IB Economics

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IB Economics
Indirect Taxes, Subsidies and Price Controls
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Taxes
A tax on expenditure
A tax on income
An indirect tax of an absolute (constant) amount
levied per unit of a commodity ex a tax of 5
per unit.
An indirect tax, which is expressed as a
proportion (percentage) of the price
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Indirect Taxes

• An indirect tax is a tax imposed upon
  expenditures.
• An indirect tax acts as an extra cost on the
  producer therefore, it manages to shift its
  supply curve to the left.
• An indirect tax is placed on top of the selling
  price hence, raising the products price and
  reducing the quantity demanded.

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A Flat (Specific) tax
S2
With a flat tax, there is a parallel shift of the
supply curve leftwards by the amount of the tax,
in this case 5.
P
S1
5
P2
P1
5
D
Q
5
An ad-Valorem (Percentage) tax
S2
P
S1
With an Ad-Valorem tax, the supply shifts further
to the left at higher prices.
P2
P1
D
Q
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How does a tax affect consumers, producers, the
government and the market?
The tax causes a decrease in supply, which in
turn causes an increase in the equilibrium price
from P1 to P2. The higher price causes a
contraction in demand from Q1 to Q2. This
contraction in market size might pose an
unemployment problem.
S2
P
S1
P2
P1
D
Q
Q2
Q1
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Who pays for the Tax?

• The tax causes an increase in the equilibrium
  price.
• The consumer bears some of the tax burden.
• The producerusuallydoes not pass the entire tax
  burden to the consumer. Why??
• The producer realizes that an increase in the
  price will result in reduced quantity demanded
  (The law of demand).
• The tax could generally be subdivided into 2
  parts The consumers burden and the producers
  burden. Call them C and S respectively.

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The consumers burden
The tax is the vertical distance between the 2
supply curves. C represents the consumers burden
and is equal to the increase in price from P1 to
P2.
S2
P
S1
P2
C
P1
D
Q
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The Producers burden
S2
S represents the producers burden and is equal
to the remaining part of the tax.
P
S1
P2
P1
S
D
Q
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Tax Revenue
S2
The Tax revenue is equal to the product of the
tax per unit with the quantity sold
P
S1
P2
P1
Tax Revenue
D
Q
Q1
Q2
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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?
• Who pays?
• Producer/consumer price elasticity of demand

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Taxation

• Effects of a tax
• Increases price
• Taxes shift supply to the left, which raises the
  equilibrium price of the product

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Taxes raise prices
S2
P
S1
Decrease in supply raises the equilibrium price
from P1 to P2.
P2
P1
D
Q
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Taxation

• Effects of a tax
• Increases price
• Taxes shift supply to the left, which raises the
  equilibrium price of the product
• Reduces output
• Increased costs leads to smaller quantities
  offered for sale

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Taxes reduce output
S2
Decrease in supply raises the equilibrium price
from P1 to P2. Decreases output from Q1 to Q2.
P
S1
P2
P1
D
Q
Q1
Q2
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Taxation

• Effects of a tax
• Increases price
• Taxes shift supply to the left, which raises the
  equilibrium price of the product
• Reduces output
• Increased costs leads to smaller quantities
  offered for sale
• Market size shrinks
• Reduced output means a reduced market size

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Taxation

• Effects of a tax
• Consumers suffer
• Consumers pay higher prices and receive less of
  the product
• Producers suffer
• Producers incur extra costs, produce less and are
  less likely to make profits
• Governments benefit
• The tax collected will increase government revenue

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• What happens to the consumer and producer tax
  burdens when demand is inelastic vs. elastic?

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Incidence of a tax on petrol
Price p per litre
S tax
S
Amount of tax 3p per litre
77
Tax Revenue
Tax burden of consumer
74
The tax effectively increases the cost of
production, shifting supply to the left
The amount of the tax is the vertical distance
between the two supply curves
Some of the tax is passed on to the consumer in
the form of higher prices this is the burden of
tax
The producer has to carry the rest of the burden.
With an inelastic demand this may not be very
much!
Petrol has an inelastic demand curve
Tax burden of producer
D
Quantity Bought and Sold (000s litres per day)
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49.5
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Incidence of an ad valorem tax on a product with
a greater degree of price elasticity
Price
S Tax
S
9
Total Tax Paid
Burden on Consumer
7
Burden on Producer
D
3
900
500
Quantity Bought and Sold
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Lets draw diagrams

• Taxation

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What is a SUBSIDY?
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Why give a subsidy?

• A subsidy is the amount of money paid by the
  government to the producers to lower the
  producers costs of production.
• Governments extend subsidies
• To lower prices of essential goods, for example
  bread, in hope of increasing their consumption.
• To guarantee the supply of products that the
  government thinks are necessary for the economy,
  such as oil and food.
• To protect industries supplying a lot of
  employment that would be lost otherwise causing
  further economic and social problems.
• To enable producers compete with overseas trade,
  thus protecting domestic industries.

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Subsidies
Price
S
14
S Subsidy
Total cost of the subsidy
10
The subsidy will encourage suppliers to offer
more for sale at every price
The amount of the subsidy is the vertical
distance between the two supply curves
The effect of the subsidy is to reduce prices and
increase the amount available but at what cost?
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First we look at the market before the subsidy
D
500
700
Quantity Bought and Sold
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Subsidies

• Subsidies
• Aim to change relative prices
• Given to the producer
• Used to help firms compete
• Numerous examples state benefits, free school
  meals, working tax credits, agriculture,
  transport, regional development, housing,
  employment, education
• Impact consumer and producer surplus

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The effect of subsidy on supply

• The subsidy will shift the supply curve to the
  right by the amount of the subsidy because it
  reduces the costs of production for the firm.
• The subsidy will cause the price to drop and the
  quantity demanded to increase.
• The price will not fall by the full amount of the
  subsidy however, consumers get to buy more units
  at a lower price.
• The amount of the subsidy involves an opportunity
  cost to the government. The money must be taken
  away from other governmental projects, or it may
  raise taxes in the future.

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Lets draw diagrams

• SUBSIDY

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In equilibrium

• The quantity demanded is equal to the quantity
  supplied
• No shortage
• No surplus
• No tendency for the price to change

P
S
D
Q
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Price Controls

• The free market does not always lead to the best
  outcomes for all producers, consumers or the
  society in general, and so governments intervene
  in the market to correct the situation.
• Two forms of government intervention in markets
  are
• Price ceiling or Maximum (low)
• Price floor or Minimum (high)

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Price Ceiling

• A price ceiling is a legal maximum imposed by the
  government to help reduce the price of
  necessities and/or merit goods. The price is not
  allowed to exceed the price ceiling.
• The price ceiling is imposed below the
  equilibrium price.

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Price ceiling
P
S

• At Pmax, there is a shortage. The quantity
  demanded by buyers, Qd exceeds the quantity
  supplied, Qs.

D
Q
Shortage
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Maximum (low/ceiling) Price Controls

• Government sets a maximum price, below the
  equilibrium price, which then prevents producers
  from raising the price above it.
• Sometimes known as ceiling prices
• Set to protect consumers
• Generally imposed in markets where product is a
  necessity and/or a merit good (a good that would
  be underprovided if the market were allowed to
  operate freely)

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Example

• Rent Controls
• Governments may attempt to impose maximum prices
  on rented accommodation to ensure affordable
  accommodation for those on low incomes
• Staples
• Governments may set maximum prices in
  agricultural and food markets to ensure low-cost
  food for the poor.

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Maximum price in the market for bread
P
S
Without government interference, the equilibrium
quantity demanded and supplied would be Q e and P
e.
Government imposes a max price of P max in order
to help the consumers of bread
Pe
Maximum price
P max
D1
Q1
O
Q e
Q2
Q
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Maximum (low/ceiling) Price Controls

• Consequences of imposing maximum prices are the
  queues and resulting parallel black markets
• Government solution to black market has been to
  limit the quantity per person by either a
  rationing system or a queuing system
• Rationing is achieved by setting a limit to
  purchases or by instituting a first come first
  served system

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Ways the government can eliminate or reduce the
shortage

• The government could start to produce the product
  themselves, thus increasing the supply
• The government could offer subsidies to the firms
  in the industry to encourage them to produce more
• If the government had previously stored some of
  the product (buffer stocks), then they could
  release some of the stocks onto the market.
  However, if the product were perishable, like
  bread, this would not be possible.

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Maximum price in the market for bread
P
If the government is able to shift the supply
curve to the right, by subsidizing, direct
provision, or using stored bread, then
equilibrium will be reached at P max, with Q2
loaves of bread being demanded and supplied.
S
S1
Pe
Maximum price
P max
D1
Q1
O
Q e
Q2
Q
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Maximum price in the market for bread
P
S
The quantity of Q1 times the maximum market price
of that quantity, P1, minus the initial purchase
price of P max gives the extent of the possible
parallel market
P 1
P e
Maximum price
P max
D1
Q1
O
Q e
Q2
Q
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Price Floor

• A price floor is a legal minimum imposed by the
  government to help increase the income of
  producers of goods and services deemed important.
  The price is not allowed to fall below the price
  floor.
• The price floor is imposed above the equilibrium
  price.

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Minimum price on an agricultural good
P
This excess cannot be allowed on the market as
this would serve to lower the price
S
Min Price
P min
P e
D1
O
Q e
Q1
Q2
Q
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Minimum (high/floor) price controls

• Government sets a minimum price, above the
  equilibrium price, which then prevents producers
  from reducing the price below it.
• Known as floor prices
• Protect and aid certain suppliers
• Government attempt to benefit society
• Minimum price on agricultural goods guarantee
  acceptable income
• Minimum price on labor (minimum wage) benefits
  those supplying their labor

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Examples

• Price supports for commodities ( agricultural and
  industrial raw materials), whose prices are
  subject to large fluctuations or to protect them
  from foreign competition.
• The minimum wage set to protect workers and
  ensure that they earn enough to lead a reasonable
  life.

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Price floor
P
At Pmin, there is a surplus. The quantity
supplied by producers, Qs exceeds the quantity
demanded, Qd.
S
D
Q
Surplus
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Minimum wages
Wage Rate
PL
SL
Minimum wage
P L min
P Le
DL
O
Q Le
QL1
QL2
Q Labour
Unemployment
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Government Intervention

• To eliminate the surplus, the government attempts
  to
• Buy the surplus
• In the case where the surplus is bought there is
  a number of options available to deal with the
  stocks
• It can be stored however, some items (fresh
  ones) cannot be stored for long periods of time
  and can therefore be immediately ruled out. Even
  the ones that can be stored will result in high
  storage costs.
• It can be destroyed, but this is considered to be
  wasteful.
• It can be sold to other countries however,
  selling the stock abroad could be regarded as
  dumping and therefore not welcomed by other
  countries.
• It can be given as overseas assistance, but this
  encourages the overdependence of LDCs on MDCs and
  discourage them from pursuing their own growth
  strategies.
• Limit producers by quotas
• Advertise to create more demand

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Ways the government can eliminate or reduce the
surplus

• Price support scheme - means that the government
  agrees to purchase the excess at the agreed
  minimum price
• - - cost will increase due to administrative
  costs, storage costs, and transportation costs

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Minimum price on an agricultural good
P
S
Min Price
P min
P e
D govt. buying
D1
O
Q e
Q1
Q2
Q
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Ways the government can eliminate or reduce the
surplus

• Price support scheme - means that the government
  agrees to purchase the excess at the agreed
  minimum price
• - - cost will increase due to administrative
  costs, storage costs, and transportation costs
• In many cases the surplus is burnt, sold on other
  markets (dumping) or even sold back to farmers
  at lower price which is then used as feed to
  produce more cattle, beef, etc.

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Problems

• The minimum wage results in unemployment
• Price floors imposed on commodities
• Taxpayers will bear the burden of this policy as
  the government will need to buy the surplus
• Higher prices paid by consumers