Explain why governments intervene in markets, analyse price controls, indirect taxes, subsidies, direct provision and regulation with diagrams, and evaluate their effects on every stakeholder.
Each is in the Economics glossary, with every other term in the subject.
An indirect tax charged as a fixed percentage of the price of a good, so the tax per unit rises with the price and the supply curve pivots upwards.
A store of a commodity that the government buys when supply is high to support the price and sells when supply is low to stop the price rising, to stabilise prices.
Government rules backed by law that require or forbid certain behaviour by firms or consumers, such as bans, quotas, standards or age limits, enforced through penalties.
The supply of goods or services by the government itself, financed from tax revenue and usually provided free or at a low price, such as state schools and public hospitals.
The situation where a government intervention leads to a less efficient allocation of resources, or a worse outcome, than the market would have produced without it.
The income a government receives, mainly from direct and indirect taxes, but also from fees, sales of goods and services, and the profits of state-owned enterprises.
A tax on spending on goods and services, paid to the government by the seller, which raises firms' costs and shifts the supply curve upwards.
A price floor in the labour market: the lowest wage rate per hour that employers may legally pay workers, usually set above the market equilibrium wage.
Explain seven reasons why governments intervene in markets.
Draw and explain price ceiling and price floor diagrams, showing the shortage or surplus, the welfare loss and the effects on stakeholders.
Draw and explain diagrams of specific and ad valorem indirect taxes and of subsidies, showing the tax incidence or the subsidy cost.
Explain how direct provision and command and control regulation change market outcomes.
Evaluate each form of intervention for consumers, producers, workers, the government and society.
Explain how consumer nudges work as a form of intervention (HL).
Calculate the effects of price controls, indirect taxes and subsidies on markets and stakeholders from values on a diagram (HL).
Governments in every country change the outcomes that markets would reach on their own. They tax petrol and tobacco, pay farmers subsidies, limit rents, set minimum wages, run schools and hospitals, and ban dangerous products. This government intervention affects the prices people pay, the quantities produced and who gains or loses, so it shapes almost every market a household or firm deals with.
The key concepts are at work throughout the topic. Governments intervene to pursue equity, efficiency, sustainability and economic well-being, but every policy involves a choice between goals and creates winners and losers, so the right amount of intervention is always debated.
375 exam-style questions on this subtopic, written in the style of the IB papers. The first has its markscheme open. Counted on
Every economy must decide how to use limited resources to satisfy the needs and wants of its population.
Using a production possibilities curve (PPC), explain the concepts of scarcity, choice and opportunity cost.
10 marks
Answers may include:
Terminology: definitions of scarcity (limited resources relative to unlimited needs and wants), choice (selecting between competing alternatives uses of resources), opportunity cost (the value of the next best alternative forgone), production possibilities curve (the maximum combinations of two goods that can be produced with all resources fully and efficiently employed, given technology).
Explanation: because factors of production are limited, the economy cannot produce beyond its PPC, so combinations outside the curve are unattainable (scarcity); society must choose a point on (or within) the curve, deciding which combination of the two goods to produce (choice); moving along the curve to produce more of one good requires resources to be transferred away from the other, so output of that good must be given up (opportunity cost); a concave curve shows that the opportunity cost rises as more of one good is produced because resources are not equally suited to both goods.
Diagram: a PPC with two goods on the axes; a point outside the curve labelled unattainable; a movement along the curve from point A to point B showing the gain in good X (ΔX) and the loss of good Y (ΔY) as the opportunity cost; may show a point inside the curve to contrast with efficient points.
A maximum of [6] should be awarded if only one or two of the three concepts are explained.
One of 60 short multiple-choice questions on 2.7. Pick an answer to see why it's right or wrong.
A tax applies only to snacks with more than a set amount of salt per 100 g. Demand for snacks is price inelastic. How can the tax still cut salt intake sharply?
The official deck for this part of the syllabus.
What is government intervention in a market?
Explain why a competitive free market with no externalities is allocatively efficient.
With a free account, Augment remembers where you stopped and what you have practiced.
Allocating a good in short supply by a method other than price, such as queuing, waiting lists, lotteries, ration coupons or sellers' preferences.
An illegal market in which a good subject to a price control is bought and sold at a price above the legal maximum, usually because the control has caused a shortage.
A legal maximum price set by the government below the equilibrium price, above which a good or service may not be sold; it creates excess demand (a shortage).
A legal minimum price set by the government above the equilibrium price, below which a good or service may not be sold; it creates excess supply (a surplus).
An indirect tax of a fixed amount of money per unit of a good sold, which shifts the supply curve upwards by the amount of the tax, parallel to the original curve.
Individuals or groups affected by an economic decision or policy, such as consumers, producers, workers, the government and society as a whole.
A payment by the government to producers, usually per unit of output, that lowers their costs and shifts the supply curve downwards, raising output and lowering the price.
How the burden of an indirect tax is shared between consumers, through a higher price paid, and producers, through a lower price received; it depends on PED and PES.
An ad valorem indirect tax charged as a percentage of the value added at each stage of production and distribution, and paid in full by the final consumer in the price.
The loss of social surplus that occurs when a market produces a quantity other than the allocatively efficient one, so some value is lost to society; also called deadweight loss.
In a competitive market the price mechanism allocates resources through the interaction of demand and supply. At the equilibrium, social surplus (the sum of consumer surplus and producer surplus) is as large as possible and the market reaches allocative efficiency: the marginal benefit of the last unit equals its marginal cost. Governments still intervene, for several reasons that can be grouped into seven aims.
Government intervention means any action by the government that changes the outcome a market would reach on its own: setting prices, taxing or subsidising goods, providing goods and services directly, or regulating behaviour.
Earning government revenue. Governments need income to pay for defence, schools, roads and welfare payments. Taxes on spending, such as value added tax and duties on fuel, alcohol and tobacco, are a large source of government revenue in most countries because they are easy to collect from a relatively small number of sellers.
Supporting firms. Governments may help producers whose survival matters to them: domestic farmers facing volatile prices, a new industry that cannot yet compete with established foreign firms, or firms hit by a sudden shock. Subsidies, price floors and grants raise the revenue these firms receive.
Supporting households on low incomes. When the market price of an essential good such as food, rented housing or energy is high relative to the incomes of poor households, governments may cap its price, subsidise it or provide it free. A minimum wage aims to raise the earnings of low-paid workers.
Influencing the level of production. Governments sometimes want more of a good produced than the market would supply, for example renewable electricity or a strategic crop, and use subsidies or guaranteed prices to encourage it. In other cases they restrict production, for example of a polluting product.
Influencing the level of consumption. Some goods are consumed more than is good for the consumer or for others, such as cigarettes, alcohol and sugary drinks; these are demerit goods. Others, such as vaccinations and education, are consumed too little; these are merit goods. Taxes, subsidies, regulation and information all change consumption.
Correcting market failure. Market failure occurs when the free market leads to a misallocation of resources, for example when production or consumption creates external costs or benefits for third parties, or when a good such as street lighting would not be provided at all. Intervention can move the market closer to the socially optimal outcome.
Promoting equity. Markets distribute goods by willingness and ability to pay, so people with low incomes get fewer of them. Many people consider this unfair for essentials such as healthcare and education. Intervention can make access to these goods more equal, a normative aim based on value judgments about fairness.
Aim of intervention | Typical tools | Short real example |
|---|---|---|
Earn government revenue | Indirect taxes (VAT, excise duties) | Fuel, alcohol and tobacco duties in most countries |
Support firms | Subsidies, price floors | India’s minimum support prices for wheat and rice |
Support households on low incomes | Price ceilings, subsidies, direct provision | UK Energy Price Guarantee, October 2022 |
Influence the level of production | Subsidies, guaranteed prices, regulation | Tax exemptions for electric cars in Norway |
Influence the level of consumption | Indirect taxes, minimum prices, bans | Scotland’s minimum unit price for alcohol, 2018 |
Correct market failure | Taxes, subsidies, regulation, provision | EU ban on certain single-use plastics, 2021 |
Promote equity | Direct provision, subsidies, price ceilings | Free grain for about 800 million people in India |
The aims often overlap and sometimes conflict. A tax on cigarettes raises revenue and reduces consumption at the same time, but the more successfully it cuts smoking, the less revenue it raises. A price ceiling on rents helps sitting tenants but can reduce the supply of housing, working against the aim of helping people on low incomes find a home.
Every intervention affects several groups differently, so its effects are analysed for each group of stakeholders in turn. The usual list is consumers, producers, workers, the government (and through it, taxpayers) and society as a whole. In international markets foreign producers and consumers are stakeholders too.
Society’s position is judged by the change in total welfare. Using consumer and producer surplus, the gain or loss to society is the change in social surplus, plus any tax revenue the government collects, minus any money it spends. When an intervention moves output away from the allocatively efficient quantity in a market with no externalities, part of the social surplus disappears. This lost surplus is the welfare loss.
Intervention takes five main forms, which differ in how directly the government overrides the market.
Form | How it works | What it changes first |
|---|---|---|
Price controls (ceilings and floors) | A legal maximum or minimum price | The price, directly |
Indirect taxes | A tax per unit or a percentage of the price | Firms’ costs, so supply falls |
Subsidies | A payment to producers, usually per unit | Firms’ costs, so supply rises |
Direct provision | The government supplies the good itself | Who produces and who receives the good |
Command and control regulation | Laws that require or forbid behaviour | What firms and consumers may do |
Price controls replace the market price with one set by law. Taxes and subsidies leave the price mechanism working but change the costs that producers face, so the market reaches a new equilibrium. Direct provision and regulation replace market decisions with government decisions. HL students also study nudges, which keep every option open but change how choices are presented.
A price ceiling sets the highest price at which a good may legally be sold. Governments use ceilings mainly to keep essential goods affordable for households on low incomes: rented housing, staple foods, electricity, gas and fuel are the usual cases.
A ceiling only changes the market if it is set below the equilibrium price. A maximum price above Pe does nothing, because the market price is already lower than the limit and settles where it would anyway.
At the ceiling price, consumers move down the demand curve and want to buy more (Qd), while producers move down the supply curve and are willing to sell less (Qs). Quantity demanded exceeds quantity supplied, so there is excess demand, a shortage of Qd − Qs. In a free market the shortage would push the price back up to Pe, but the law prevents the price from rising, so the shortage persists.
Only Qs units are traded, because consumers cannot buy what producers do not supply. The quantity traded is always the smaller of the two quantities at the controlled price, which for a ceiling is Qs.
Since price can no longer ration the good, it has to be allocated in other ways. This is non-price rationing: first come, first served (queues and waiting lists), lotteries, ration coupons issued by the government, or sellers choosing buyers by personal connection or other criteria. Queuing has an opportunity cost, the time spent waiting, which falls hardest on people whose time is scarce.
Some consumers are willing to pay much more than the ceiling for the limited quantity Qs. On the demand curve, the price at which consumers would buy exactly Qs is Ppm, well above both Pmax and Pe. People who obtain the good at the legal price can resell it illegally at a price close to Ppm. This illegal trade is a parallel market (also called a black market).
Producers receive a lower price, so they have less reason to maintain quality. Landlords under rent control may spend less on repairs; food producers may switch to uncontrolled products. Over time, supply responds more strongly to the low price, because price elasticity of supply is higher in the long run: some producers leave the market and few new ones enter. The shortage therefore tends to grow the longer the ceiling lasts.
Before the ceiling, consumer surplus is the area under the demand curve and above Pe, and producer surplus the area above the supply curve and below Pe, up to Qe. After the ceiling, consumers who still buy gain area A, which producers lose, because they pay Pmax instead of Pe on Qs units. Triangle B, the surplus on the units between Qs and Qe that are no longer produced, is lost by both groups and gained by no one: it is the welfare loss.
This analysis assumes the Qs units go to the consumers who value them most. With queues, lotteries or favouritism, some units go to consumers with a lower willingness to pay, so the true loss of consumer surplus is larger than the diagram shows.
YouTubeStakeholder | Effect of a price ceiling |
|---|---|
Consumers who buy the good | Pay a lower price and gain area A of producer surplus. |
Consumers who cannot buy it | Face the shortage, queues and waiting lists, or pay parallel-market prices above Pe. |
Producers | Receive a lower price and sell less; revenue and producer surplus fall, and some leave the market. |
Workers | Lower output means less labour is needed, so some workers in the industry may lose jobs or hours. |
Government | May gain political support but must enforce the ceiling; may need to ration the good or subsidise producers. |
Society | Loses the welfare loss B; resources are underallocated to the good, and parallel markets reduce tax revenue and trust in the law. |
Berlin froze the rents of most of its older flats from February 2020, a ceiling aimed at sitting tenants facing fast-rising rents. In 2021 Germany’s Federal Constitutional Court declared the law void because rent law is a matter for the federal parliament, so the policy ended before its long-run supply effects could fully appear.
Energy prices are another common target. From 1 October 2022 the UK’s Energy Price Guarantee limited the prices households paid for gas and electricity, so that a household with typical use would pay about £2,500 a year, and the government paid energy suppliers the difference between this and their costs. Because the state covered the gap, suppliers did not cut supply, so there was no shortage. The cost to taxpayers depended on wholesale gas prices and was highly uncertain, and the guarantee for all households ended in June 2023.
Spain and Portugal took a different route from June 2022, the “Iberian exception”: they capped the price of the gas used to generate electricity, paid for by extra charges on consumers. Electricity prices fell, but cheaper gas-fired power raised the quantity of electricity demanded and with it gas use and carbon emissions, an unintended consequence of a ceiling on one input.
Sources: Federal Constitutional Court of Germany (2021); UK Government, Energy Price Guarantee (2022–23); Haro Ruiz, Schult and Wunder, Applied Economics Letters (2024); González-de Miguel, van Wunnik and Sumper, Energies (2024).
Strengths. A ceiling acts quickly, costs the government little to announce and directly lowers the price of an essential good for the consumers who obtain it, which can protect the economic well-being of low-income households in a crisis. It is easy for the public to understand, which helps explain its political popularity.
Limitations. The shortage means the good is rationed by queues, luck or connections rather than need, so the poorest households may not be the ones who benefit. Parallel markets, falling quality and a shrinking supply over time all work against the aim. Enforcement is costly, and the welfare loss means society as a whole is worse off.
What the outcome depends on. The damage is greater the further below Pe the ceiling is set and the more price-elastic supply is, since a more elastic supply curve means a larger fall in quantity supplied. It is also greater the longer the ceiling lasts, because supply becomes more elastic over time. A short, temporary ceiling in an emergency does less harm than a permanent one.
Judgment. A price ceiling is most defensible as a short-term measure in a crisis, or when it is combined with policies that hold up supply, such as payments to producers or public building of housing. Alternatives that raise the incomes of poor households, such as cash transfers or housing benefit, help them afford the good without destroying the incentive to supply it, although they cost the government more.
A price floor sets the lowest price at which a good may legally be sold. Governments use floors for three main purposes: to raise and stabilise the incomes of producers, especially farmers; to raise the pay of low-paid workers, through a minimum wage; and to reduce the consumption of demerit goods such as alcohol.
A floor only has an effect if it is set above Pe. At the higher price Pmin, producers move up the supply curve and offer more (Qs), while consumers move up the demand curve and buy less (Qd). Quantity supplied exceeds quantity demanded, so there is excess supply, a surplus of Qs − Qd. The price cannot fall to clear it, because selling below Pmin is illegal.
If nobody buys the surplus, only Qd units are sold (left panel). Consumers pay Pmin instead of Pe on these units, so area A is transferred from consumer surplus to producer surplus. Triangle B, the surplus on the units between Qd and Qe that are no longer traded, is the welfare loss. Producers who cannot sell their output are left with unsold stock, so the floor helps some producers and hurts others.
To make a floor work for all producers, the government usually promises to buy whatever is not sold at Pmin (right panel). Producers then sell the whole quantity Qs at Pmin: Qd to consumers and Qs − Qd to the government, which spends Pmin × (Qs − Qd), the shaded rectangle. The government must then do something with the surplus:
Store it, which costs money for warehouses, and perishable goods lose value or rot.
Destroy it, which wastes the resources used to produce it.
Sell it abroad, often below cost with an export subsidy, which lowers world prices and harms farmers in other countries.
Give it away, for example as food for low-income households at home or as food aid abroad.
Sell it in later years when harvests are poor, which turns the scheme into a buffer stock.
A buffer stock scheme uses this idea to stabilise prices rather than to raise them: the government buys a commodity when supply is high and the price would fall below a target, and sells from its stock when supply is low and the price would rise above it.
When the government buys the surplus, the welfare cost is larger than triangle B. Society now produces Qs units, more than Qe, and the extra units cost more to make than consumers value them at. Resources are overallocated to the good, and taxpayers pay for both the purchase and the storage.
A minimum wage is a price floor in the labour market. Firms demand labour and households supply it, so the diagram has the wage rate on the vertical axis and the quantity of labour on the horizontal one. A minimum wage set above the equilibrium wage raises the pay of workers who keep their jobs but reduces the quantity of labour firms want to hire.
In this simple model, the excess supply of labour Qs − Qd is unemployment. Employment falls from Qe to Qd, while more people (Qs) offer to work at the higher wage. Workers who keep their jobs gain; those who lose them, or never find one, lose. In practice the effect on jobs depends on how far above the market wage the minimum is set and on how much power employers have to set wages, so real-world minimum wages often raise pay with smaller job losses than this model predicts.
A floor can also be used to cut consumption. Scotland introduced a minimum price of 50p per unit of alcohol on 1 May 2018 after the UK Supreme Court rejected a legal challenge from the Scotch Whisky Association, and raised it to 65p in 2024. The policy targets cheap, strong drinks bought mainly by heavy drinkers. One evaluation estimated that it reduced deaths directly caused by alcohol by 13.4%.
Sources: Alcohol (Minimum Pricing) (Scotland) Act 2012; UK Supreme Court (2017); Wyper et al., The Lancet (2023).
Unlike an agricultural floor, the surplus here is not bought by the government: the aim is for less of the good to be sold. The higher price per unit also goes to retailers and producers rather than to the government, which is one reason some economists prefer a higher alcohol tax instead.
Stakeholder | Effect of a price floor (with government purchase of the surplus) |
|---|---|
Consumers | Pay a higher price and buy less; consumer surplus falls. |
Producers | Receive a higher, more stable price and sell more; revenue and producer surplus rise. Inefficient producers are protected. |
Workers | More output can mean more jobs in the industry; with a minimum wage, those employed earn more but some lose jobs. |
Government | Spends Pmin × (Qs − Qd) buying the surplus, plus storage and disposal costs, which has an opportunity cost. |
Society | Overallocation of resources and welfare loss; possible environmental costs from excess production. |
Foreign producers | Lose if the surplus is dumped on world markets at low prices. |
Strengths. A floor gives producers a predictable income, which matters for farmers whose prices swing with the weather. Stable farm incomes can support rural employment and a country’s food security. A minimum wage can raise the living standards of the lowest-paid workers and reduce reliance on welfare payments, and a minimum price can reduce consumption of harmful goods.
Limitations. Consumers pay more, the government faces large and rising costs, and surpluses are wasteful to store or destroy. Guaranteed prices weaken the incentive for farmers to cut costs or switch to crops that consumers want more, so resources are tied up in the supported crops. Dumping surpluses abroad harms farmers in poorer countries.
What the outcome depends on. The size of the surplus and the cost to taxpayers depend on how far above Pe the floor is set and on the price elasticities of demand and supply: the more elastic they are, the larger the surplus. Costs also grow over time, since supply becomes more elastic in the long run and producers expand in response to the guaranteed price.
Judgment. A floor set only slightly above the market price, or used as a buffer stock to smooth prices around their long-run average, can stabilise incomes at a moderate cost. A floor set well above the market price and held for many years tends to produce growing surpluses and costs, as India’s minimum support prices for wheat and rice show. Direct income support to farmers can raise their incomes without encouraging overproduction.
An indirect tax is a tax on spending on goods and services. The seller pays it to the government, but part of it is passed on to consumers through a higher price. Indirect taxes raise revenue and discourage consumption of the taxed good, and a tax designed to correct a negative externality is called a Pigouvian tax.
There are two types. A specific tax is a fixed amount per unit, such as a duty of a certain amount per litre of petrol or per packet of cigarettes. An ad valorem tax is a percentage of the price; the best-known example is value added tax (VAT), called goods and services tax (GST) in some countries.
A specific tax is the same amount whatever the price of the good, so the supply curve shifts up by the same vertical distance at every quantity. An ad valorem tax is a fixed percentage, so it adds more to a high price than to a low one.
For a firm, a tax of $1 per unit is like a $1 rise in the cost of each unit. To supply any given quantity, the firm now needs a price $1 higher than before, so the supply curve shifts upwards by $1 to S + tax. The vertical distance between S and S + tax is the tax per unit.
The new equilibrium is where S + tax crosses demand: quantity falls from Qe to Q₁ and the price consumers pay rises from Pe to Pc. Producers collect Pc but pass the tax to the government, so the price they keep is Pp, read off the original supply curve at Q₁. The tax per unit is the gap Pc − Pp.
Government revenue is the tax per unit times the quantity sold: (Pc − Pp) × Q₁, the rectangle A + B. The part above Pe (area A) is paid by consumers in the higher price, and the part below Pe (area B) is paid by producers in the lower price they keep. Triangle C is the welfare loss: the surplus on the units between Q₁ and Qe that are no longer traded.
Tax incidence describes who bears the burden of a tax. Although firms hand the tax to the government, they share its burden with consumers: consumers pay Pc − Pe more per unit, and producers keep Pe − Pp less. The split depends on the price elasticities of demand and supply.
When demand is price-inelastic, consumers keep buying even as the price rises, so producers can pass most of the tax on: the consumer share is large and quantity falls little. When demand is price-elastic, consumers cut their purchases sharply if the price rises, so producers have to absorb most of the tax. The same logic applies to supply: the less elastic supply is, the more of the tax falls on producers.
This explains which goods governments tax most heavily for revenue. Fuel, tobacco and alcohol have price-inelastic demand (price elasticity of demand below 1), so a tax raises a lot of revenue with a small fall in quantity. The same feature means such taxes do little to reduce consumption, which matters when the aim is to cut consumption rather than to raise money.
With an ad valorem tax, the tax per unit is a percentage of the price, so it is larger at higher prices. The supply curve S + tax therefore diverges from S: the gap between them is small at low prices and widens as the price rises. The analysis is otherwise the same: consumers pay Pc, producers keep Pp, output falls to Q₁, and the rectangle (Pc − Pp) × Q₁ is the government’s revenue.
YouTubeStakeholder | Effect of an indirect tax |
|---|---|
Consumers | Pay a higher price (Pc) and buy less; consumer surplus falls. Low-income consumers are hit hardest. |
Producers | Keep a lower price (Pp) and sell less; revenue and producer surplus fall. |
Workers | Lower output can reduce employment in the industry. |
Government | Gains revenue (Pc − Pp) × Q₁, which can fund spending or replace other taxes. |
Society | Loses the welfare loss C if the market had no externalities; gains if the tax corrects a negative externality. |
The UK Soft Drinks Industry Levy, introduced on 6 April 2018, is a tiered specific tax on producers: 18p per litre on drinks with more than 5 g of sugar per 100 ml and 24p per litre on drinks with more than 8 g. Because the tax is avoided entirely by keeping sugar below the threshold, many manufacturers reformulated their drinks. A 2025 study estimated that around 80% of the resulting fall in calorie intake came from reformulation rather than from consumers buying less, and the levy raised £336 million in 2019–20.
Sources: HM Treasury, Soft Drinks Industry Levy (2018); HM Revenue and Customs (2020); studies summarised in Wikipedia, “Sugary drink tax” (2025).
The levy shows that the design of a tax matters as much as its size. A tiered tax with a threshold changes what producers make, not only what consumers buy, so it can reduce sugar consumption even where demand for soft drinks is price-inelastic.
Strengths. Indirect taxes raise large amounts of revenue cheaply, since a few thousand sellers collect them. They reduce consumption of demerit goods and, when set close to the external cost, move the market towards the socially optimal output. Consumers keep the freedom to buy the good if they value it enough.
Limitations. Where demand is price-inelastic, a tax barely reduces consumption. Indirect taxes are often regressive: low-income households spend a larger share of their income on taxed goods such as tobacco, fuel and food, so they pay a larger share of their income in tax, which works against equity. High taxes encourage smuggling and cross-border shopping, and producers and workers in the taxed industry lose.
What the outcome depends on. The price elasticity of demand decides whether the tax mainly raises revenue or mainly cuts consumption. Its effect on equity depends on what the revenue is spent on: revenue used to fund services for poorer households can offset the regressive effect. In the long run demand becomes more elastic as consumers find substitutes, so the effect on consumption grows over time.
Judgment. Indirect taxes are an efficient way to raise revenue and a useful tool against demerit goods, especially when combined with information campaigns and regulation that reduce demand. They are a weak tool for cutting consumption of goods with very inelastic demand on their own, and their regressive effect means the use of the revenue matters.
A subsidy is a payment from the government to producers, usually a fixed amount per unit of output. It is the opposite of an indirect tax: it lowers firms’ costs, so supply increases, the price falls and output rises.
Governments subsidise goods for several reasons: to support producers’ incomes (farm subsidies), to make essential goods cheaper for consumers (food and fuel subsidies), to increase consumption of merit goods and goods with positive externalities (public transport, renewable energy, vaccinations), to help domestic firms compete with imports, and to encourage new industries.
A subsidy of $1 per unit means a firm can supply each quantity at a price $1 lower than before, so the supply curve shifts down by the subsidy per unit to S − subsidy (sometimes labelled S + subsidy, since supply increases). The vertical distance between the two supply curves is the subsidy per unit.
At the new equilibrium, output rises from Qe to Q₁ and the price consumers pay falls from Pe to Pc. Producers receive Pc from consumers plus the subsidy from the government, so in total they receive Pp, read off the original supply curve at Q₁. The subsidy per unit is Pp − Pc.
Government spending on the subsidy is the subsidy per unit times the new quantity: (Pp − Pc) × Q₁, the whole shaded rectangle. Consumers gain because they pay less and buy more, and producers gain because they receive more and sell more. The combined gain in consumer and producer surplus is smaller than the government’s spending. The difference, the hatched triangle, is the welfare loss: the units between Qe and Q₁ cost more to produce than consumers value them at, so resources are overallocated to the good.
As with a tax, the elasticities decide how the gain is shared. When demand is price-inelastic, most of the subsidy passes to consumers as a lower price; when demand is price-elastic, more of it stays with producers as a higher price received.
Stakeholder | Effect of a subsidy |
|---|---|
Consumers | Pay a lower price (Pc) and buy more; consumer surplus rises. |
Producers | Receive a higher price (Pp) and sell more; revenue and producer surplus rise. |
Workers | Higher output means more jobs in the industry. |
Government | Spends (Pp − Pc) × Q₁, which has an opportunity cost: the money could fund schools or hospitals, or allow lower taxes. |
Taxpayers | Pay for the subsidy through taxes or higher government borrowing. |
Society | Loses the welfare loss if the market had no externalities; gains if the subsidy corrects a positive externality. |
Foreign producers | Lose market share if subsidised domestic goods replace imports or are exported cheaply. |
Norway has long used the tax system to subsidise electric cars, exempting them from the purchase tax and VAT that buyers of petrol and diesel cars pay, alongside benefits such as exemption from road tolls. By 2025, plug-in cars made up 97.4% of new car sales. The policy shows how a large enough subsidy can change consumption, and also its cost: every exemption is revenue the government gives up.
Sources: Opplysningsrådet for Veitrafikken (OFV), via Wikipedia, “Electric car use by country” (2026).
Strengths. Subsidies make goods cheaper for consumers, support producers’ incomes and employment, and can increase the consumption of merit goods and goods with positive externalities towards the socially optimal level. They can help a new industry reach a scale at which it can compete without support.
Limitations. Subsidies are costly, and the money has an opportunity cost. Once introduced, they are politically hard to remove, since producers and consumers come to rely on them. They can protect inefficient firms, encourage overproduction, and break international trade rules when they help exporters. Some of a subsidy may go to people who would have bought the good anyway, which makes it a costly way to change behaviour.
What the outcome depends on. The effect on quantity depends on PED and PES; the value for money depends on whether the good has positive externalities, which would make the extra output socially valuable. The cost depends on how many units are produced, so a successful subsidy that raises output sharply becomes more expensive.
Judgment. A subsidy is easiest to justify for a good with significant positive externalities or for a short period to establish a new industry. Permanent subsidies to mature industries with no externalities usually create welfare losses and burden taxpayers, and are better replaced with targeted support for households or workers.
With direct provision, the government supplies a good or service itself, financed from tax revenue, and usually makes it available free or at a low price. Typical examples are state schools, public hospitals and clinics, roads, policing, parks, public libraries, and in some countries public housing and transport.
Governments provide goods directly for three main reasons. Merit goods such as education and healthcare would be underconsumed if people had to pay the market price. Public goods such as street lighting and national defence would not be provided by the market at all, because people could use them without paying. And free provision promotes equity, since access depends on need rather than on ability to pay. The UK’s National Health Service, which treats patients without charge at the point of use, is a well-known example.
Direct provision has no simple demand and supply diagram of its own. Its effect is that consumption rises well above the level the market would reach, because a price of zero means people consume until their marginal benefit is zero. This links to the analysis of merit goods and positive externalities.
Strengths. It guarantees access to essential services for everyone, which promotes equity and economic well-being, and it can raise long-run productivity through a healthier and better-educated workforce. Large public systems can also buy inputs cheaply in bulk.
Limitations. It is very expensive, so it has a high opportunity cost and needs high taxes. A zero price means demand often exceeds supply, so services are rationed by waiting lists, as in many public health systems. Without competition or a profit motive, public providers may have weak incentives to cut costs or improve quality, and government may misjudge what people want. A mixed approach in which the government pays but private firms supply the service, called contracting out, tries to combine the strengths of both.
Command and control regulation uses laws to require or forbid certain behaviour, backed by fines, licence withdrawal or prosecution. Rather than changing prices, it changes what firms and consumers are allowed to do.
Common forms include outright bans (on certain drugs, products or practices), limits on quantities (fishing quotas, emission limits for factories), product standards (safety rules, fuel efficiency standards, food labelling), age limits (on buying alcohol or tobacco), restrictions on where and when goods may be sold or used (smoking bans in public places), and licensing of professions such as doctors.
The European Union’s Single-Use Plastics Directive (2019/904) is a clear case. From 3 July 2021, member states could no longer allow certain single-use plastic items to be sold where affordable alternatives exist, including food and drink containers made of expanded polystyrene and all products made of oxo-degradable plastic. The directive also sets targets for collecting plastic bottles separately: 77% by 2025 and 90% by 2029.
Sources: European Commission, Single-use plastics (2026).
Strengths. Regulation is simple to understand and can act directly on harmful behaviour, which is essential when the harm is so serious that the quantity must be limited or reduced to zero, for example for dangerous chemicals. Its effect on quantity is more certain than that of a tax, whose effect depends on PED.
Limitations. Regulation has to be monitored and enforced, which is costly, and fines must be high enough to deter. It gives firms no reward for doing better than the standard, unlike a tax that falls as pollution falls. A ban can create a parallel market, and a one-size-fits-all rule ignores differences in the costs that different firms face, so the same reduction could often be achieved at lower cost with a tax or tradable permits. Regulators can also come under the influence of the industries they regulate.
Judgment. Regulation works best where the harm is large, easy to observe and the same across firms, or where a clear minimum standard protects people who cannot judge the risk themselves. Where firms’ costs of meeting a target vary widely, market-based tools are usually more efficient.
Traditional intervention changes prices or forbids choices. A nudge changes the way a choice is presented so that people are more likely to choose an option that improves their own well-being or society’s, while leaving every option open and without changing prices significantly. Nudges are designed using choice architecture, the deliberate arrangement of the context in which people choose.
Nudges rest on the finding from behavioural economics that people do not always behave like the fully rational consumers of standard theory. They have limited time and attention (bounded rationality), struggle to act on long-run plans (bounded self-control) and are influenced by what others do. Small changes in how choices are framed can therefore change behaviour substantially.
Default choices. Making the desired option the one people get if they do nothing. When employees are automatically enrolled in a workplace pension and must opt out to leave, far more of them save, as the UK’s automatic enrolment scheme shows. Opt-out systems for organ donation use the same idea.
Social norms. Telling people what most others do. In a field experiment with over 200,000 UK taxpayers, the Behavioural Insights Team and HM Revenue and Customs added messages to reminder letters stating how many people pay their tax on time. These messages increased payments, bringing in more than £1.6 million within 23 days at no extra cost.
Information and framing. Calorie counts on menus, traffic-light labels on food, and graphic health warnings on cigarette packets make costs more visible at the moment of choice.
Placement. Putting healthy food at eye level in school canteens or removing sweets from checkout areas makes the healthier choice the easier one.
Sources: Hallsworth, List, Metcalfe and Vlaev, NBER Working Paper 20007 (2014).
Strengths. Nudges are cheap, often costing almost nothing to implement, and they keep freedom of choice, so they face less political opposition than taxes or bans. They can work where price changes do not, for example where demand is price-inelastic because of habit, and they can be tested quickly with randomised trials before being scaled up.
Limitations. Their effects are often small and may fade as people get used to them. They work less well for deeply habitual or addictive behaviour, where stronger tools are needed. Critics argue that nudging is manipulative, since it changes behaviour without people being aware of it, and that governments may not know better than individuals what is good for them. Nudges also do little about causes such as low incomes or prices that do not reflect external costs.
Judgment. Nudges are best seen as a complement to, not a replacement for, traditional intervention. The UK’s action on sugar, for example, combined a tax (the Soft Drinks Industry Levy) with information such as front-of-pack labelling, so that both the price and the way the choice is presented push in the same direction. Where the harm to others is large, a nudge alone is unlikely to be enough.
When a diagram gives the prices and quantities before and after an intervention, every effect can be measured. Spending and revenue are price times quantity; the government’s revenue or cost is a rectangle; changes in surplus and the welfare loss are areas of rectangles and triangles. The four worked examples use the same hypothetical market, in which price is in dollars and quantity in units per week. Before any intervention the equilibrium price is $5 and 70 units are traded, so consumer expenditure (and producer revenue) is 5 × 70 = $350.
The same method works for a price floor. The difference is that the government may buy the surplus, which adds a cost for taxpayers on top of the change in consumer spending and producer revenue.
For an indirect tax, the diagram gives the price consumers pay and the price producers keep after the tax. Tax revenue is split between consumers and producers using the original equilibrium price.
A subsidy is calculated the same way, with the supply curve shifting down instead of up and the government paying instead of collecting.
No form of intervention is best in every market. The right choice depends on the aim, on the elasticities of demand and supply, on the government’s budget and administrative capacity, and on how quickly the effect is needed. Every policy can also lead to government failure, where the intervention makes resource allocation worse, for example through unintended consequences, poor information or political pressure.
Intervention | Main advantage | Main drawback | Works best when |
|---|---|---|---|
Price ceiling | Immediate, low cost to government | Shortage, parallel markets, falling supply | Short-term crisis, combined with support for supply |
Price floor | Stable, higher producer incomes | Surplus, high cost to taxpayers | Set close to the market price or used as a buffer stock |
Indirect tax | Raises revenue, keeps consumer choice | Regressive; weak if demand is inelastic | Demand is elastic, or revenue is the aim |
Subsidy | Lowers price, raises output and jobs | Costly, hard to remove | Positive externalities, or a new industry |
Direct provision | Access based on need (equity) | High cost, weak efficiency incentives | Merit goods and public goods |
Regulation | Certain effect on quantity | Enforcement costs, inflexible | Serious harm that must be limited |
Nudge (HL) | Very cheap, keeps choice | Small and uncertain effects | As a complement to other tools |
The key concepts help organise the evaluation. Each intervention trades one goal against another: a price ceiling serves equity at the cost of efficiency, a subsidy for renewable energy serves sustainability at an opportunity cost for taxpayers, and a tax on sugary drinks serves well-being while hitting low-income households hardest. A strong judgment names the aim, weighs these trade-offs and considers which stakeholders matter most in the context.
India supports the prices of its main food grains through a large price floor scheme. Each year the government announces minimum support prices (MSPs) for more than 20 crops, on the recommendation of the Commission for Agricultural Costs and Prices. For the 2026–27 marketing season the MSP for wheat was set at ₹2,585 per quintal (100 kg), up from ₹2,425 the year before; for 2027–28 it was raised again to ₹2,610, more than double the commission’s estimated cost of production of ₹1,264.
The MSP is not a legal ban on selling below the floor. It works through government purchase: the Food Corporation of India and state agencies stand ready to buy wheat and rice at the MSP. Where they buy in large quantities, as in Punjab and Haryana, the market price cannot fall below the floor, because farmers can always sell to the state.
In the 2026–27 season about 33.8 million tonnes of wheat had been procured by mid-June 2026, against a harvest estimated at 120.7 million tonnes. Where procurement is thin, many farmers sell below the MSP: in 2021, about 95% of paddy growers in Punjab benefited from it, compared with 3.6% in Uttar Pradesh.
The scheme follows the logic of the price floor diagram with the government buying the surplus. The guaranteed price encourages farmers to grow more wheat and rice than consumers buy at that price, and the state absorbs the difference. On 1 July 2026, the central pool held 92.6 million tonnes of wheat and rice, more than double the stocking norm of 41.1 million tonnes; rice stocks were three times their norm.
Much of the grain is then distributed through the second half of the system, direct provision. Since 2020 the Pradhan Mantri Garib Kalyan Anna Yojana has given about 800 million people 5 kg of free wheat or rice per person per month. From January 2024 it was extended for five years, to December 2028, at a projected cost of about ₹11.8 lakh crore (₹11.8 trillion). Using the surplus as free food for low-income households is the “give it away” option for disposing of a surplus, and it advances equity and food security.
Producers in states with strong procurement gain a high, predictable income, which explains why the MSP is politically powerful. When the government passed three laws in September 2020 to open crop trading outside regulated markets, farmers from Punjab, Haryana and western Uttar Pradesh protested for more than a year, fearing that the reforms would end purchases at the MSP and demanding that it be guaranteed by law. Parliament repealed the laws on 29 November 2021.
Taxpayers and society bear large costs. Food and fertiliser subsidies together made up about one-eighth of the central government’s 2023–24 budget. The guaranteed prices tie resources to rice and wheat, crops that use large amounts of water, and contribute to water scarcity and pollution in the main growing states, a problem for sustainability. India’s rice support was reported at about 12.1% of the value of production in 2022–23, above the 10% limit allowed by World Trade Organization rules, which led India to invoke a temporary exemption, the “peace clause”, affecting interdependence with trading partners.
Consumers are affected in two ways. They pay a market price kept up by the floor, but low-income households receive free grain from the stocks. The net effect on equity is positive for the poorest households, though it is financed by all taxpayers and the scheme’s benefits for farmers go mainly to those in a few states.
Limits of the case. The textbook diagram assumes a single national market with one price. In India the floor binds only where the government buys, so the scheme helps some producers far more than others. Large stocks also give the government a buffer against harvest failures and price spikes, a benefit the simple diagram does not show. The judgment depends on the weight placed on food security and farm incomes against fiscal cost, efficiency and sustainability.
Sources: Business Today, “Global food security faces fresh risks but India’s grain buffer offers a cushion” (8 October 2026); Cabinet Committee on Economic Affairs, MSP for rabi crops 2026–27 (October 2025); Department of Food and Public Distribution, PMGKAY; Times of India (29 November 2021); Lok Sabha and Rajya Sabha records (2020–21); WTO notifications summarised in the Economic Times (2024).
Government intervention appears in every paper. Paper 1 asks for explanations with diagrams in part (a) and evaluation of a policy with real-world examples in part (b). Paper 2 asks you to define terms, draw intervention diagrams linked to the text and evaluate a policy using the data. HL Paper 3 sets calculations of the effects on stakeholders and asks you to recommend a policy.
Part (b) widens the analysis to a judgment about a policy, and it needs a developed real-world example.
Paper 2 questions build on a case study text, so each answer must use the market and the figures in the text.
The final Paper 2 item is a 15-mark evaluation that must use the text. Its structure is the same as Paper 1 part (b), with the evidence taken from the case study rather than from outside examples.
Governments intervene to earn revenue, support firms and low-income households, influence production and consumption, correct market failure and promote equity.
A price ceiling below Pe causes a shortage, non-price rationing, parallel markets and a welfare loss; supply falls further in the long run.
A price floor above Pe causes a surplus; if the government buys it, taxpayers pay Pmin × (Qs − Qd) and resources are overallocated.
An indirect tax shifts supply up by the tax per unit; consumers and producers share its burden in a way that depends on PED and PES, and the government gains revenue.
A subsidy shifts supply down; consumers pay less, producers receive more, and the government spends (Pp − Pc) × Q₁.
Direct provision and command and control regulation replace market decisions with government ones, with gains in equity or certainty but costs in money and flexibility.
HL: nudges change how choices are presented, and the effects of each intervention can be calculated from the prices and quantities on a diagram.
Every policy creates winners and losers, so a judgment weighs the stakeholders, the elasticities, the time frame and the alternatives.
I can explain the seven aims of government intervention with an example of each.
I can draw a price ceiling diagram and explain the shortage, parallel market and welfare loss.
I can draw a price floor diagram, including the government buying the surplus, and a minimum wage diagram.
I can draw specific and ad valorem tax diagrams and explain how PED affects tax incidence.
I can draw a subsidy diagram and identify the government spending and the welfare loss.
I can explain how direct provision and command and control regulation work and evaluate them.
I can evaluate each intervention for consumers, producers, workers, the government and society.
I can explain and evaluate consumer nudges as a form of intervention (HL).
I can calculate shortages, surpluses, revenue, spending, incidence and welfare loss from a diagram (HL).
Level | Marks | Descriptor |
|---|---|---|
0 | 0 | The work does not reach a standard described by the descriptors below. |
1 | 1–2 | Little understanding of the specific demands of the question. Relevant economic theory is stated but not relevant. Economic terms are stated but not relevant. |
2 | 3–4 | Some understanding of the specific demands of the question. Relevant economic theory is described. Some relevant economic terms are included. |
3 | 5–6 | The specific demands of the question are understood but only partially addressed. Relevant economic theory is partly explained. Some relevant terms are used appropriately. Where appropriate, relevant diagram(s) are included. |
4 | 7–8 | The specific demands of the question are understood and addressed. Relevant economic theory is explained. Relevant terms are used mostly appropriately. Where appropriate, relevant diagram(s) are included and explained. |
5 | 9–10 | The specific demands of the question are understood and addressed. Relevant economic theory is fully explained. Relevant terms are used appropriately throughout. Where appropriate, relevant diagram(s) are included and fully explained. |
Using real-world examples, evaluate the view that the price mechanism is the best way to allocate scarce resources.
15 marks
Answers may include:
Terminology: price mechanism, signalling, incentive and rationing functions of price, allocative efficiency, market failure, government intervention, planned economy.
Explanation: in competitive markets, changes in relative prices signal where resources are wanted and give producers an incentive to reallocate them; prices ration goods to those most willing and able to pay; at the competitive equilibrium marginal benefit equals marginal cost, so social surplus is maximized and allocative efficiency is achieved, without the information problems faced by central planners.
Diagram(s): demand and supply diagram showing a rise in demand, a higher price and an extension of supply as resources are reallocated; may show an externalities diagram with a welfare loss where the market over- or under-allocates resources.
Synthesis/evaluation: the price mechanism fails where there are externalities, public goods, common pool resources or (for HL candidates) asymmetric information and market power; it allocates according to ability to pay, so outcomes may be inequitable for necessities such as healthcare or housing; prices may be volatile (agricultural markets); government intervention can itself fail (information gaps, shortages under price controls, inefficiency in state enterprises); most real economies are mixed, suggesting that the price mechanism works best for most private goods while government is needed for others; consideration of the word 'best' and of alternatives such as planning or direct provision; a reasoned judgement.
Examples: shortages and queues in the former Soviet Union under central planning; Venezuela's price controls on food from the 2000s and the resulting shortages; the reallocation of resources towards electric vehicles and batteries as relative prices and demand changed; the failure of markets to provide clean air without carbon pricing, such as the EU Emissions Trading System (EU ETS); state provision of healthcare through the UK National Health Service (NHS).
For 'best' questions, a maximum of [12] should be awarded where no alternative methods of allocation are considered.
N.B. Terminology, theory, diagrams and examples given in part (a) and referred to in part (b) should be rewarded.
Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.
Markbands (best fit)
Level | Marks | Descriptor |
|---|---|---|
0 | 0 | The work does not reach a standard described by the descriptors below. |
1 | 1–3 | Little understanding of the specific demands of the question. Theory is stated but not relevant. Terms are not relevant. No synthesis or evaluation. Real-world examples are identified but not relevant. |
2 | 4–6 | Some understanding of the demands. Relevant theory is described. Some relevant terms are included. Synthesis or evaluation is superficial. A relevant real-world example is identified. |
3 | 7–9 | The demands are understood but only partially addressed. Theory is partly explained. Some terms are used appropriately. Relevant diagram(s) are included where appropriate. Synthesis or evaluation is appropriate but lacks balance. Example(s) are identified and partly developed in context. |
4 | 10–12 | The demands are understood and addressed. Theory is explained. Terms are used mostly appropriately. Diagram(s) are included and explained. Synthesis or evaluation is appropriate and mostly balanced. Example(s) are identified and developed in the context of the question. |
5 | 13–15 | The demands are understood and addressed. Theory is fully explained. Terms are used appropriately throughout. Diagram(s) are included and fully explained. Synthesis or evaluation is effective and balanced. Example(s) are identified and fully developed to support the argument. |
Economies differ in the extent to which resources are allocated by markets or by the state.
Distinguish between a free market economy and a planned economy in the way each answers the basic economic questions.
10 marks
Using real-world examples, discuss the view that government intervention in markets does more harm than good.
15 marks
Governments must decide how much of a country's resources to devote to healthcare rather than to other goods and services.
Using a production possibilities curve (PPC), explain why the opportunity cost of producing additional healthcare is likely to increase as more healthcare is produced.
10 marks
Using real-world examples, evaluate the consequences for stakeholders of the direct provision of healthcare by the government.
15 marks