What this lesson teaches
I can explain, draw and evaluate the ways a government corrects market failure, from price controls and taxes to regulation and direct provision.
Syllabus K343, 2.10.3. Government intervention to address market failure: definitions, drawing and interpretation of diagrams, advantages and disadvantages of: maximum and minimum prices in product markets, indirect taxation, subsidies; definitions, advantages and disadvantages of: regulation, privatisation, nationalisation, direct provision of goods and services, quotas, e.g. for the extraction of natural resources
Make a guess
The government sets a maximum rent below the market rent. What happens to the number of flats offered for rent?
- It rises, because more people can afford rent.
- It falls, so some tenants cannot find a flat.
- It stays the same, because the flats already exist.
Show the answer
It falls, so some tenants cannot find a flat.
At the lower rent, landlords offer fewer flats while more people want one. The result is a shortage.
A maximum price below equilibrium causes a shortage; a minimum price above equilibrium causes a surplus.
A maximum price is a legal upper limit on price. It is set below the equilibrium price to make a good affordable, such as rent or staple food. At this lower price, quantity demanded rises and quantity supplied falls, creating a shortage.
A shortage leads to problems. Queues form, sellers choose whom to sell to, and illegal black markets may appear where goods sell above the maximum.
A minimum price is a legal lower limit, set above equilibrium. It aims to raise producers' incomes, as with some farm prices, or to discourage consumption, as with a minimum price for alcohol.
At the higher price, quantity supplied rises and quantity demanded falls, creating a surplus. The government may have to buy and store the surplus, which is costly.
- Maximum price
- Legal ceiling below equilibrium; causes a shortage.
- Minimum price
- Legal floor above equilibrium; causes a surplus.
- Black market
- Illegal trading at prices above the legal maximum.
Worked example: Analysing a maximum price on rice
Suppose a government sets a maximum price for rice below the market price.
- Aim: make a staple food affordable for poor households.
- Diagram: Pmax sits below the equilibrium price.
- Effect: quantity demanded rises to Qd and quantity supplied falls to Qs, so there is a shortage.
- Consequence: some buyers get cheaper rice, but others cannot find any; black markets may develop.
Watch out for this
A maximum price above the equilibrium price causes a shortage.
A maximum price above equilibrium has no effect, because the market price is already lower. It must be below equilibrium to change anything.
Check your understanding
A government sets a minimum price for milk above the equilibrium price. What is the likely result?
- A shortage of milk, because buyers rush to buy before prices rise
- No change, because the price of milk is set by the farmers
- A surplus of milk, because quantity supplied exceeds quantity demanded
Show the answer
A surplus of milk, because quantity supplied exceeds quantity demanded
Right. The higher price encourages supply and discourages demand.
Check your understanding
The equilibrium price of a good is $3, where 700 units are traded. The government sets a maximum price of $2. At $2, quantity demanded is 900 and quantity supplied is 500. What is the result?
- A shortage of 400 units
- A shortage of 200 units
- No effect, because the price is below equilibrium
- A surplus of 400 units
Show the answer
A shortage of 400 units
Right. Buyers want 900 but sellers offer only 500, so 400 units are missing.