1. Indirect Taxes, Subsidies and Price Controls
IB Economics
Indirect Taxes, Subsidies and Price Controls

2. Ad- Valorem (Percentage)
Taxes
Direct
Indirect
A tax on income
A tax on expenditure
Flat (Specific)
Ad- Valorem (Percentage)
Ad-Valorem: according to value
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

3. 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.

4. 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) taxS2 P S1
With an Ad-Valorem tax, the supply shifts further to the left at higher prices. P2 P1 D Q

6. 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 Q2 Q Q1

7. Who pays for the Tax?
The tax causes an increase in the equilibrium price.
The consumer bears some of the tax burden.
The producer—usually—does 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 consumer’s burden and the producer’s burden. Call them C and S respectively.

8. The consumer’s burden
The tax is the vertical distance between the 2 supply curves.
C represents the consumer’s burden and is equal to the increase in price from P1 to P2. S2 P S1 P2 C P1 D Q

9. The Producer’s burden S2
S represents the producer’s burden and is equal to the remaining part of the tax. P S1 P2 P1 S D Q

10. 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 Q2 Q1

11. 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

12. Taxation Effects of a tax: Increases price
Taxes shift supply to the left, which raises the equilibrium price of the product

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

14. Taxation Effects of a tax: Increases price Reduces output
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

15. 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 Q2 Q1

16. Taxation Effects of a tax: Increases price Reduces output
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

17. Taxation Effects of a tax: Consumers suffer Producers 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

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

19. 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 producer has to carry the rest of the burden. With an inelastic demand this may not be very much!
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 tax effectively increases the cost of production, shifting supply to the left
Petrol has an inelastic demand curve
Tax burden
of producer D
Quantity Bought and Sold
(000s litres per day) 50
49.5

20. 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
Amount of the tax (£6) £7
Burden on
Producer D £3
500
900
Quantity Bought and Sold

21. Let’s draw diagrams
Taxation

22. What is a SUBSIDY?

23. Why give a subsidy?
A subsidy is the amount of money paid by the government to the producers to lower the producer’s 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.

24. Subsidies Price S £14 S + Subsidy Total cost of the subsidy £10 £7 D
The effect of the subsidy is to reduce prices and increase the amount available – but at what cost?
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
First we look at the market before the subsidy D
500
700
Quantity Bought and Sold

25. 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

26. 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.

27. Let’s draw diagrams
SUBSIDY

28. In equilibrium…
The quantity demanded is equal to the quantity supplied
No shortage
No surplus
No tendency for the price to change P S PE QE D Q

29. 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)

30. 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.

31. Price ceiling P S
At Pmax, there is a shortage. The quantity demanded by buyers, Qd exceeds the quantity supplied, Qs. PE
Pmax Qs Qd D Q
Shortage

32. 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)

33. Example Rent Controls Staples
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.

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

35. 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
Black markets where products are sold at higher prices

36. 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.

37. Maximum price in the market for bread
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
Shortage
P max D1 O Q1
Q e Q2 Q

38. Maximum price in the market for breadS
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
Shortage
P max D1 O Q1
Q e Q2 Q

39. 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.

40. Minimum price on an agricultural good
This excess cannot be allowed on the market as this would serve to lower the price S
SURPLUS
Min Price
P min
P e D1 O Q1
Q e Q2 Q

41. 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

42. 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.

43. Price floor P
At Pmin, there is a surplus. The quantity supplied by producers, Qs exceeds the quantity demanded, Qd. S
Pmin Qs Qd PE D Q
Surplus

44. Minimum wages SL DL PL P L min P Le O QL1 Q Le QL2 Q Labour Wage Rate
SURPLUS
Of Labor
Minimum wage
P L min
P Le DL O
QL1
Q Le
QL2
Q Labour
Unemployment

45. 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

46. 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

47. Minimum price on an agricultural goodS
SURPLUS
Min Price
P min
P e
D + govt. buying D1 O Q1
Q e Q2 Q

48. 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.

49. 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