Chapter 6

Indirect taxes, subsidies, and elasticity (HL)

Aim
Explore the effects upon demand and supply when government imposes a tax on products Consider these effects and how they are influenced by the relative price elasticities of the product

Indirect tax
tax imposed on the selling price of a product adds to the firms costs and shifts the supply curve of the product upwards by the amount of the tax less will be supplied at every price

Two types of indirect taxes

Specific tax Fixed amount of tax, e.g. $1 per unit. Supply curve will shift upwards by $1 See Figure 6.1, from supply curve S to S+tax after the imposition of the tax Less will be supplied at any given price *

Figure 6.1a The effect of a specific tax on a supply curve

Percentage tax A.k.a. ad valorem tax (Latin according to value) Tax is a percentage of the unit price See Figure 6.1b Distance between S1 and S+tax get bigger as the product price increases.

Figure 6.1a The effect of an ad valorem tax on a supply curve

Questions
What is the effect on consumers, producers, the government, and the market? Consider the following: What will happen to the price that consumers pay? What will be the effect on producers revenue? What will be the effect on government revenue? What will be the effect on the market as a whole and unemployment?

Questions
With the imposition of the tax what will the producers do next? What will happen next?

Tax burden
The share of the tax burden for consumers and producers depends on the relative values of price elasticity of demand and supply for the product. The government revenue and the effect on size of the market will also depend on the relative values of price elasticity of demand and supply of a product.

Two scenarios
The price elasticity of demand is relatively elastic and the price elasticity of supply is relatively inelastic. PED >1 and < PES <1 and >0 The price elasticity of demand is relatively inelastic and the price elasticity of supply is relatively elastic. PED <1 and >0 PES >1 and <

Figure 6.3 The effect of a specific tax where PED > PES

Figure 6.3 The effect of a specific tax where PED < PES

Rules on the effects of an indirect tax on producers and consumers

PED = PES, tax burden will be shared equally between the consumers and producers PED > PES producers will bear more of the tax than consumers PED < PES consumers will bear more of the tax than producers

 Alcohol and cigarettes have relatively inelastic demand, therefore governments tend to impose indirect taxes on these products.

Subsidy
Money paid by the government to firms, per unit of output. Reasons: 1) To make essential goods affordable to many. 2) To ensure the availability of products the government deems necessary for the economy. 3) To protect the local industry so that producers can remain competitive.

Two types of subsidies

Percentage Percentage subsidies are rarely granted Specific A specific amount of money is given for each unit, e.g. $2 per unit. Supply curve will shift downwards by $2 See Figure 6.5, from supply curve S1 to S1subsidy after the subsidy is given More will be supplied at any given price

Question
What will be the effect of the granting of a subsidy to a product? a) Producer revenue b) Consumer expenditure c) Amount of government subsidy

(a) Increase in producer revenue Producer income? Before subsidy OPeXQe X After subsidy ODWQ1 Consumer Expenditure? OP1ZQ1 Amount paid to producers? P1DWZ

Fig. 6.6 The granting of a specific subsidy on a product

Producer income = Consumer expenditure + Subsidy amount OP1ZQ1 + P1DWZ

Consumer expenditure saved? P1PeXY Consumer extra expenditure? QeYZQ1

Fig. 6.6 The granting of a specific subsidy on a product

Will total consumer expenditure increase or fall? This will depend on the relative savings and extra expenditure.

Subsidy cost? P1DWZ

Fig. 6.6 The granting of a specific subsidy on a product

Question
How will the government fund the subsidy? There is opportunity cost involved. Less money available to build roads, bridges, schools, health centers etc. Raise taxes.

Two scenarios
The price elasticity of demand is relatively elastic and the price elasticity of supply is relatively inelastic. PED >1 and < PES <1 and >0 The price elasticity of demand is relatively inelastic and the price elasticity of supply is relatively elastic. PED <1 and >0 PES >1 and <

Fig. 6.7 The granting of a specific subsidy on a product where PED > PES

Consumption of the product is increased and producer revenue also is increased. No big drop in price but since demand is relatively elastic, consumption increases by a significant amount.

than PES

Consumption of the product is increased and producer revenue also is increased. A big drop in price but since demand is relatively inelastic, consumption does not increase by a significant amount.

Rules on the effects of a subsidy on producers and consumers

PED = PES, price of the product falls by half of the subsidy PED > PES price of the product falls by less than half of the subsidy PED < PES price of the product falls by more than half of the subsidy In all cases, consumption of the product is increased and producer revenue also is increased.

The government needs to assess a number of things when considering the granting of a subsidy. the opportunity cost of government spending on the subsidy Who is actually paying for the subsidy? Possibility of producers becoming inefficient adverse effect on foreign relations anti-dumping measures by governments of countries whose farmers do not receive the subsidies.