DP Economics HL 2.7 Role of Government in Microeconomics

DP Economics HL 2.7 Role of Government in Microeconomics - Full notes

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DP Economics HL | 2.7 Role of Government in Microeconomics

DP ECONOMICS · UNIT 2: MICROECONOMICS

2.7

Role of Government in Microeconomics

Full notes for HL · IB-style

Contents

1	Why governments intervene in markets
2	Indirect taxes
3	Tax incidence and elasticity
4	Subsidies
5	Price ceilings (maximum prices)
6	Price floors (minimum prices)
7	Other forms of intervention
8	Calculating the effects of taxes and subsidies (HL only)
9	Reasons for government intervention
10	Price ceilings: diagram analysis
11	Price floors: diagram analysis
12	Price controls: calculations
13	Indirect taxes: incidence calculations
14	Ad valorem taxes
15	Subsidies: calculations
16	Evaluating government intervention
17	Command and control regulation
18	Mixed review: worked problems
19	Additional exam-style practice
20	Common misconceptions and links
21	Exam-style question with markscheme
22	Check your understanding
23	Summary and topic map

These are full teaching notes. Read each section in order, try the Think about it question before you read on, and do every Quick check before moving to the next section.

Before you start

Rate yourself on each statement now, and again after you've worked through the notes. Shade R (not yet), A (getting there) or G (confident).

I can…	R	A	G
explain why governments intervene in markets
explain the effects of specific and ad valorem taxes on stakeholders, with diagrams
explain how PED and PES determine the incidence of a tax
explain the effects of a subsidy on stakeholders, with a diagram
explain the effects of price ceilings and price floors, including shortages, surpluses and welfare loss
evaluate the use of taxes, subsidies and price controls with real examples
calculate the effects of a tax or subsidy on price, quantity, revenue and welfare from linear functions

Section 8 is Additional Higher Level content. Every other section is common to SL and HL.

Guiding questions

Why do governments tax some goods and subsidise others? Who really pays a tax: the buyer or the seller? What happens when governments set prices instead of letting the market decide?

How this topic is examined

2.7 is one of the most heavily examined topics. Tax, subsidy and price-control diagrams appear in nearly every exam session, usually with a question about the effects on different stakeholders: consumers, producers, the government, workers and society.

Strong answers draw precise diagrams, label every price and quantity, identify each stakeholder's gain or loss using areas, and evaluate with real examples. At HL, Paper 3 frequently asks you to calculate tax incidence, revenue and welfare loss from functions.

Command term	What the examiner wants
Define	the precise meaning, ideally in the IB wording, in one or two sentences
Draw / Sketch	a fully labelled diagram with every axis, curve, equilibrium and change labelled
Explain	a causal chain linked to economic theory, usually supported by a diagram
Analyse	break a situation into its parts and trace the effects of each
Evaluate / Discuss	weigh up arguments, question assumptions and reach a justified conclusion using real-world examples
Calculate	solve the functions step by step, label Pc and Pp, and give units

How to use these notes

Each section teaches one part of the syllabus in full. You'll see these boxes throughout; each has one job:

Box	What it's for
Think about it	a question to get you thinking before a section; the answer comes in the section
Key point	the one idea you must not forget
Common mistake	an error examiners see every year, and how to avoid it
In the real world	where the economics shows up outside the classroom
Try this	something quick you can do yourself to test the idea
Worked example	full solutions with IB-style marks (M1 method, A1 answer, R1 reasoning)
Quick check	short questions to test yourself at the end of each section

1 Why governments intervene in markets

Markets are powerful, but they don't always deliver efficient or fair results.

Think about it

Petrol in your country is taxed heavily while bread is not taxed at all. Why might the government treat these two goods so differently?

In 2.3 you saw that a competitive market can allocate resources efficiently. But governments intervene in almost every market. There are several reasons.

To earn government revenue. Governments need money to pay for public services such as health care, education and defence. Indirect taxes on goods and services are a major source of revenue.

To support firms and industries. Governments may want to protect jobs, help an industry through a difficult period, or encourage new industries, for example through subsidies to farmers or to renewable energy producers.

To support low-income households. Price controls on essentials, subsidies on basic food and minimum wages aim to make goods affordable or raise incomes for poorer people. This is about equity.

To influence the level of consumption or production. Governments discourage the consumption of goods that harm people or the environment (by taxing them) and encourage goods that benefit society (by subsidising them).

To correct market failure. When markets produce too much or too little of a good, because of externalities, public goods or information problems, intervention can move output closer to the socially optimal level. You will study this in depth in 2.8 to 2.12.

To promote equity. Markets reward ownership of resources, so they can leave some people with very low incomes. Intervention can redistribute income and opportunity.

Tool	How it works	Example
Indirect tax	raises the cost of supplying a good	excise duty on tobacco
Subsidy	lowers the cost of supplying a good	grants to solar panel producers
Price ceiling	legal maximum price below equilibrium	rent control
Price floor	legal minimum price above equilibrium	minimum wage; agricultural price support
Direct provision	government supplies the good	state schools
Regulation	rules that limit behaviour	emissions standards

Quick check

1. Give three reasons why governments intervene in markets.

2. Which reason relates to fairness?

Answers: 1. revenue, support firms, support low-income households, influence consumption, correct market failure, equity 2. equity / supporting low-income households

2 Indirect taxes

A tax on producers shifts supply up by the amount of the tax.

Think about it

If the government adds a $1 tax to each packet of cigarettes, does the price in shops rise by exactly $1? Why might it rise by less?

2.1 Specific and ad valorem taxes

An indirect tax is a tax on spending on goods and services. It is collected from producers, who pay it to the government, but part of it is passed on to consumers through higher prices. Indirect taxes are 'indirect' because the person who ultimately bears the tax need not be the person who pays it to the tax authorities.

A specific tax (or excise tax) is a fixed amount per unit sold, such as $1 per packet of cigarettes or $0.50 per litre of petrol. Because the tax is the same at every price, it shifts the supply curve vertically upward by the amount of the tax, parallel to the original curve.

An ad valorem tax is a percentage of the price, such as 20% VAT. The tax per unit is larger at higher prices, so the supply curve shifts upward by a growing amount: the new curve pivots away from the original.

2.2 Effects of a specific tax on stakeholders

Figure 1. A specific tax shifts supply from S to S + tax. Consumers pay Pc, producers receive Pp, quantity falls from Qe to Q1. The shaded area is tax revenue.

Walk through the diagram. Before the tax, equilibrium is at Pe and Qe. The tax shifts supply up by the tax per unit. The new equilibrium is where demand crosses the new supply curve: quantity falls to Q1 and the price consumers pay rises to Pc. Producers must hand the tax to the government, so the price they actually keep is Pp: Pc minus the tax.

Notice that Pc rises by less than the full tax, and Pp falls by less than the full tax. The burden is shared.

Stakeholder	Effect of the tax
Consumers	pay a higher price (Pc) and buy less (Q1); consumer surplus falls
Producers	receive a lower price (Pp) and sell less; producer surplus and revenue fall
Government	gains tax revenue = tax per unit × Q1 (the shaded rectangle)
Workers	may lose jobs as output falls
Society	welfare (deadweight) loss: output Q1 is below the efficient level Qe

The welfare loss is the triangle between the demand and supply curves from Q1 to Qe. For those units, consumers valued the good more than it cost to produce, but because of the tax they are no longer traded. The loss of consumer and producer surplus that the government does not collect as revenue is a pure loss to society. (Where the good causes harm to others, the tax may actually improve welfare, as you will see in 2.8.)

Key point

Tax revenue = tax per unit × quantity after the tax (Q1), not the original quantity Qe.

Common mistake

Showing the tax as a shift of demand, or shifting supply to the right. A tax on producers raises their costs, so supply shifts upward (to the left).

Quick check

1. How does a specific tax shift the supply curve?

2. Why do consumers pay less than the full tax?

3. Identify the area of tax revenue.

4. What causes the welfare loss?

Answers: 1. vertically up by the tax, in parallel 2. producers absorb part of it 3. tax per unit × new quantity 4. units between Q1 and Qe are no longer traded although MB > MC

3 Tax incidence and elasticity

The less elastic side of the market pays more of the tax.

Think about it

Smokers and drinkers often complain that they bear the burden of 'sin taxes'. Are they right? What determines who pays?

The incidence of a tax is the distribution of its burden between consumers and producers. The consumer burden is the rise in the price paid (Pc − Pe) times the quantity; the producer burden is the fall in the price received (Pe − Pp) times the quantity.

Incidence depends on the price elasticities of demand and supply. The general rule is: the more inelastic side of the market bears more of the tax.

If demand is inelastic (compared with supply), consumers keep buying even when the price rises, so producers can pass most of the tax on: consumers bear most of the burden. This is the case for petrol, cigarettes and alcohol.

If demand is elastic, consumers would switch away if the price rose much, so producers must absorb most of the tax themselves by accepting a lower price: producers bear most of the burden.

Figure 2. The same tax with inelastic and elastic demand: who bears the burden depends on elasticity.

The same logic applies on the supply side: if supply is very inelastic, producers cannot easily reduce output and must bear more of the tax. Governments therefore get the most revenue, with the smallest change in quantity, from taxing goods with inelastic demand. But if the purpose of the tax is to reduce consumption, inelastic demand makes the tax less effective at that goal.

In the real world

Tobacco taxes in many countries now make up more than 70% of the retail price of cigarettes. Because demand is inelastic, consumption falls slowly while tax revenue remains very large. Governments combine the tax with advertising bans and health warnings to reduce smoking further.

Quick check

1. Define tax incidence.

2. Who bears most of a tax when demand is inelastic?

3. Why might a tax on cigarettes fail to reduce smoking much?

Answers: 1. how the burden of a tax is shared 2. consumers 3. demand is inelastic, so quantity falls little

4 Subsidies

A subsidy is a negative tax: supply shifts down by the subsidy per unit.

Think about it

Many governments subsidise public transport. Who benefits from a bus subsidy: the bus company, the passengers, or both?

A subsidy is a payment by the government to firms per unit of output. Governments subsidise goods to lower prices for consumers, to support producers' incomes, to encourage the production or consumption of goods that benefit society (merit goods, renewable energy), or to help domestic firms compete internationally.

A subsidy lowers producers' costs, so the supply curve shifts vertically downward by the amount of the subsidy. The new equilibrium has a lower price for consumers (Pc) and a larger quantity (Q1). Producers receive the price paid by consumers plus the subsidy (Pp).

Figure 3. A subsidy shifts supply from S to S + subsidy (downward). Consumers pay Pc, producers receive Pp, quantity rises to Q1. The shaded area is the cost to the government.

Stakeholder	Effect of the subsidy
Consumers	pay a lower price and buy more; consumer surplus rises
Producers	receive a higher price (Pp) and sell more; producer surplus and revenue rise
Government	pays the subsidy per unit × Q1; this has an opportunity cost (other spending or higher taxes)
Workers	more jobs as output rises
Society	if there is no market failure, overproduction beyond Qe creates a welfare loss

Subsidies have several drawbacks. They are costly, and the money must come from taxes or borrowing. They can keep inefficient firms in business and are hard to remove once firms depend on them. In world markets, subsidies to domestic farmers can lead to overproduction that is 'dumped' abroad at low prices, harming farmers in developing countries.

Common mistake

Calculating the subsidy cost as subsidy × Qe. The government pays the subsidy on every unit actually sold after the subsidy, so the cost is subsidy × Q1.

Quick check

1. How does a subsidy shift supply?

2. What is the cost of a subsidy to the government?

3. Give one disadvantage of subsidies.

Answers: 1. vertically down by the subsidy 2. subsidy per unit × new quantity 3. opportunity cost / inefficient firms / hard to remove

5 Price ceilings (maximum prices)

A ceiling below equilibrium creates a shortage.

Think about it

A city caps rents at half their market level. Five years later, tenants complain they cannot find a flat at all. How did a policy designed to help renters make things worse?

A price ceiling (maximum price) is a legal limit on how high a price can be. To have any effect it must be set below the equilibrium price. Governments use ceilings to make essential goods, such as rented housing, basic food or fuel, affordable for low-income households.

At the ceiling price, quantity demanded (Qd) exceeds quantity supplied (Qs): there is a shortage (excess demand) of Qd − Qs. Because the price cannot rise, the price mechanism cannot ration the good, and other ways of allocating it appear.

Figure 4. A price ceiling Pmax below equilibrium: quantity supplied falls to Qs, quantity demanded rises to Qd, creating a shortage.

Consequences of a price ceiling:

Shortages and queues. Goods are allocated on a first-come, first-served basis, or through waiting lists. People spend time queuing, which is itself a cost.

Black (parallel) markets. Buyers who cannot obtain the good legally may pay more than the ceiling on an illegal market, so the ceiling is undermined.

Lower quality and less investment. Producers earning low prices cut costs: landlords stop maintaining flats, and new rental housing is not built. Over time supply becomes more elastic and the shortage grows.

Rationing and favouritism. Governments may introduce ration coupons, or sellers may favour friends or those who pay bribes.

Welfare loss. Fewer units are traded (Qs instead of Qe), so some social surplus is lost. Consumers who do get the good gain, because they pay less; producers lose.

In the real world

Rent controls have been used in cities including Berlin, Stockholm and San Francisco. Studies of San Francisco's expansion of rent control in 1994 found that landlords converted affected buildings to condominiums, reducing the supply of rental housing by about 15% and raising rents elsewhere in the city.

Quick check

1. Where must a price ceiling be set to have an effect?

2. What does a price ceiling create?

3. Name two consequences of a maximum price.

Answers: 1. below equilibrium 2. a shortage 3. queues, black markets, lower quality, less investment

6 Price floors (minimum prices)

A floor above equilibrium creates a surplus.

Think about it

If a government guarantees farmers a high minimum price for wheat, what happens to all the wheat nobody wants to buy at that price?

A price floor (minimum price) is a legal limit on how low a price can be. To have an effect it must be set above the equilibrium price. At the floor, quantity supplied exceeds quantity demanded: there is a surplus (excess supply) of Qs − Qd.

Figure 5. A price floor Pmin above equilibrium: quantity supplied rises to Qs, quantity demanded falls to Qd, creating a surplus.

6.1 Minimum prices in agriculture

Governments set minimum prices for farm products to stabilize and raise farmers' incomes. To keep the price at the floor, the government must buy the surplus (Qs − Qd). This is costly: the government pays the minimum price for the surplus, stores it and then must dispose of it, perhaps by selling it abroad cheaply, giving it as aid, or destroying it. Consumers pay higher prices for food, and resources are misallocated into overproduction.

6.2 Minimum wages

A minimum wage is a price floor in the labour market: the legal minimum hourly wage. If it is set above the equilibrium wage, the quantity of labour supplied (workers seeking jobs) exceeds the quantity demanded by firms: a surplus of labour, which is unemployment.

Supporters argue that minimum wages raise the incomes of low-paid workers, reduce poverty and in-work benefits, and may raise productivity and motivation. Critics argue that they cause unemployment among the least skilled, particularly young workers, and raise costs for small firms. The evidence is mixed: many studies find that moderate minimum wages cause little job loss, especially where employers have some power over wages or where demand for labour is inelastic.

	Price ceiling	Price floor
Set	below equilibrium	above equilibrium
Creates	shortage (excess demand)	surplus (excess supply)
Aim	affordability for consumers	higher incomes for producers or workers
Examples	rent control, fuel price caps	agricultural support prices, minimum wage, minimum alcohol price
Side effects	queues, black markets, lower quality	storage costs, overproduction, unemployment

Quick check

1. Where must a price floor be set to have an effect?

2. What must the government do to maintain an agricultural minimum price?

3. Why might a minimum wage cause unemployment?

Answers: 1. above equilibrium 2. buy the surplus 3. the wage exceeds equilibrium, so labour supplied exceeds labour demanded

7 Other forms of intervention

Taxes, subsidies and price controls are not the only tools.

Direct provision. The government can produce a good or service itself and supply it free or below cost, as with state schools, public hospitals, roads and street lighting.

Regulation and legislation. Laws can ban goods (some drugs), restrict them (age limits on alcohol), or set standards (food safety, emissions limits).

Information and nudges. Health campaigns, labelling and behavioural nudges (2.4) influence choices without changing prices.

Buffer stock schemes. Governments or international agencies buy a commodity when its price is low and sell from stocks when it is high, to stabilize prices. Such schemes have often failed when the target price was set too high, leaving huge stocks.

Key point

Every intervention has costs as well as benefits: government failure, unintended consequences and opportunity cost. Good evaluation always names both.

8 Calculating the effects of taxes and subsidies (HL only)

Shift the supply function, solve again, then measure every area.

HL only

This section is Additional Higher Level content. SL students do not need it.

With a specific tax t per unit, producers receive P − t for each unit sold. Replace P with (P − t) in the supply function, solve for the new equilibrium, and the solution gives the price paid by consumers, Pc. The price received by producers is Pp = Pc − t. With a subsidy s, producers receive P + s, so replace P with (P + s).

WORKED EXAMPLE 1 A specific tax

Qd = 100 − 10P and Qs = −20 + 10P. A $2 tax per unit is imposed. Calculate (a) the original equilibrium, (b) Pc, Pp and the new quantity, (c) tax revenue and the consumer and producer burden, (d) the welfare loss.

Solution

(a) 100 − 10P = −20 + 10P, so P = $6, Q = 40A1

(b) New supply: Qs = −20 + 10(P − 2) = −40 + 10PM1

100 − 10P = −40 + 10P, so Pc = $7, Pp = $5, Q = 30A1 A1

(d) Welfare loss = ½ × 2 × (40 − 30) = $10M1 A1

WORKED EXAMPLE 2 A subsidy

Qd = 80 − 4P and Qs = −10 + 5P. A $3 subsidy per unit is paid to producers. Calculate the new price paid by consumers, the price received by producers, the quantity, and the cost of the subsidy.

Solution

New supply: Qs = −10 + 5(P + 3) = 5 + 5PM1

80 − 4P = 5 + 5P, so 9P = 75 and Pc = $8.33; Pp = $11.33A1 A1

Q = 80 − 4(8.33) = 46.7A1

Cost = 3 × 46.7 = $140A1

WORKED EXAMPLE 3 A price ceiling

Qd = 100 − 10P and Qs = −20 + 10P. A maximum price of $4 is set. Calculate the shortage.

Solution

At $4: Qd = 100 − 40 = 60; Qs = −20 + 40 = 20M1

Shortage = 60 − 20 = 40A1

Common mistake

Substituting P + t instead of P − t for a tax. Producers keep less than the market price, so it is P − t; for a subsidy, P + s.

Quick check

1. Qd = 60 − 2P, Qs = −20 + 2P. Find equilibrium.

2. A $4 tax is imposed. Find Pc, Pp and Q.

3. Calculate tax revenue.

Answers: 1. P = $20, Q = 20 2. Pc = $22, Pp = $18, Q = 16 3. $64

9 Reasons for government intervention

Why intervene?

Governments intervene in markets to: earn revenue, support firms (subsidies), support households (lower prices, higher incomes), influence consumption and production (merit and demerit goods), correct market failure, and promote equity.

WORKED EXAMPLE 4 Reasons (standard)

Give three reasons governments intervene in markets.

Solution

Raise revenue; correct market failureA1

Promote equity; support producers or consumersA1

10 Price ceilings: diagram analysis

Maximum prices.

A price ceiling set below equilibrium causes a shortage (Qd > Qs). Consequences: queues, rationing, black markets, reduced quality, and welfare loss. Consumers who buy gain; those who cannot buy and producers lose.

Figure 6. A maximum price below equilibrium creates a shortage.

WORKED EXAMPLE 5 Rent control (exam level)

Explain two consequences of rent controls.

Solution

Shortage of rental housing: more people want to rent than units availableR1

Landlords may reduce maintenance; black markets or key moneyR1

11 Price floors: diagram analysis

Minimum prices.

A price floor set above equilibrium causes a surplus (Qs > Qd). In agriculture, governments may buy the surplus (storage costs) or export it. Minimum wages are price floors in the labour market and may cause unemployment if set too high.

Figure 7. A minimum price above equilibrium creates a surplus.

WORKED EXAMPLE 6 Agricultural floor (standard)

Explain why governments often buy surpluses created by agricultural price floors.

Solution

Prevent prices falling below the floorR1

Costly storage or dumping on world marketsR1

12 Price controls: calculations

Shortages and surpluses.

With linear functions, substitute the controlled price into Qd and Qs to find the shortage or surplus.

WORKED EXAMPLE 7 Ceiling (standard)

Qd = 200 − 4P, Qs = −40 + 6P. Equilibrium P = $24. A ceiling of $20 is set. Calculate the shortage.

Solution

Qd = 120; Qs = 80M1 A1

Shortage = 40 unitsA1

Quick check

1. Calculate the surplus if a floor of $30 is set in the same market.

Answers: 1. Qd = 80, Qs = 140: surplus 60

13 Indirect taxes: incidence calculations

Who pays the tax?

A specific tax shifts supply up by the tax per unit. Consumer burden = (new price − old price) × new quantity; producer burden = (old price − price received) × new quantity; government revenue = tax × new quantity.

Figure 8. A specific tax: consumers pay Pc, producers receive Pp.

WORKED EXAMPLE 8 Incidence (exam level)

Before a $3 tax, P = $10, Q = 1000. After, consumers pay $12 and Q = 800. Calculate revenue and each group's burden.

Solution

Revenue = 3 × 800 = $2400A1

Consumers: (12 − 10) × 800 = $1600; producers: (10 − 9) × 800 = $800A1 A1

14 Ad valorem taxes

Percentage taxes.

An ad valorem tax is a percentage of the price (VAT, sales tax). The supply curve shifts up by a larger amount at higher prices, so the vertical gap widens.

Quick check

1. Distinguish specific and ad valorem taxes.

Answers: 1. specific: fixed amount per unit; ad valorem: percentage of price

15 Subsidies: calculations

Paying producers.

A subsidy shifts supply down by the subsidy per unit. Government cost = subsidy × new quantity; consumers gain from a lower price; producers gain from a higher price received.

Figure 9. A subsidy: consumers pay Pc, producers receive Pp.

WORKED EXAMPLE 9 Subsidy (exam level)

Before a $2 subsidy, P = $8, Q = 500. After, consumers pay $7 and Q = 600. Calculate the government cost and the price producers receive.

Solution

Cost = 2 × 600 = $1200A1

Producers receive $7 + $2 = $9A1

16 Evaluating government intervention

Stakeholders.

Evaluate effects on consumers, producers, workers, government budget and society. Consider unintended consequences (black markets, smuggling), administrative costs and government failure.

WORKED EXAMPLE 10 Evaluation (exam level)

Evaluate a subsidy on electric vehicles.

Solution

Lower prices, higher consumption, reduced emissionsR1

Opportunity cost of government spending; benefits richer householdsR1

17 Command and control regulation

Rules and standards.

Governments also use regulations: bans (lead in petrol), standards (emissions limits), licensing and quotas. Regulations are simple to understand but may be costly to enforce and inflexible.

Quick check

1. Give one advantage and one disadvantage of regulation.

Answers: 1. clear and direct; costly to monitor and may not encourage improvement beyond the standard

18 Mixed review: worked problems

Bringing the ideas together.

WORKED EXAMPLE 11 Mixed problem (exam level)

Qd = 100 − 2P, Qs = 3P − 50. (a) Find equilibrium. (b) A minimum price of $35 is set. Calculate the surplus and the government cost if it buys the surplus.

Solution

(a) P = 30, Q = 40M1 A1

(b) Qd = 30, Qs = 55: surplus 25A1

Cost = 35 × 25 = $875A1

19 Additional exam-style practice

Paper 1 and Paper 3.

WORKED EXAMPLE 12 Paper 1 part (b) (exam level)

Using real-world examples, evaluate the use of price ceilings. [15]

Solution

Diagram showing shortage; explain intended aims (affordability)R1 R1

Consequences: black markets, quality, welfare lossR1

Stakeholder analysis; alternatives; justified judgementR1 R1

20 Common misconceptions and links

Students often think…	Actually…
tax revenue = tax × original quantity	use the quantity after the tax
consumers always pay the whole tax	incidence depends on elasticities
a ceiling above equilibrium causes a shortage	it has no effect; ceilings bite only below equilibrium
subsidies always improve welfare	without market failure they cause overproduction and a welfare loss
minimum wages always cause large unemployment	evidence is mixed; effects depend on elasticity and market power

How 2.7 connects to the rest of the course

Topic	Connection
2.3 Equilibrium	consumer and producer surplus measure gains and losses
2.5 and 2.6 Elasticity	determine tax incidence
2.8 Externalities	Pigouvian taxes and subsidies correct market failure
3.4 Inequality	minimum wages and transfers
4.2 Trade protection	tariffs and subsidies in international trade

21 Exam-style question with markscheme

Try this under exam conditions (about 18 minutes) before reading the markscheme.

Figure 10. Rental housing after a rent control.

Text A. In 2021 the city capped rents at 30% below the market level. Tenants in rent-controlled flats now pay much less, but landlords have sold many flats to owner-occupiers and new building has almost stopped.

(a) Define price ceiling. [2]

(b) Calculate the shortage of rental housing in 2023. [1]

(d) Explain why the shortage grew over time. [3]

(e) Rental demand is Qd = 120 − 0.05P and supply Qs = −30 + 0.1P (P = monthly rent in $). Calculate equilibrium rent and the shortage at a ceiling of $800. [4]

Markscheme

Part	Answer	Marks
(a)	a legal maximum price	A1
	set below equilibrium	A1
(b)	70 000 − 31 000 = 39 000 units	A1
(c)	diagram: ceiling below equilibrium; Qs and Qd labelled	A1
	lower rents for tenants who have homes	R1
	landlords supply fewer homes	R1
	shortage Qd − Qs; queues / black market	R1
(d)	supply more elastic in the long run	R1
	landlords sell or convert properties, little new building	R1
	low rents attract more demand	R1
(e)	120 − 0.05P = −30 + 0.1P, P = $1000	M1 A1
	at $800: Qd = 80, Qs = 50	M1
	shortage = 30 (thousand)	A1

Examiner's comments. In (c), many answers placed the ceiling above equilibrium. In (d), the best answers used the idea that supply becomes more elastic over time. In (e), some candidates forgot that P is monthly rent and Q is in thousands.

22 Check your understanding

Section A: multiple choice

1. A maximum price set below equilibrium causes

A. a shortage B. a surplus C. no effect D. higher prices

2. A minimum price set above equilibrium causes

A. a shortage B. no effect C. a surplus D. lower prices

3. An indirect tax shifts the supply curve

A. downward B. upward by the amount of the tax C. to the right D. not at all

4. The incidence of a tax falls mainly on consumers when demand is

A. price elastic B. perfectly elastic C. unit elastic D. price inelastic

5. A subsidy to producers

A. raises price and lowers quantity B. lowers price and raises quantity C. has no effect D. creates a shortage

6. Black markets often develop under

A. maximum prices B. minimum prices C. subsidies D. free markets

7. Government revenue from a specific tax equals

A. tax per unit × original quantity B. price × quantity C. consumer surplus D. tax per unit × quantity sold after the tax

8. An ad valorem tax is

A. a fixed amount per unit B. a tax on income C. a percentage of the price D. a tax on profits

9. Qd = 100 − 10P, Qs = −20 + 10P; a $2 tax. The price paid by consumers is

A. $6 B. $8 C. $5 D. $7

Section B: structured

10. Using a diagram, explain the effects of an indirect tax on consumers, producers and the government. [6]

11. Explain why consumers bear most of a tax when demand is inelastic. [3]

12. Using a diagram, explain the consequences of a minimum price for wheat. [4]

13. Evaluate the use of minimum wages to reduce poverty. [6]

14. Qd = 60 − 2P, Qs = −20 + 2P and a $4 tax: calculate the welfare loss. [2]

Answers

1. A 2. C 3. B 4. D 5. B 6. A 7. D 8. C 9. D

10. Supply shifts up by tax; consumers pay more and buy less; producers receive less and sell less; government gains tax × Q1; welfare loss.

11. Consumers keep buying despite higher prices, so producers pass most of the tax on.

12. Surplus Qs − Qd; government buys and stores surplus; higher food prices; overproduction.

13. Raises low pay; may reduce poverty; risk of unemployment; depends on elasticity and market power; alternative: transfers.

14. DWL = ½ × 4 × (20 − 16) = $8.

23 Summary and topic map

Idea	Remember
Reasons	revenue, support firms and households, influence consumption, correct market failure, equity
Specific / ad valorem tax	parallel shift up / pivot up
Incidence	the more inelastic side bears more
Subsidy	supply shifts down; cost = subsidy × Q1
Price ceiling	below equilibrium; shortage, black markets
Price floor	above equilibrium; surplus, unemployment for minimum wage
HL	replace P with P − t (tax) or P + s (subsidy)

Before the exam, make sure you…

•label Pc, Pp, Q1 and Qe on every tax and subsidy diagram
•identify every stakeholder's gain or loss
•link incidence to PED and PES
•place ceilings below and floors above equilibrium
•evaluate with a real example

Role of Government in Microeconomics on one page

Cover this page with a sheet of paper and try to rebuild it from memory. Whatever you can't recall is what to revise next.

Figure 11. Topic map for Role of Government in Microeconomics.

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