Indirect taxes, subsidies, maximum and minimum prices, tradable pollution permits, state provision, regulation and information provision, and the causes of government failure.

What this dot point is asking

Edexcel wants you to explain the main tools governments use to correct market failure, analyse each on a supply and demand diagram, evaluate their strengths and weaknesses, and explain why intervention can itself cause government failure. This sits in Theme 1 and feeds directly into Theme 3 microeconomic policy and Theme 4 environmental and development policy, so the analysis here is reused across the whole course.

The answer

Indirect taxes

A tax on a good with a negative externality shifts the supply curve left (or up by the amount of the tax), raising price from the free-market level toward the social optimum where marginal social benefit equals marginal social cost. On a diagram, the new equilibrium quantity is lower, the welfare loss triangle shrinks, and the government collects revenue equal to the tax per unit multiplied by the new quantity. The incidence of the tax (who actually pays) depends on elasticity: when demand is more inelastic than supply, consumers bear most of the burden. The UK uses fuel duty, tobacco duty and the Soft Drinks Industry Levy (2018) in exactly this way.

Subsidies

A subsidy raises output toward the social optimum and lowers price to consumers, but it has a direct opportunity cost to the taxpayer, can be hard to remove once firms depend on it, and may be captured as producer profit rather than passed on.

Price controls and tradable permits

Tradable pollution permits cap total emissions and let firms buy and sell the right to pollute. Low-cost abaters sell permits to high-cost abaters, so total pollution is cut at least cost (this is the logic of the EU Emissions Trading System and the UK ETS). The weaknesses are that the cap is hard to set, prices can be volatile, and monitoring and enforcement are costly.

State provision, regulation and information

Governments also provide public and merit goods directly (the NHS, state education), use regulation (emissions standards, age limits, the smoking ban) backed by fines, and run information provision campaigns (5-a-day, anti-smoking advertising) to close information gaps so consumers value merit goods correctly.

Government failure

Examples in context

The Soft Drinks Industry Levy (2018) is a tiered ad valorem-style tax that prompted reformulation, cutting sugar content rather than just raising price, an example of a tax changing producer behaviour. Scotland's minimum unit price for alcohol of $0.50$ (2018, raised to $0.65$ in 2024) targets cheap high-strength drinks; early studies found a roughly $3\%$ fall in alcohol sales, small because demand is inelastic. Rent controls in cities such as Berlin produced shortages and reduced housing supply, a textbook case of a maximum price causing government failure through unintended consequences.

Try this

Q1. Explain why a maximum price set below equilibrium causes a shortage. [3 marks]

• Cue. At the lower price, quantity demanded exceeds quantity supplied, so there is excess demand.

Q2. Assess the case for using an indirect tax rather than regulation to reduce carbon emissions. [12 marks]

• Cue. Compare the market-based flexibility and revenue of a tax against the certainty of a regulation, and evaluate by elasticity, setting the right rate, and competitiveness effects.