Indirect taxes, subsidies, and price controls
IB Economics
Learning Objectives By the end of this section you should be able to
Define and give examples of an indirect tax Explain the difference between a specific tax and a percentage tax Explain the importance of elasticity in understanding the effect of a specific
tax on the demand for, and supply of, a product Explain how the imposition of an indirect tax may affect consumers,
producers and government Define a subsidy Explain how the granting of a subsidy may affect consumers, producers and
government Explain, distinguish between, illustrate and give examples of maximum and
minimum price controls Discuss the consequences of price controls on the stakeholders in a market HL - Explain the significance of the elasticity of demand and supply in
assessing the incidence of an indirect tax HL – using equations of linear functions, show and explain the effects of
indirect (specific) taxes on a market HL - illustrate and calculate how the incidence of tax differs for consumers,
producers and government HL – using equations of linear functions, show and explain the effects of
subsidies on a market HL – calculate the effects of minimum and maximum prices from diagrams
Indirect Taxes An indirect tax is a tax on
spending Government taxes the firm
which increases its costs The supply curve shifts
vertically by the amount of the tax
Less product is supplied at every price
The price increase There are two types of indirect
tax This diagram illustrates a
specific tax The shift is vertically upward
of the amount of the tax An example would be the tax
on a packet of cigarettes
Indirect tax – tax on expenditure
S
P1
specific tax – a fixed amount of tax that is imposed on a product e.g. $1 per unit
Quantity
S + tax
Q2
D
Q1
tax
P2
Pric
e
Indirect TaxesA percentage tax
increases as the selling price increases as shown in the diagram
An example would be VAT in the UK (currently 20%)
Indirect tax – tax on expenditure
A percentage tax (Ad Valorem) – the tax is the percentage of the selling price. As the price rises the tax will rise
Quantity
S + tax
Q2
D
Q1
S tax
P1
P2
tax
Pric
e
What effect will the tax have on consumers, producers, government and the market as a whole?
Let’s use the specific tax as an example
Before the tax the firm’s revenue is Q1xP1 (the blue square)
When the tax of XY is charged the firm would like to pass it all onto the consumer by raising the price to P2
At that price we can see there is an excess of supply
The price falls to a new equilibrium at P3
S
P1
Quantity
S + tax
Q3
D
Q1
XY
P2P3
Pric
e
What effect will the tax have on consumers, producers, government and the market as a whole?
The price is now P3 and has increased from P1
The consumer is paying a higher price
We can see that the tax burden is roughly shared about ½ and ½
Burden of the tax – who pays the tax
S
P1
Quantity
S + tax
Q2
D
Q1
XY
P3
C
Consumer tax
Producer tax
Pric
e
What effect will the tax have on consumers, producers, government and the market as a whole?
The producer is now only receiving C per unit
The firm’s revenue was Q1P1 (blue)
The firm’s revenue has decreased to Q3C (yellow)
S
P1
Quantity
S + tax
Q3
D
Q1
XY
P3
C
Pric
e
What effect will the tax have on consumers, producers, government and the market as a whole?
The government gains tax revenue of XY x Q3 (quantity x tax (purple))
The market falls in size from Q1 to Q3 which could mean unemployment in that in that industry (derived demand for labour)
S
P1
Quantity
S + tax
Q3
D
Q1
XY
P3
C
Pric
e
Time for you to do some work!!Read through pages 63-64Complete the student workpoint P65Complete Exam Q’s 1 on P75
Only 1a if you are SL1a and b if you are HL (after the next slides)
HL bit!
The tax burden & elasticity The outcome of the share of tax
burden, the amount of producer/government revenue and the size of the market depends on the PED and PES
Firstly we will look at what happens when the PED is relatively elastic and the PES is inelastic
Initially equilibrium is at P1Q1
With the specific tax of XY the supply curve shifts to S+tax
There is a new equilibrium of P2Q2
The consumer pays P1P2Q2 in tax The producer pays CP1Q2 in tax We can see that the producer is
paying much more of the tax This is because the PED elastic;
the firm knows that the consumer is price sensitive; if the price goes too high the consumer will stop buying the product
They have to bear most of the burden of the tax
S
P1
Quantity
S + tax (XY)
Q2
D
Q1
X
P2
C
Y
Pric
e
The tax burden & elasticity Now we will look at what happens
when the PED is relatively inelastic and the PES is elastic
Initially equilibrium is at P1Q1
With the specific tax of XY the supply curve shifts to S+tax
There is a new equilibrium of P2Q2
The consumer pays P1P2Q2 in tax
The producer pays CP1Q2 in tax We can see that the consumer is
paying much more of the tax This is because the PED is
inelastic; the firm knows that if the consumer is not sensitive to price; if the price is increased the consumer % demand will not change as much as the % change in price
The consumer bears most of the burden of the tax
S
P1
Quantity
S + tax (XY)
Q2
D
Q1
X
P2
C Y
Pric
e
The rules When PED = PES the burden of tax will be
equal between the consumer and producer
When PED is greater than PES the burden of tax will be greater for the producer
When PED is less than PES the burden of tax will be greater for the consumer
This is why governments like to place taxes on products that have relatively inelastic demand such as alcohol or cigarettesThe market will not reduce in size too much
because consumers are price insensitive which protects unemployment
And still there will be large tax revenues
Time for you to do some work!!Read through pages 65-66 / make notesComplete the student workpointCover the answers of the assessment advice (P67), see if you can answer the question and then check your answersNow you can complete 1b from P75
Pajholden videos• Indirect taxation
– http://www.youtube.com/watch?v=t9N4La0-k9c
Subsidies (for all)
Subsidy When a subsidy is given to a firm
it’s costs are lowered and therefore it will supply more.
Percentage subsidies are rare so we concentrate on specific subsidies
The supply curve shifts to the right as seen in the diagram
It shifts by the amount of the subsidy
There are several reasons why government gives subsidies
To lower the price of essential goods to increase consumption (e.g. milk)
To guarantee the supply of goods in an industry the government believes is necessary e.g. coal
To help producers compete overseas (protection of industries)
Subsidy – an amount of money paid by the government to a firm per unit of output
S+subsidy
P2
Quantity
S
Q1
D
Q2
subsidy
P1
Pric
e
Subsidy We can see that when
the subsidy is given to the firm the price reduces from P1 to P2 which is not the whole subsidy
If the whole subsidy was given the price would drop to P3 (HL - depending on elasticities)
We can now look at the effect on producer revenue, consumer expenditure and government spending
Subsidy – an amount of money paid by the government to a firm per unit of output
S+subsidy
P2
Quantity
S
Q1
D
Q2
subsidy
P1
Pric
e
P3
Producer RevenuePrior to the subsidy
the firm would be making P1Q1 in revenue (blue box)
If a subsidy of WZ is given by the government
The firm is now making Q2D (yellow plus box) in revenue
Revenue has increased by the yellow amount
Subsidy – an amount of money paid by the government to a firm per unit of output
S+subsidy
P2
Quantity
S
Q1
D
Q2
P1
Pric
e
D W
Z
Consumer expenditure Prior to the subsidy
consumers could buy Q1 at the price of P1
They can now buy Q1 at the price of P2 so they make a saving of P1-P2 x Q1 (pink box)
However they will purchase more units at the lower price of Q2-Q1
The extra expenditure is Q2-Q1 x P2 (purple box)
Total expenditure may increase or fall depending upon relative savings and extra expenditure
Subsidy – an amount of money paid by the government to a firm per unit of output
S+subsidy
P2
Quantity
S
Q1
D
Q2
P1
Pric
e
D W
Z
Government expenditure
Government expenditure is the shaded area DWP2Z
This money has to be found somewhere
There is an opportunity cost Government can either take
this away from other areas of spending (building infrastructure, providing public services)
Or it must raise taxes (unpopular with voters)
Or it could borrow money and increase debt
Subsidy – an amount of money paid by the government to a firm per unit of output
S+subsidy
P2
Quantity
S
Q1
D
Q2
P1
Pric
e
D W
Z
Evaluation of Subsidies The issue of the opportunity cost Does the subsidy allow firms to be
inefficient In a free market they might have to be
more efficient to compete (on price) Although the subsidy allows consumers to
pay a lower price they may also be the taxpayers that are funding the subsidy
Subsidies can lead to overproduction There is a great deal of international
debate about subsidies given to farmers in high income countries
This leads to overproduction and is damaging to farmers in developing countries that cannot compete
High income countries are accused of dumping their products in developing countries (we will learn more about this later)
Pajholden videos• Subsidies
– http://www.youtube.com/watch?v=NykcR3RhyR4
Time for you to do some work!!Read through pages 68-69 / Make notesComplete all of the student workpoints (only one if you are SL) Complete Exam Q 2a and b on P75
Price ControlsWatch the mjmfoodie videohttp://www.youtube.com/watc
h?v=XgBPAucs-W4
Time for you to do some work!!Read through pages 70-74 / Make notes
Miss out the assessment advice on P72 if you are SLComplete all of the student workpoints (one extra if you are HL) Complete Exam Q 3a and b on P75Complete the Data Response Question on P76
Pajholden videos• Indirect taxation
– http://www.youtube.com/watch?v=t9N4La0-k9c
• Subsidies– http://www.youtube.com/watch?v=NykcR3Rhy
R4
Mjmfoodie video
• Price floors and ceilingshttp://www.youtube.com/watch?v
=XgBPAucs-W4