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Correcting Market Failure

Subsidies and Taxation

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Subsidies and Taxation

Subsidies:
Aim to change relative prices Given to the producer Used to help re-distribute income Used to help firms compete Numerous examples state benefits, free school meals, working tax credits, agriculture, transport, regional development, housing, employment, education

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Subsidies and Taxation

Effects of Subsidies:
Shifts supply curve to right Reduces price to consumer Increases output market failure is perceived as a lack of output Long term effects on market distorts price signals Who benefits depends who gets the subsidy and how it is used! Welfare effects: cost of the subsidy to the taxpayer minus the value of the benefits received Impact on relative consumer and producer surplus

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Price 14 10

Subsidies and Taxation

S S + Subsidy Total cost of the subsidy Amount of subsidy per unit (4)
The The amount effect subsidy of of the will the subsidy encourage subsidy is is to First we look at the market the reduce suppliers vertical prices to distance offer and more increase between for sale the before the subsidy the amount at every two supply available price curves but at what cost?

D 500 700 Quantity Bought and Sold

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Subsidies and Taxation

Taxation:
Specific or flat rate amount per unit Ad Valorem percentage of the price Levied on the producer indirect tax Examples: VAT, excise duties, tariffs, levies, duties (e.g. stamp duty) National Insurance Contributions (NICs) a tax on employment?

Incidence who pays?

Producer/consumer price elasticity of demand
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Subsidies and Taxation

Effects of a tax: Increases price Reduces consumption/output Welfare effects:
Burden of tax on producer and consumer changes in producer and consumer surplus Tax yield minus the cost of the tax
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Subsidies and Taxation

Effects of Taxation:
Distortion of the market Influence on behaviour Extent of the effect dependent on the degree of elasticity number of substitutes, addictiveness of the product, proportion of income devoted, time scale Creation of underground markets smuggling, booze cruises, etc. Increases business costs competitiveness? Raises revenue to help pay for government services

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Price p per litre

Incidence of a tax on petrol

S + tax S Amount of tax = 3p per litre

76.8
Tax burden of Tax Revenue consumer

74
Tax burden of producer

The The Some The producer amount tax of the effectively of tax has the is to passed tax increases carry is the the on rest to the of Petrol has an inelastic the vertical consumer the burden. cost distance of in With production, the an form between inelastic of shifting higher the demand two prices demand curve this supply supply this may is curves not to the the be burden left very of much! tax

D 50 49.5 Quantity Bought and Sold (000s litres per day)

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Incidence of an ad valorem tax on a product with a greater degree of price elasticity

Price S + Tax
S

Burden on Consumer

Total Tax Paid Burden on Producer 3 500

Amount of the tax (6) D 900

Quantity Bought and Sold

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