A) Indirect taxation

Indirect taxes increase firms’ costs of production and can be used to reduce the production or consumption of goods which create negative externalities.

An ad valorem tax is charged as a percentage of the value of a good or service. This means that the amount of tax increases as the value of the product increases.

A specific tax is different because a fixed amount of tax is charged on each unit sold. In both cases, the tax reduces supply and some of the cost may be passed on to consumers through a higher market price.

Indirect taxation can therefore be used to move the market closer to the socially optimum level where a good is being overproduced or overconsumed.

B) Subsidies

A subsidy is money provided by the government to reduce firms’ costs of production. This increases supply and can result in a lower market price and a higher equilibrium quantity.

Subsidies may therefore be used where a good or service is being underproduced or underconsumed. Increasing its consumption can help the market move closer to the socially optimum level.

However, subsidies also have a cost to the government and not all of the subsidy necessarily has to be passed on to consumers.

C) Maximum and minimum prices

Maximum prices

A maximum price is a legal limit on how high the price of a good or service can be set. If it is placed below the market equilibrium price, consumers are willing to demand more while firms are willing to supply less.

Maximum prices may be used where the government wants to make a good or service more affordable. However, the resulting excess demand means that some method of rationing may still be required.

Minimum prices

A minimum price is a legal limit on how low the price of a good or service can fall. If it is placed above the equilibrium price, quantity supplied rises while quantity demanded falls.

A minimum price may be used to reduce consumption of a good which creates negative externalities by increasing the price faced by consumers.

D) State provision

The government may decide to provide some goods and services directly where it believes that the free market would provide too little or would not provide the good at all.

Examples can include merit goods and public services which are funded through taxation and made available to consumers without a direct price at the point of use.

State provision can increase access to goods and services and may help reduce inequalities. However, without a price rationing mechanism there can also be excess demand.

E) Other methods of government intervention

Governments can also use other policies depending on the cause of the market failure.

• Tradable pollution permits – The government can limit the total amount of pollution and allow firms to trade permits giving them the right to pollute.
• Provision of information – Information campaigns or warnings can be used where consumers do not understand the full costs or benefits of their decisions.
• Regulation – Governments can introduce rules or legal limits which force consumers or firms to change their behaviour.

What the full guide adds

For this topic, the full AS guide also covers:

• The full specific-tax analysis, including the division of the tax burden between consumers and producers.
• Detailed evaluation of indirect taxation, including price elasticity of demand, black markets and the use of tax revenue.
• A fuller analysis of subsidies, including the benefits to consumers and producers, the cost to government, opportunity cost and possible producer inefficiency.
• More detailed application of maximum and minimum prices, including real-world examples and the excess demand or excess supply which may result.
• Tradable pollution permits in full, including the permit-market diagram, incentives for firms, administrative costs and the difficulty of setting the correct number of permits.
• A fuller evaluation of state provision, including opportunity cost, possible inefficiency and the problem of rationing excess demand.
• Detailed examples of the provision of information, including health warnings and information campaigns.
• Regulation, including its impact on firms’ costs, enforcement costs, information problems and the risk of government failure.