Government intervention: purpose, and correcting externalities with taxes and subsidies

Why governments intervene

The main purpose is to correct market failure and so achieve a better allocation of resources: move output towards the social optimum (MSB = MSC). Governments may also intervene to make outcomes fairer (equity), to raise revenue or to stabilise prices (for example farm incomes).

Whether intervention is justified depends on whether it makes society better off once its costs and side effects are counted (government failure, last lesson of the unit).

Indirect taxes to correct negative externalities

A tax equal to the marginal external cost 'internalises' the externality: the polluter pays (the 'polluter pays principle').

Diagram in words: the negative production externality diagram (MPC, MSC, MPB = MSB). The tax shifts MPC up to MPC + tax, which ideally lies on MSC. The new equilibrium is at Q*, the social optimum; the welfare loss triangle is removed.

Advantages: internalises the external cost; raises revenue that can be used to offset the harm; leaves choice to consumers and firms; gives a lasting incentive to cut pollution or switch to cleaner products.

Disadvantages: the external cost is hard to value, so the tax may be set too high or too low; with inelastic demand quantity falls little; taxes on goods like fuel are regressive; firms may relocate abroad; consumers may switch to illegal or untaxed sources (smuggling).

Real-world example: the UK Soft Drinks Industry Levy, introduced in April 2018, charged producers 18p or 24p per litre depending on sugar content (19.4p and 25.9p since April 2025) (GOV.UK). Because it is charged to producers, many reformulated their drinks to fall into a lower band or below the threshold, showing a tax can change supply as well as demand.

Subsidies to correct positive externalities

A subsidy equal to the marginal external benefit lowers costs, shifting supply (MPC) down to raise output to Q* where MSB = MSC. Examples: subsidised public transport, vaccinations, renewable energy, training.

Advantages: increases consumption of goods with external benefits; can make goods affordable for low-income households.

Disadvantages: opportunity cost to the government; hard to value the external benefit; if demand is price inelastic, quantity rises little; producers may become inefficient or dependent; once given, subsidies are politically hard to remove.

Worked example

Using a diagram described in words, explain how a tax could correct the over-production of a good whose production causes pollution.

1. Draw MPB = MSB sloping down, MPC sloping up, and MSC above MPC by the marginal external cost.
2. The market produces Qm where MPB = MPC, more than the social optimum Q* where MSB = MSC.
3. A tax equal to the external cost shifts MPC up to MSC.
4. Firms now face the full social cost, so output falls to Q* and the welfare loss is removed.

Answer: A tax equal to the marginal external cost shifts MPC to MSC, reducing output to the social optimum.

Check yourself

1. To correct a negative production externality fully, an indirect tax should ideally equal
   • the price of the good
   • the firm's profit per unit
   • the marginal external cost at the social optimum
   • the marginal private cost
   Show answer

   the marginal external cost at the social optimum. This makes the MPC + tax curve pass through the social optimum.

2. Why might a tax on petrol do little to reduce car use in the short run?
   • Demand for petrol is price inelastic
   • Demand for petrol is price elastic
   • Petrol is a public good
   • Petrol has many close substitutes
   Show answer

   Demand for petrol is price inelastic. Drivers have few short-run alternatives, so quantity falls little.

3. One criticism of taxes on goods such as tobacco and fuel is that they are often
   • progressive
   • impossible to collect
   • regressive, taking a larger share of income from poorer households
   • a cause of positive externalities
   Show answer

   regressive, taking a larger share of income from poorer households. Poorer households spend a larger share of income on these goods.

4. A subsidy is given to producers of a good with external benefits. The aim is to
   • reduce output to zero
   • increase output towards the social optimum
   • raise the market price
   • create a negative externality
   Show answer

   increase output towards the social optimum. The good is under-produced, so the subsidy raises output.

5. At the social optimum, the marginal private cost of a good is $30 and the marginal social cost is $42. What per-unit tax would internalise the externality?
   Show answer

   $12. Tax = MSC - MPC = 42 - 30 = $12 per unit.

6. Give one reason why an indirect tax may fail to achieve the socially optimal output.
   Show answer

   The government cannot measure the external cost accurately in money terms, so the tax may be set too high or too low; also, if demand is price inelastic, quantity falls only slightly.. Valuation problem or elasticity.

Practise with instant feedback Print this lesson

Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (2018)
• GOV.UK news story: Soft Drinks Industry Levy comes into effect (2018)
• GOV.UK: Soft Drinks Industry Levy statistics commentary (published 30 January 2026)

Last updated 8 November 2026. Spotted a mistake? Tell us.