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 Price

Indirect Taxes  A 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 Price

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 P2 P3 Price

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 Price

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 Price

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 Price

Time for you to do some work!!  Read through pages  Complete the student workpoint P65  Complete Exam Q’s 1 on P75  Only 1a if you are SL  1a 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 P 1 Q 1  With the specific tax of XY the supply curve shifts to S +tax  There is a new equilibrium of P 2 Q 2  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 Price

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 P 1 Q 1  With the specific tax of XY the supply curve shifts to S +tax  There is a new equilibrium of P 2 Q 2  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 Price

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 cigarettes  The 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 / make notes  Complete the student workpoint  Cover the answers of the assessment advice (P67), see if you can answer the question and then check your answers  Now you can complete 1b from P75

Pajholden videos Indirect taxation – k9chttp:// 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 Price

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 Price P3

Producer Revenue  Prior 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 Price DW 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 Price DW 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 Price DW 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 – R4http:// R4

Time for you to do some work!!  Read through pages / Make notes  Complete all of the student workpoints (only one if you are SL)  Complete Exam Q 2a and b on P75

Price Controls  Watch the mjmfoodie video  h?v=XgBPAucs-W4 h?v=XgBPAucs-W4

Time for you to do some work!!  Read through pages / Make notes  Miss out the assessment advice on P72 if you are SL  Complete all of the student workpoints (one extra if you are HL)  Complete Exam Q 3a and b on P75  Complete the Data Response Question on P76

Pajholden videos Indirect taxation – k9chttp:// k9c Subsidies – R4http:// R4 Mjmfoodie video Price floors and ceilings  W4 W4