is the main purpose of intervention, but a government may also act for two other reasons.
Each purpose needs its own test. Correcting a market failure is worth it only if society gains more than it loses. The gain is the welfare loss the intervention removes. The losses are what the intervention costs to run and any new problems it creates. In Osira coal, an intervention can recover at most $75 a day.
Why is "it moved the quantity the right way" not enough? Because moving it has costs. The government pays staff to collect a tax or check emissions, and firms spend time on forms. A tool may also push the quantity past the social optimum, or cause a new problem, such as a shortage. If these costs are greater than the welfare recovered, the result is a net welfare loss: society is worse off than if the government had done nothing.
Where the aim is fairness, there is no welfare loss to recover, because the market already produces the socially optimal quantity. So the case rests on who gains and who loses. Where the aim is stable prices, the question is whether the steadier price helps growers and buyers by more than the scheme costs.
The eight methods differ in what they change directly, such as the price, the quantity or what people know.
A government has eight methods of intervention. Each is easiest to learn by what it changes directly.
Why does it matter what a tool changes? Because a tool that fixes the price leaves the quantity to the market, and a tool that fixes the quantity leaves the price to the market. A maximum price fixes the price, and the market decides the quantity. A permit scheme fixes the quantity, and the market decides the price. So a government must decide which matters more in each case: getting the price right or getting the quantity right.
A tax equal to the external cost makes sellers count that cost, so the market moves to the social optimum.
In Osira, the free market burns 60 tonnes of coal a day, 10 more than the social optimum. The national government now puts an indirect tax on coal.
Indirect tax: a tax on spending on goods and services, paid to the government by the seller, who may pass some or all of it on to buyers in a higher price.
Put simply, the government collects the tax from the coal seller each time a tonne is sold, but buyers may end up paying part of it through a higher price.
The tax is $15 a tonne, the same as the external cost. Each point on the supply curve shows the price sellers need to receive to supply that quantity. Now sellers must pay $15 to the government on every tonne. To supply the same quantity as before, they need the old price plus $15. This is why the supply curve shifts up by $15. Marginal social cost (MSC) is supply plus the $15 external cost, and the new supply curve is supply plus the $15 tax. Because the tax equals the external cost, the two are the same line.
What happens at the old price of $60? The quantity demanded is still 60 tonnes. But sellers now need $75 to supply 60 tonnes, so at $60 the quantity supplied falls below the quantity demanded. This is a shortage (excess demand). Buyers who cannot get coal offer more, so the price rises. As it rises, the quantity demanded contracts along the unchanged demand curve, and the quantity supplied extends along the new supply curve. The shortage is gone at $70, where both quantities are 50 tonnes: the social optimum.
After the tax there are two prices. Buyers pay $70, where the new supply curve meets demand. Sellers keep $55, because $15 of each $70 goes to the government. On the original supply curve, $55 is exactly what sellers need to supply 50 tonnes.
The welfare loss of $75 a day is now gone. Every tonne still burnt is worth at least as much to buyers as it costs society, because 50 tonnes is where demand meets MSC. The government also collects $15 on every tonne still sold. This money is its tax revenue. It can spend it on the harm, for example on treating illness caused by the smoke, or on anything else.
Exam Matters: Say which price you mean every time: buyers pay $70, sellers keep $55. After a tax they are different prices.
An indirect tax can be a fixed sum on each unit or a percentage of the price.
The $15 tax on coal in Osira is charged per tonne. It is one of two types of indirect tax.
Specific tax: a fixed amount of tax on each unit of a good sold, whatever its price.
Ad valorem tax: a tax charged as a percentage of the price of a good, so the tax on each unit is larger when the price is higher.
Put simply, a specific tax is a set number of dollars on each unit; an ad valorem tax is a share of the price, like a 10% sales tax.
The key difference is what happens when the price changes. With a specific tax, the tax on each unit stays the same. With an ad valorem tax, the tax on each unit changes with the price.
This decides the shape of the new supply curve. A specific tax adds the same amount at every quantity, so the new supply curve is parallel to the old one: the same distance above it everywhere. An ad valorem tax adds a percentage of the price sellers need. Along the supply curve, that price is higher at larger quantities, so the tax adds more there, and the gap between the curves widens as the quantity rises.
Which type fits an external cost? In Osira, each tonne of coal burnt does $15 of harm, whatever coal costs. A specific tax of $15 a tonne matches that harm at every quantity. Suppose instead the tax were 25% of the price sellers receive. At $60 a tonne it is $15, which matches the harm. At $80 it is $20, more than the harm, and below $60 it is less. The harm per tonne has not changed, so the tax no longer equals it.
So a harm per unit is matched more closely by a specific tax.
Exam Matters: Label the new curve S + tax and show the vertical gap. For a specific tax it is the same at every quantity; for an ad valorem tax it is wider at higher prices.
A tax set at the external cost can reach the social optimum, but three things decide how well it works.
In Osira, a $15 tax takes the coal market to the social optimum. Three things decide whether a real tax does as well.
Measuring the external cost. The tax works only if it equals the external cost, so the government must measure that cost. Nobody sends a bill for smoke, so the figure is an estimate. A tax set too low leaves the quantity above the social optimum. A tax set too high pushes the quantity below it. Either way, society still loses some welfare.
Price elasticity of demand. Demand is price inelastic when the quantity demanded changes by a smaller percentage than the price. This is usual when buyers have few close substitutes, other goods they could use instead. The tax then raises the price, but the quantity demanded contracts only a little. The tax can still be set correctly. But the quantity demanded changes little when the price rises, so even a tax equal to the whole external cost moves the quantity only a little. The social optimum is therefore close to the free-market quantity, and reaching it changes little. The tax raises a lot of revenue and changes behaviour only a little. Where buyers can switch easily to a close substitute, demand is more price elastic, and the same tax cuts the quantity by more. Where a government hopes for a large fall in use, as with smoking, a tax alone may disappoint.
Who pays. Where demand is price inelastic, buyers bear a large part of the tax through a higher price. If the good is a necessity, one that households must buy whatever its price, such as fuel for cooking, a low-income household spends a larger share of its income on it than a rich household does. So the tax takes a larger share of a low income than of a high one. A tax like this is regressive. What the government does with the revenue matters too. Returning some of it to poorer households reduces the regressive effect, and spending it on the harm itself, such as treating people made ill by the smoke, adds to the good the tax does.
So whether an indirect tax is the right tool depends on three things: how well the external cost can be measured, how price elastic demand is, and who ends up paying.
Real Example: Singapore taxes emitters for each tonne of greenhouse gas they release. The tax was S$5 a tonne from 2019 to 2023, to give firms time to adjust, then S$25 in 2024 and S$45 from 2026. This is a specific tax on the harm itself, and its rate rises over time.
A subsidy equal to the external benefit makes the market count that benefit, so the quantity rises to the social optimum.
Clinics in Osira show the opposite problem. A patient treated early does not infect others, so each consultation gives $20 of benefit to other people. This is an external benefit: a benefit that reaches people outside the deal. Demand shows the marginal private benefit (MPB) to patients. Marginal social benefit counts the external benefit as well (MSB = MPB + external benefit), so MSB is $20 above demand at every quantity.
The free market settles where demand meets supply: 40 consultations a week at $50. A consultation creates no external cost, so supply is also MSC, and MSB meets it at 50 consultations and $60: the social optimum.
Welfare gain: The net gain to society from producing or consuming units whose marginal social benefit is greater than their marginal social cost.
Put simply, these units are worth more to society than they cost, so missing them is a gain not taken.
Each consultation from 40 to 50 is worth more to society, on MSB, than it costs, on supply. The diagram marks H, the free-market equilibrium (40, $50); J, where MSB meets supply (50, $60); and K, on MSB at 40 ($70). The welfare gain not taken is triangle KJH.
Subsidy: a payment by the government to producers for each unit of a good they produce or sell, which lowers their costs and increases supply.
Put simply, the government pays part of each consultation's cost, so clinics can charge less.
The national government pays clinics $20 for each consultation, equal to the external benefit, so providers need $20 less from patients to supply each quantity. This is why supply shifts down by $20.
Before the subsidy, providers needed $70 to supply 60 consultations; now they need $20 less, $50. So at the old price of $50 they would supply 60 consultations. But the quantity demanded is still 40, so the quantity supplied is above the quantity demanded: a surplus (excess supply). The price falls. The quantity demanded extends along the unchanged demand curve, and the quantity supplied contracts along the new supply curve, until both are 50, the social optimum. Patients pay $40 for each consultation. The government adds $20, so providers receive $60 in all.
A subsidy can reach the social optimum, but the government pays it on every unit sold, not only the extra ones.
A subsidy costs the government money, and that cost is the first thing to weigh.
Cost of a subsidy: the total amount the government spends on a subsidy.
Put simply, it is the bill that taxpayers pay: one payment for every unit sold once the subsidy is in place.
Set this against what it buys: the $100 a week of welfare gain that was not being taken. The two numbers measure different things. The $100 is a gain to society as a whole. Most of the $1,000 is not lost. It moves from taxpayers to patients and clinics: what taxpayers pay, patients and clinics receive. So the real question is whether that money could do more good elsewhere.
Why is the bill so large? Because the $20 is paid on all 50 consultations, and 40 of them happened before the subsidy. On those 40, the payment changes nothing about the quantity. It only lowers the price patients pay, from $50 to $40, and raises what providers receive, from $50 to $60, for consultations that would have happened anyway.
Opportunity cost. The $1,000 a week could pay for teachers or roads instead. The best of those uses is the opportunity cost of the subsidy. If it would do more good, the subsidy is the wrong choice.
Hard to remove. Once patients and clinics plan around the $40 price, ending the subsidy raises the price back to $50. Many governments find a rise like that hard to make.
Targeting. Targeting means paying a subsidy only to chosen groups. Here, it would be paid only for patients who would not otherwise come, such as low-income families. If it were paid only on the 10 extra consultations, it would cost $200 a week instead of $1,000.
So a subsidy is worth its cost when the external benefit is large compared with what the money could do elsewhere, and when the payment is well targeted.
Real Example: In June 2024 Malaysia set the diesel price in Peninsular Malaysia at RM3.35 a litre, up from RM2.15. Logistics vehicles with fleet cards still paid RM2.15, and eligible owners of private diesel vehicles were offered RM200 a month. This is targeting: the government kept paying for chosen groups instead of for every litre sold.
A maximum price below the market price lowers the price, but it leaves a shortage that the price cannot remove.
Rented flats in Osira show a different reason to intervene. The market rent is $500 a month, and 200 flats are let. No one outside the deal is harmed or helped when a flat is let, so there is no external cost or benefit. The problem is fairness: many households cannot pay $500.
Maximum price: a price set by the government above which a good cannot legally be sold.
Put simply, it is a legal ceiling: a landlord may charge less, but never more.
A maximum rent has an effect only if it is below the market rent of $500. If it were $550, landlords could still charge $500, which is legal, so nothing would change. So the national government sets the maximum rent at $400.
At $400, the quantity demanded is 250 flats, because more households can now afford one. The quantity supplied is only 150, because some landlords sell their flats or use them for something else when the rent falls. The quantity demanded is greater than the quantity supplied: a shortage (excess demand). Normally a shortage pushes the price up. Here the law does not allow that, so the shortage stays.
Who gains and who loses? Tenants who keep a flat pay $100 less each month. But a flat can be let only if a landlord supplies it, so the number let is the quantity supplied, 150, not the quantity demanded, 250. Fewer flats are let than at $500, so some households who had a flat before no longer have one.
If the rent cannot decide who gets a flat, something else must. Sharing out a good by anything other than its price is called non-price rationing. It takes forms such as:
A maximum price also has a strength. It acts at once, and it needs no estimate of an external cost.
A minimum price above the market price raises the price, but it leaves a surplus that someone must deal with.
Minimum price: a price set by the government below which a good cannot legally be sold.
Put simply, it is a legal floor: a seller may charge more, but never less.
A minimum price changes nothing unless it is above the market price. In Osira the market price of coal is $60, so a floor below $60 would change nothing. Suppose instead the national government sets a minimum price of $70 a tonne, to reduce the amount of coal burnt.
At $70, the quantity demanded contracts to 50 tonnes along the demand curve, because the price is higher. The quantity supplied extends to 80 tonnes along the supply curve, because each tonne now earns sellers more. The quantity supplied is greater than the quantity demanded: a surplus (excess supply) of 30 tonnes a day. Normally a surplus pushes the price down, but the law does not allow that.
Guaranteed price: a minimum price that the government guarantees to producers by buying any output that is not sold at that price.
Put simply, sellers are promised that nothing will stay unsold at that price, because the government will buy whatever others do not.
Guaranteed prices are used mostly for farm crops. Growers must decide what to plant months before the harvest. A guaranteed price tells them, before they plant, the lowest price they will receive.
This is where the surplus becomes a cost. A public agency buys the crop that nobody else buys at the guaranteed price. It must then store it, sell it abroad, often for less, or destroy it. Each of these costs money. As long as the floor stays above the market price, growers produce a surplus every year, so the agency pays this cost every year.
So one tool can serve two motives. On coal, a minimum price reduces the quantity of a harmful good. On a crop, a guaranteed price gives growers a price they can plan around.
A $70 minimum price and a $15 tax give coal buyers the same price, but the extra money goes to different people.
In Osira, the national government could cut the quantity of coal burnt to 50 tonnes a day in two ways: a $15 tax, or a minimum price of $70. Here are the two side by side.
Why do buyers see no difference? Under both tools they face a price of $70. Demand has not changed, so at $70 the quantity demanded is 50 tonnes either way.
Everyone else sees a difference. Under the tax, sellers keep $55. At $55, the quantity supplied is 50 tonnes, the same as the quantity demanded, so nothing is left unsold. Under the minimum price, sellers receive the full $70. At $70 the quantity supplied is 80 tonnes, but the quantity demanded is only 50, so a surplus appears.
Which tool is better? The tax gives the government revenue, which it can spend on the harm, for example on treating illness caused by the smoke. The minimum price needs no tax to be collected. But it gives the extra $15 a tonne to the sellers of the harmful good, and it leaves a surplus that someone must store or destroy. So a government that wants to reduce the harm and pay for its effects has a reason to prefer the tax.
Exam Matters: When you compare two tools that give buyers the same price, say who receives the extra amount on each unit, and whether a surplus appears.
Tradeable permits fix the quantity of pollution, and the market then sets the price.
Tradeable pollution permits: permits issued by the government that allow a firm to emit a set amount of pollution, and that can be bought and sold between firms.
Put simply, each permit is a ticket to pollute a set amount, and a firm that does not need its ticket can sell it to one that does.
In Osira, the national government wants coal burning at the social optimum, 50 tonnes a day. Suppose a seller needs one permit for each tonne of coal sold for burning, and the government issues 50 permits a day. This limit on the total is called a cap. Without a permit, no tonne can be sold. So the quantity supplied cannot go above 50, whatever the price. On the diagram, supply becomes a vertical line at 50 tonnes.
Where does the price settle? With only 50 tonnes available, buyers compete for them, and the price rises until the quantity demanded is also 50. Demand shows that happens at $70, so buyers pay $70.
But supplying the 50th tonne costs only $55, read off the original supply curve. A seller with a permit earns $70 on a tonne that costs $55, so a permit is worth $15 to whoever holds it.
This is the same $15 as the tax, because both tools put the quantity at 50 tonnes. At 50 tonnes buyers pay $70 and supplying the 50th tonne costs $55, so the gap is $15. The tax sets the amount added to each tonne, and the market finds the quantity. The cap sets the quantity, and the market finds the price.
Why let firms trade the permits? Firms differ in what it costs them to cut pollution. Suppose one firm can switch to cleaner fuel cheaply, while another cannot. The first cuts its pollution and sells the permits it no longer needs to the second. Compare this with a rule that makes each firm cut the same amount. With trading, both firms are better off. The first earns more from selling a permit than its extra cut costs it. The second pays less for a permit than cutting would cost it. So the cuts happen where they cost least, and the total stays at 50 tonnes.
The government can auction the permits, selling each one to the firm that offers the most, and then it receives their value. Or it can give them to firms for free, and then the firms keep that value.
Some external costs exist because the people harmed have no legal claim, so giving them one brings the cost into the deal.
Why does a factory ignore the harm it does to a river? Because no one has a legal claim over the river. The families who fish it have no legal claim over the water, so they cannot make the factory pay or stop.
Property rights: the legal rights to own, use and sell a resource, and to stop others from using it.
Put simply, a property right says who owns a thing and what the owner may do with it, including taking someone to court for damaging it.
Extension of property rights gives a claim to people who did not have one. Suppose a law gives the families who fish a river a legal right to clean water. Now the factory must pay the families for the harm, or stop polluting. Either way, the factory now pays for the harm, so the harm becomes part of its own costs. It is no longer an external cost. With a higher cost for each unit it makes, the factory supplies less at every price, so it produces less.
A tradeable permit is itself a property right. It is a right to emit a set amount of pollution, and it belongs to whoever holds it. Because it is owned, it can be sold, which is why permits can be traded.
Extending property rights works best when three things are true:
It fails where many people are each harmed a little. Smoke over a city harms millions of people, each by a small amount. Few of them would go to court alone, and nobody can own the air above a city. In cases like this, a tax, permits or regulation work better.
Regulation sets rules that every firm or consumer must follow, backed by penalties.
Regulation: rules set by the government, backed by penalties, that control what firms or consumers may do.
Put simply, regulation tells people what they must or must not do, and fines or closes those who break the rule.
Regulation takes four main forms:
A rule can reach the same quantity as a tax or permits. Osira's government could order every coal seller to cut sales by one sixth, which takes the market from 60 to 50 tonnes. But every firm must then cut the same share of its sales, whether cutting is cheap or costly for it. So, unlike tradeable permits, a rule does not move the cuts to the firms that can make them most cheaply. If firms differ in what cutting costs them, the same total cut costs more.
When is a rule the better tool? First, when a harm is so serious that no amount is acceptable, such as a poison in food. A tax would still allow some of it, for anyone willing to pay. Second, when the behaviour is easy to see and check, such as whether a car has a filter. Then a rule is simple to enforce and easy for everyone to understand.
Real Example: In 2016 India decided to skip one stage of its vehicle emission standards and move straight to the Bharat Stage VI norms from 1 April 2020. This is a standard: it does not put a price on pollution, it sets the level every manufacturer must reach.
The best tool for an external cost depends on what the government can measure and check.
In Osira, a $15 tax, a cap of 50 permits and a rule can all bring coal down to 50 tonnes a day. They differ in what each one fixes:
What each needs the government to know. A tax needs the external cost per tonne. A cap needs the socially optimal quantity. A rule needs the action each firm should take. If the government gets its figure wrong, any of the three misses the social optimum.
What each costs to check. A tax on coal is charged on each tonne sold, so it needs only records of how much each firm sells. Permits need each firm's pollution itself measured, so that no firm emits more than its permits allow. A rule needs inspectors, officials who visit every firm to check that it follows the rule.
Who receives the money. A tax gives the government revenue, and so do permits sold at auction. Permits given away let firms keep their value. A rule raises no money, and firms pay the full cost of meeting it.
So what decides the choice? A tax is better when the harm per tonne is easier to estimate than the right total. A cap is better when a total must not be passed, such as the most waste a lake can take. With a tax, a rise in demand would raise the quantity. With a cap, it raises only the permit price. A rule fits a harm too dangerous to allow at any price, or a behaviour that is easy to check.
Under state provision the government supplies the good itself, so its budget, not a price, sets the quantity.
State provision: the supply of a good or service by the government, funded from taxation and often free at the point of use.
Put simply, the government runs the clinic or the school itself, and taxpayers pay for it instead of the people who use it.
Suppose Osira's national government runs clinics and offers consultations free. At a price of zero, the quantity demanded is 90 consultations a week, because no patient has to pay anything. But the government's budget pays for only 60 consultations a week. So 30 patients a week must wait or go elsewhere. As under a maximum price, something other than a price, such as a waiting list, decides who is seen.
The quantity is now set by the budget, not by willingness to pay. Here the budget allows 60 consultations, more than the social optimum of 50. A smaller budget could leave the quantity below it. With no price, nothing shows whether the quantity is too high or too low.
The main strength of state provision is who it reaches. Under a subsidy, patients still pay a price: $40 after the $20 subsidy. A family that cannot pay $40 is not reached by the subsidy, but it can use a free clinic. So where those who most need a good can least afford it, state provision reaches them.
The costs are real. Taxes must rise, or other spending must fall, to pay for the clinics. And the government, not patients, decides how many consultations there are and where.
When buyers do not know a good's benefit to themselves, telling them raises demand without paying for the good.
Imperfect market information: When buyers and/or sellers do not have all the information they need to make a rational decision.
Put simply, people choose badly when they are missing a fact, such as what a product will save them later.
Provision of information: the government giving consumers or producers information so that they can make better informed choices.
Put simply, the government fills the gap, through campaigns, labels or rules that a fact must be shown.
Suppose the problem in Osira's clinics is missing information, not an external benefit. Patients do not know that an early check-up saves them $20 of treatment later, so the market settles at 40 consultations a week at $50, and demand is lower than it would be if they knew.
The national government runs a campaign that tells patients this. Each patient now sees an extra $20 of benefit to themselves from a check-up. So at every quantity, the most they are willing to pay for a check-up rises by $20. The demand curve shows this willingness to pay, so it shifts right by $20. Supply has not changed. At the old price of $50 there is now a shortage (excess demand), so the price rises. The market settles at 50 consultations a week, and patients pay $60.
Compare this with the subsidy. Both reach 50 consultations a week. Under the subsidy, patients pay $40 and the government pays $1,000 a week. Under information, patients pay $60 and the government pays only for the campaign. The quantity is the same, but the cause is different: the subsidy shifts supply, while information shifts demand.
Information has one important limit. It works only where buyers lack a fact about their own benefit. Telling a patient that a check-up protects their neighbours does not change the benefit the patient receives, so it need not change what they will pay. So information alone is unlikely to correct an external benefit; a subsidy or state provision fits better.
Exam Matters: Say which curve moves and why: information shifts demand, because buyers learn of a benefit to themselves.
Health and education usually have an external benefit, while housing usually has a fairness problem instead.
Governments intervene in many markets. In each one, the first question is what goes wrong, because that decides which tools fit.
Health. Treating one patient early protects others from infection, so this kind of health care has an external benefit. Many patients also lack information about what a check-up can save them. Both problems leave the market quantity below the social optimum. Governments use subsidies, state provision and information, often together. One limit: a subsidy still leaves a price, which the poorest households may not be able to pay.
Education. An educated worker earns more, and the people who work alongside them become more productive too. That second benefit is external, so a free market provides less education than the social optimum. Many families also lack information about how much schooling would raise their own children's earnings. Governments provide schools free at the point of use and run information campaigns. One limit: the budget sets the number of school places, so classes can become crowded.
Housing. Often there is no external cost or benefit at all. The number of flats the market lets may be the socially optimal number. But the rent may be more than many households can pay. That is a fairness problem, not a market failure. The tools are maximum rents and state provision of housing. One limit: a maximum rent leaves a shortage, so something other than the rent decides who gets a flat.
So the same tool can serve different aims. State provision corrects an external benefit in education, and meets a fairness aim in housing.
Transport, the environment and energy usually have external costs, but energy also raises a question of fairness.
Transport. Each extra car on a busy road slows every other driver, and its exhaust harms people nearby. These are external costs, so the market produces more car journeys than the social optimum. Governments charge drivers for using busy roads, limit the number of vehicles, and provide public transport. One limit: a road charge needs a way to record every car that uses the road.
Environment. Pollution from production is the clearest external cost, as with coal in Osira. Taxes, tradeable pollution permits, property rights and regulation are all used here. Which one fits depends on what the government can measure, such as the harm per tonne or a safe total.
Energy. Burning fossil fuels, such as coal, oil and gas, causes external costs, which points towards a tax. But fuel for cooking and travel is a necessity, and it takes a larger share of a low income. So fairness points towards keeping fuel prices low, often through a subsidy. The two aims pull in opposite directions. So a government must decide which aim comes first, or find a way to meet both. For example, it can tax the fuel and return part of the revenue to low-income households.
Real Example: Singapore limits growth in the number of vehicles. A buyer must first win a Certificate of Entitlement, the right to register a vehicle, in an open bidding exercise (an auction) held twice a month, and each certificate lasts 10 years. This works like a permit scheme: the government limits how many certificates it issues, and bidding sets the price of the right to register a vehicle.
Farm and commodity prices can swing sharply, because supply and demand are both price inelastic in the short run.
A crop is planted months before it is sold. Once it is in the ground, growers cannot change the quantity they bring to market this season. So in the short run, supply is price inelastic: the quantity supplied changes very little when the price changes.
Demand for a staple food, one that people eat almost every day, such as rice or wheat, is also price inelastic. People need to eat, and there are few close substitutes, so the quantity demanded changes little when the price changes.
Put the two together. Suppose a drought cuts the harvest. Supply decreases: at every price, the quantity supplied is smaller. At the old price this leaves a shortage (excess demand). Because demand is price inelastic, the quantity demanded falls only a little as the price rises, so the price must rise sharply before the quantity demanded matches the smaller harvest. A small change in the harvest causes a large change in the price.
A large harvest reverses each of these steps. Supply increases, so at the old price there is a surplus (excess supply). Because demand is price inelastic, the quantity demanded rises only a little as the price falls, so the price must fall sharply before the quantity demanded matches the larger harvest. The price falls by a larger percentage than the quantity sold rises. Growers' income is the price multiplied by the quantity sold, so it falls, and growers can earn less from a good harvest than from a poor one.
Governments respond in two main ways. A guaranteed minimum price gives growers a known floor before they plant, though the agency must then store or sell what it buys. When a staple's price rises sharply, a government may instead subsidise it or set a maximum price, to keep it within reach of low-income households.
Commodities are raw materials traded in large amounts. Those beyond farming, such as fuel and metals, can show the same swings. A new mine or oil field takes years to open, so supply is price inelastic in the short run, and many buyers have no quick substitute.
Real Example: India announces minimum support prices at the start of the sowing season. The Food Corporation of India and state agencies then buy grain at that price from farmers who offer it. So growers know their floor before they choose what to plant. This is a guaranteed price in use: the agencies buy what is offered.
Government failure happens when an intervention leaves society worse off than doing nothing would have.
A government may intervene in a market to remove a welfare loss: a loss to society from producing or consuming the wrong quantity. But an intervention can go wrong, and leave society worse off than before.
Government failure: Intervention that results in a net welfare loss.
Put simply, the intervention costs society more than it gives back, so leaving the market alone would have been better.
The word net matters. It means the intervention is compared with what would have happened with no intervention at all, not with a perfect market. So you weigh the welfare it recovers against everything it costs society, including the cost of running it.
Burning coal in Osira, a small country, does $15 of harm a tonne to people outside the market. Suppose the national government overestimates this external cost and sets a tax of $30 a tonne.
MSC, the marginal social cost, is the cost of each tonne to society: what sellers need to supply it, plus the $15 harm. On the diagram, L is the point on the demand curve at 40 tonnes ($80). M is the point on the MSC curve at 40 tonnes ($65). The third corner, F, is the social optimum at 50 tonnes and $70. The welfare loss is triangle LMF.
Before the tax, the free market lost $75 a day by burning 10 tonnes too many. The $30 tax removes that loss, but it creates a new loss of $75 a day by burning 10 tonnes too few. So the welfare the tax recovers is $75 − $75 = $0 a day. Collecting the tax still costs money, so society is worse off than with no tax at all: a net welfare loss.
Exam Matters: When you define government failure, include the word "net" and say what the intervention is compared with: the outcome with no intervention.
A government sets each tool from information it must estimate or know, and a wrong estimate puts the tool in the wrong place.
A market can fail because buyers or sellers lack information. A government can fail for the same reason. To set any tool in the right place, it needs information that no price list shows.
Why is this information so hard to find? Much of it is the value of things that nobody buys or sells, such as clean air, an hour of someone's time or a lower risk of illness. These have no market price, so the government must estimate them. Two careful estimates of the same cost can be very different.
A wrong estimate moves the quantity away from the social optimum. If the government overestimates an external cost, the tax is too high, and the quantity falls below the optimum. In Osira, a $30 tax on coal, set against a true external cost of $15, cuts the quantity to 40 tonnes, 10 below the optimum, and a $75 welfare loss returns.
If the government underestimates the external cost, the tax is too low. A $6 tax on coal, set against a true external cost of $15, cuts the free-market quantity of 60 tonnes only to 56 tonnes, 6 above the optimum of 50. On each tonne from 50 to 56, the tax is less than the $15 harm, so the cost to society is still more than buyers will pay. The gap grows to $9 at 56 tonnes, so a welfare loss of ½ × $9 × 6 = $27 a day remains. Either way, the government pays to run a tool that recovers less welfare than it could.
Exam Matters: When you explain this cause, name what the tool needs the government to estimate, then say which way a wrong estimate moves the quantity from the social optimum.
A state provider has less reason to keep its costs down, so it may use more resources than the service needs.
When the government supplies a good or service itself, it takes the place of firms in that market. So it helps to ask what keeps a private firm's costs down.
A firm in a competitive market faces two pressures. If its costs rise above its rivals' costs, it must charge more, and customers leave for a cheaper rival. If it finds a saving, it keeps the extra profit. Both pressures give the firm a reason to look for cheaper ways to produce.
A state provider usually faces neither pressure. It usually has no rivals, so patients or pupils cannot go to another provider. If the department finds a saving, the money usually goes back to the government's central budget. So the department that found it gains nothing. With less reason to look for savings, its costs can rise.
Why is this a cause of government failure? A higher cost means the provider uses more labour and materials than the service needs. Those resources could have produced something else, so the extra cost is a welfare loss. A demand and supply diagram does not show it, because it shows only prices and quantities. If this loss is greater than the welfare the provision recovers, the result is a net welfare loss.
One answer is contracting out: the government pays a private firm to run the service for a set number of years. When the contract ends, the firm can lose it to a rival. That threat brings back the pressure to keep costs down, but only if rival firms could really win the contract.
People respond to an intervention in ways the government did not plan, and their response can work against its aim.
An intervention changes what is worth doing for buyers and sellers. People then change what they do, and some of these changes were never part of the plan. They are called unintended consequences.
In Osira, the national government sets a maximum rent of $400 a month, below the market rent of $500. At $400 the quantity supplied is only 150 flats, less than the quantity demanded, so there is a shortage (excess demand), and something else, such as a waiting list, decides who gets a flat.
Over the years that follow, something new happens. Each flat now earns at most $400 a month. Some landlords find a better use for their flats: they sell them to people who will live in them, or let them by the night to visitors. Rents for these short lets are not controlled. With each flat that leaves the rental market, the number of flats let at $400 falls further below 150. So the shortage grows. The maximum rent was meant to help more households afford a flat, but now fewer households find one at the rent the government set.
Other tools have their own unintended consequences:
Why do these cause government failure? Each response creates a new loss that the government did not count when it chose the tool. If that loss is greater than the welfare the tool recovers, the intervention results in a net welfare loss.
Every intervention costs money to run, and if that cost is greater than the welfare it recovers, society loses.
Every intervention uses resources. Its staff, offices and equipment could have produced something else. These are its administrative costs, and they come in four kinds:
These costs never appear on a demand and supply diagram, which shows only prices and quantities. Yet they decide whether the intervention is worth making.
In Osira, the free market's welfare loss from coal is $75 a day. So $75 a day is the most any coal intervention can recover. Suppose permits put the quantity exactly at the social optimum of 50 tonnes. If measuring each firm's smoke, checking its reports and fining cheats costs more than $75 a day, society is worse off than with no intervention. That is a net welfare loss, even though the quantity is exactly right.
Tools differ in how much they cost to run. A tax can use the tax collection the government already has. A permit scheme needs new systems to measure each firm's smoke. An information campaign usually costs less to run than a permit scheme, because it needs no measurement of each firm. So when an intervention can recover only a little welfare, only a tool that is cheap to run may be worth using.
When a government protects people from a risk, some take more of that risk, so the protection costs more.
Governments often protect people from a loss: a fall in a crop's price, a bank that fails, a flooded house. But protection changes the choices people make.
Moral hazard: When an individual or firm takes more risks because somebody else will bear some or all of the cost of those risks.
Put simply, when someone else will pay if things go wrong, you have less reason to be careful.
Why is moral hazard a cause of government failure, and not just one more cost? The protection increases the very risk it protects against. More poor land is planted, more risky loans are made, and more homes stand where floods are likely. So the cost of the protection grows over time. It becomes larger than the government expected when it decided the policy was worth making. If it grows past the welfare the protection gains, the result is a net welfare loss.
One answer is partial protection. A guaranteed price set below the expected market price pays only if the market price falls below it, and compensation for only part of the damage pays only part of the loss. Either way, some of the loss stays with the person who takes the risk. They then still have a reason to take care.
Governments intervene when a market produces too much or too little of a good, so that society loses welfare.
A government may intervene to correct a market failure, to make outcomes fairer, or to keep prices stable.