Indirect taxes to internalise an externality

The aim is to make the polluter pay — to internalise the externality by setting a tax equal to the marginal external cost. That shifts the firm's supply curve (MPC) up until it sits on MSC, so the firm now chooses the socially optimal output Q*. This is a Pigouvian tax.

• Specific tax — fixed £ per unit (fuel duty, alcohol duty). Parallel upward shift of S.
• Ad valorem tax — a % of price (20% VAT). S pivots and the gap widens as price rises.

Evaluation: ✅ Internalises the externality, raises revenue (which can be hypothecated — spent on cleaning up the damage), and preserves the price mechanism. ❌ Demand for polluting goods is often inelastic, so a big tax cuts output little (it mostly raises revenue). ❌ Indirect taxes are regressive — they take a larger share of a poor household's income. ❌ You need to know the exact size of the MEC to set the tax right — and you don't (see government failure).

Your turn — tax revenue

Subsidies to encourage merit goods

A subsidy is a payment to producers per unit, designed to lower price and raise output towards the social optimum where there is a positive externality (vaccination, training, public transport, insulation).

• The consumer subsidy is the fall in the price consumers pay. The producer subsidy is the rise in the price producers receive. Together they equal the subsidy per unit.
• If demand is inelastic, most of the subsidy is captured by producers as a higher price received, and the price to consumers falls very little — the policy fails on its own terms.

Evaluation: ✅ Increases consumption of the merit good, can improve equity and raise long-run productivity (a supply-side effect, Theme 2.6.3). ❌ Opportunity cost — every £1 of subsidy is £1 not spent on the NHS, and it worsens the budget deficit. ❌ Firms may become complacent and inefficient if permanently subsidised. ❌ Once given, subsidies are politically very hard to remove.

Your turn — cost of a subsidy

Maximum prices (price ceilings)

A maximum price is a legal cap. To have any effect it must be set below the free-market equilibrium. Aim: make a necessity affordable (rent controls, an energy price cap).

Consequences: the price is prevented from performing its rationing function (1.2.7), so the shortage is rationed by queues, waiting lists, first-come-first-served — or by an illegal black market where the good resells above Pmax. Producers, facing a lower price, cut supply and under-invest, which makes the shortage worse over time. Rent controls are the classic case: rents are lower for those who have a flat, but fewer flats are built and quality falls.

Maximum prices

Minimum prices (price floors)

A minimum price is a legal floor. To bite it must be set above the equilibrium. Aims: protect producer incomes (agricultural price support, the National Living Wage in the labour market) or discourage consumption of a demerit good (minimum unit pricing for alcohol, introduced in Scotland in 2018).

The EU's Common Agricultural Policy guaranteed farmers a minimum price. The predictable result: enormous, permanent surpluses — the "butter mountains" and "wine lakes" of the 1980s — bought and stored by the taxpayer, then dumped on world markets, depressing prices for farmers in developing countries. A textbook case of government failure.

Your turn — the size of a surplus

Tradable pollution permits

The government caps total emissions by issuing a fixed number of permits, then lets firms trade them. This is cap and trade — the model behind the EU and UK Emissions Trading Schemes.

• Permits are scarce, so they have a price. The supply of permits is perfectly inelastic (a vertical line at the cap); demand comes from firms.
• A firm that can cut emissions cheaply does so and sells its spare permits. A firm for which abatement is expensive buys permits instead. The result: the cap is met at the lowest possible total abatement cost. That is the whole beauty of the scheme.
• The government can tighten the cap over time, raising the permit price and forcing further cuts, and can auction permits to raise revenue.

Evaluation: ✅ Certainty over the total quantity of pollution (a tax gives no such certainty). ✅ Creates a dynamic incentive to invent cleaner technology, because saved permits can be sold. ❌ Setting the cap requires knowing the optimal level of pollution — information gap. ❌ If the cap is set too loose (as in the EU ETS's early years), the permit price collapses and nothing changes. ❌ Expensive to monitor, and firms may relocate to countries with no scheme (carbon leakage).

Cap and trade

Three non-price interventions

• State provision of public goods — the only answer to a missing market (1.3.3). Defence, street lighting, flood defences, and (in the UK) free-at-the-point-of-use healthcare and education. Funded by taxation. ❌ Weakness: with no price signal and no profit motive, the state has poor information about how much people actually want, and weak incentives to be productively efficient.
• Provision of information — directly attacks an information gap (1.3.4). Calorie labelling, cigarette health warnings, energy-efficiency ratings, drink-driving campaigns, compulsory publication of school results. ✅ Cheap and preserves free choice. ❌ People may ignore it — especially where the good is addictive or the harm is far in the future (present bias, 1.2.10).
• Regulation — rules backed by law: bans (smoking indoors, single-use plastics), minimum standards (emissions limits, building regs), age limits, licensing. ✅ Fast, simple, effective where the harm is severe. ❌ Sets a blunt uniform standard regardless of each firm's costs, so it is less efficient than a tax or permit. ❌ Expensive to monitor and enforce; may push activity into black markets. ❌ Regulatory capture — the regulator can end up serving the industry it polices.

Sort the interventions

Does it work through the price, does it work by rule or provision, or is it an example of the policy going wrong?

Government failure

Note the word net. A policy that costs something but delivers more is not government failure. Edexcel names four causes:

• Distortion of price signals. Interventions stop prices rationing, signalling and incentivising. Minimum prices create surpluses; maximum prices create shortages; subsidies keep inefficient firms alive and misdirect resources into activities the market never wanted.
• Unintended consequences. Agents respond to incentives in ways policymakers did not foresee. The landfill tax raised the cost of legal disposal — and fly-tipping rose. Rent controls reduced housing supply. Banning plastic bags raised sales of thicker (more carbon-intensive) reusable bags.
• Excessive administrative costs. A policy can cost more to design, monitor and enforce than the welfare gain it delivers. A complex means-tested subsidy may spend a large share of its budget on bureaucracy.
• Information gaps. The government does not know the true size of the MEC, the true PED, or the optimal cap. Set the tax too low and the externality persists; too high and you destroy an industry unnecessarily. Governments face the same Hayekian knowledge problem as the central planner in 1.1.6.

Also worth citing: political self-interest and the short-termism of the electoral cycle (policies chosen to win the next election, not to maximise long-run welfare), and regulatory capture.

Match the failure to its cause

Tap the example on the left, then the Edexcel cause of government failure on the right.

Is it government failure?

Choosing between the policies

• Tax vs permit. A tax fixes the price of pollution and lets the quantity settle — good if you care about cost certainty for firms. A permit fixes the quantity and lets the price settle — good if you have a hard emissions target. Which is better depends on which uncertainty you fear more.
• Elasticity governs everything. A tax on a good with inelastic demand raises lots of revenue but changes little behaviour. If the aim is to cut consumption, you may need regulation or an information campaign alongside it.
• Equity vs efficiency. Indirect taxes are efficient but regressive. A policy can be right on efficiency grounds and still be rejected on distributional grounds — a value judgement (1.1.2).
• Time period. Judge policies over the long run. A fuel duty looks useless in year one (inelastic demand) but drives the shift to EVs over a decade.
• The clincher. Compare the welfare gain from correcting the market failure with the welfare cost of the intervention. Intervene only if the first exceeds the second.

Distorted price signals

The big ideas to know

That completes Theme 1. Press Finish to see your score.