Indirect taxes: internalising the externality

An indirect tax is levied on expenditure and paid to the government by the seller (who then tries to pass it on). It raises firms' costs, shifting the supply curve left/up.

• Specific (unit) tax → a fixed amount per unit (£0.24 per litre): the supply curve shifts up in parallel.
• Ad valorem tax → a percentage of price (VAT at 20%): the supply curve pivots, widening the gap as price rises.

The Pigouvian ideal is to set the tax exactly equal to the marginal external cost at the social optimum. That forces the producer to pay for the harm, internalising the externality: MPC rises onto MSC, output falls to the social optimum, and the welfare loss disappears.

Tax incidence — who actually bears it — is decided by elasticity, not by who hands over the cheque:

• Demand inelastic relative to supply → the consumer bears most of the burden (tobacco, petrol).
• Demand elastic relative to supply → the producer absorbs most of it, or loses the sale.

Your turn — tax revenue

Your turn — tax incidence

Who bears the tax?

Subsidies and state provision

A subsidy is a payment to producers (or consumers) to lower the price and raise output. It shifts the supply curve right/down by the size of the subsidy, cutting the price consumers pay and raising the price producers receive.

• Purpose: to internalise a positive externality — raising consumption of a merit good (vaccines, apprenticeships, insulation) towards the social optimum.
• Cost: total subsidy = subsidy per unit × the new (higher) quantity. This is an opportunity cost to the taxpayer — the money could have gone to the NHS.
• Who gains? Again elasticity decides. If demand is inelastic, most of the subsidy is captured by producers as higher revenue rather than passed to consumers as lower prices — which is precisely the criticism levelled at some housing and childcare subsidies.
• Risk: subsidised firms may become complacent and X-inefficient; subsidies are politically very hard to remove.

State provision goes further: the government supplies the good directly, free at the point of use (state schooling, NHS treatment, defence). It guarantees access regardless of income and defeats free-riding — but it removes the profit incentive, so there is no automatic pressure to keep costs down, and the state must guess the right quantity without a price signal to guide it.

Your turn — cost of a subsidy

Maximum prices, minimum prices and buffer stocks

A maximum price (price ceiling) is a legal cap. To have any effect it must be set below the equilibrium. Result: quantity demanded exceeds quantity supplied → excess demand.

• Intended: affordability — rent controls, energy price caps, ticket-price caps.
• Actual: shortages, queues, waiting lists, deteriorating quality, rationing by non-price means, and a black (secondary) market at prices above the cap. Rent controls reliably shrink the supply of rental housing over time, because landlords exit.

A minimum price (price floor) is a legal minimum, set above equilibrium. Result: excess supply.

• Examples: the national minimum wage (in the labour market), minimum unit pricing for alcohol, guaranteed farm prices.
• Actual: surpluses. If the state guarantees to buy the surplus, the cost falls on taxpayers (the old EU butter mountains).

Buffer stock schemes try to stabilise volatile commodity prices: the agency buys and stores the surplus when the price falls below a floor, and sells from the store when it rises above a ceiling. In theory it is self-financing. In practice it needs huge working capital, storage costs are large, perishables cannot be stored, and a run of good harvests exhausts the funds — almost every international buffer stock scheme has collapsed.

Maximum prices

Regulation, permits, competition policy and information

Regulation (command and control) — rules backed by law: emissions limits, bans (leaded petrol, smoking indoors), age restrictions, safety standards, planning law. Strength: certain, immediate, easy to understand. Weakness: it is a blunt instrument — it treats all firms alike regardless of how cheaply each could abate; it needs costly monitoring and enforcement; and if the penalty is smaller than the profit from breaking the rule, firms will simply pay the fine as a cost of business.

Tradable pollution permits — the market-based alternative (e.g. the EU/UK Emissions Trading Scheme). The state sets a cap on total emissions and issues permits up to that cap; firms may buy and sell them.

• A firm that can cut emissions cheaply does so and sells its spare permits; a firm facing high abatement costs buys permits instead. The cap is met at the lowest total cost to society, which regulation cannot guarantee.
• It creates a permanent dynamic incentive to invent cleaner technology, because every tonne saved is a permit sold.
• Problems: setting the cap requires knowing the optimal level of pollution; over-issuing permits collapses the price (as happened in the early EU ETS) and destroys the incentive; and it is administratively complex.

Competition policy (the CMA) tackles monopoly power: blocking anti-competitive mergers, fining cartels, regulating natural monopolies' prices, and forcing the break-up of dominant firms. Information provision (calorie labelling, energy ratings, public health campaigns) attacks information failure directly, and is cheap — but it works slowly, and is easily drowned out by advertising.

Why permits beat a blunt rule

Government failure

Government failure occurs when intervention leads to a net welfare loss — a misallocation of resources worse than the market failure it was meant to correct. Causes:

• Information gaps. To set a Pigouvian tax the government must know the MEC in money terms. What is a tonne of carbon worth? What is a decibel of aircraft noise? It guesses, and the tax is wrong.
• Unintended consequences. Rent controls shrink the housing stock. The 1990s "dash for diesel" cut CO2 but poisoned urban air with NOx and particulates. A tax on landfill bred fly-tipping.
• Administrative and enforcement costs can exceed the welfare gain, especially for small externalities.
• Regulatory capture. The regulator, dependent on the industry for information and staff, ends up defending it. (Stigler's theory of regulation.)
• Political self-interest and short-termism. Governments face a five-year electoral cycle; the costs of climate policy fall now, the benefits in fifty years. Vote-seeking, lobbying and rent-seeking distort decisions.
• Distortion of price signals. Subsidies and controls jam the very mechanism that carries information about scarcity, causing shortages, surpluses and misallocation.

The mature answer. "Market failure" and "government failure" are not a knock-out argument for either side. The examinable judgement is comparative: does this specific intervention, given real-world information and incentives, leave society better off than the imperfect market would have? That depends on the size of the externality, the elasticities, the quality of the information, and whether the policy is enforceable.

Identify the government failure

Evaluating intervention

Regulatory capture

Which intervention is it?

Tap a policy, then tap the type of intervention it is.

Match the policy or problem to its consequence

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered government intervention and government failure from the OCR A-level Economics (H460) specification. Press Finish to see your score.