Methods and effects of government intervention in markets

An indirect tax is a tax on spending, collected by sellers. A specific (per-unit) tax raises firms' costs, shifting the supply curve upward by the amount of the tax. This raises the equilibrium price consumers pay and lowers the quantity sold; the price producers keep after paying the tax is lower than before. The total tax per unit is therefore split between consumers (who pay a higher price) and producers (who receive a lower net price) — this split is the incidence.

How the burden is shared depends on the relative price elasticity of demand and supply.

If demand is price-inelastic (e.g. cigarettes or petrol), consumers cannot easily reduce their purchases when the price rises, so they continue buying and the price rises by most of the tax. The incidence falls mainly on consumers. This is why governments tax inelastic goods — they raise large revenue with only a small fall in quantity.

If demand is price-elastic, consumers respond strongly to the higher price by switching away, so firms cannot pass much of the tax on without losing sales. To keep customers, producers absorb most of the tax themselves, and the incidence falls mainly on producers.

The general rule is that the more inelastic side of the market bears the larger share of the tax, because it is less able to avoid it by changing quantity. In the special cases, a perfectly inelastic demand means consumers bear the entire tax, while a perfectly elastic demand means producers bear it all.

The $2 subsidy lowers producers' costs, shifting the supply curve down by $2. The effects can be read from the source figures.

Price and quantity. The market price fell from $5 to $4 — a fall of $1 for consumers — and quantity rose from 300m to 500m litres. So consumers benefit from a lower price and more biofuel is consumed.

Sharing of the subsidy. The subsidy is $2 per litre, but the price to consumers fell by only $1. So consumers gain $1 per litre, and producers gain the other $1 per litre (they now receive $4 from the market + $2 subsidy = $6, which is $1 more than the original $5). The roughly even split suggests demand and supply have similar elasticities here.

Cost to the government. Total subsidy cost = subsidy per litre × new quantity = $2 × 500m = $1,000m ($1bn). This must be funded by taxation or borrowing and has an opportunity cost.

Overall. The subsidy lowers the price, raises output and consumption of biofuel (useful if it has environmental benefits), and shares the gain between consumers and producers — but at a significant cost to the government.

A maximum price (ceiling) set below the equilibrium lowers the price of a good to make it more affordable. Whether it is the best way depends on its effects compared with alternatives.

The case for a maximum price. It directly and immediately lowers the price, helping consumers — especially the poor — afford an essential good such as housing, food or medicine. For those who can still obtain the good, welfare clearly rises (a gain in consumer surplus per unit). It is administratively simple to announce.

The drawbacks. Because the price is held below equilibrium, quantity demanded exceeds quantity supplied, creating a shortage. The shortage means some consumers who want the good at the capped price cannot get it, so the good is rationed by queues, waiting lists or favouritism. It can also create black markets, where the good is sold illegally above the cap — sometimes leaving the poor paying more than before. The low price reduces producers' incentive to supply or maintain quality (e.g. landlords cutting maintenance under rent controls), worsening the shortage over time. So the policy can fail the very people it aims to help.

Alternatives. Other tools may achieve affordability without a shortage:

• A subsidy lowers the price by raising supply, so there is no shortage (price falls and quantity rises) — though it costs the government money.
• Direct provision (e.g. social housing) increases supply directly.
• Raising poor households' incomes through transfer payments lets them afford the good at the market price, tackling the real problem (low income) rather than the symptom (high price).

Judgement. A maximum price can improve affordability in the short run or during a crisis, but its shortage and supply-side side effects make it a poor long-term solution. In most cases, subsidies, direct provision or income support make a good affordable without creating a shortage, so they are usually superior. The most defensible conclusion is that a maximum price is not generally the best method: it may be justified as a temporary emergency measure, but a subsidy or income support is normally a better way to achieve lasting affordability.

A buffer stock scheme stabilises a commodity's price by buying and storing surpluses when prices are low (supporting a minimum price) and selling from stock when prices are high (enforcing a maximum price). For farmers in a developing economy, whose incomes are often volatile, this has clear attractions but also serious problems.

The case for. Agricultural prices are highly volatile because supply is inelastic and varies with weather, while demand is also inelastic. A buffer stock stabilises farm incomes by guaranteeing a minimum price in good harvests, which helps farmers plan, invest and avoid ruin in a glut. It also protects consumers from price spikes in poor harvests by releasing stored stock. For a developing economy heavily dependent on agriculture, stable farm incomes can support rural living standards and overall stability.

The drawbacks. Buffer stocks are expensive and difficult to run. They require large funds to buy surpluses and storage facilities; many crops are perishable and spoil in storage. If the minimum (target) price is set too high, the agency must keep buying persistent surpluses until it runs out of money or space — a common reason such schemes collapse. Guaranteed prices can encourage over-production, worsening surpluses. There is also scope for mismanagement and corruption, and developing-economy governments may lack the administrative capacity and funds to operate the scheme effectively.

Alternatives. Farmers could instead be helped by subsidies, crop insurance, income support, or measures to improve productivity and access to markets — which avoid the storage and funding problems of buffer stocks.

Judgement. A buffer stock scheme can support farmers and stabilise prices in principle, and is best suited to storable, non-perishable commodities where prices are genuinely volatile. However, in practice it is costly, hard to manage and prone to failure, especially in a developing economy with limited funds and administrative capacity, and especially if the target price is set wrongly. The most defensible conclusion is that a buffer stock can help in the right conditions (storable crop, well-set target price, adequate funding), but for many developing economies alternatives such as subsidies, insurance or productivity support are likely to be more reliable ways to support farmers.