IB EconomicsIB Economics

Indirect Taxes, Indirect Taxes, Subsidies and Price Subsidies and Price

ControlsControls

Taxes

IndirectDirect

Flat (Specific) Ad- Valorem (Percentage)

A tax on income A tax on expenditure

An indirect tax, which is expressed as a proportion (percentage) of the price

An indirect tax of an absolute (constant) amount levied per unit of a commodity ex: a tax of $5 per unit.

Indirect TaxesIndirect Taxes►An indirect tax is a tax imposed An indirect tax is a tax imposed

upon expenditures.upon expenditures.►An indirect tax acts as an extra An indirect tax acts as an extra

cost on the producer; therefore, it cost on the producer; therefore, it manages to shift its supply curve manages to shift its supply curve to the left.to the left.

►An indirect tax is placed on top of An indirect tax is placed on top of the selling price; hence, raising the the selling price; hence, raising the products price and reducing the products price and reducing the quantity demanded.quantity demanded.

A Flat (Specific) taxA Flat (Specific) tax

P

D

S1

P1

P2

S2

$5

Q

With a flat tax, there is a parallel shift of the supply curve leftwards by the amount of the tax, in this case $5.

$5

An ad-Valorem (Percentage) An ad-Valorem (Percentage) taxtax

P

D

S1

P1

P2

S2

Q

With an Ad-Valorem tax, the supply shifts further to the left at higher prices.

How does a tax affect How does a tax affect consumers, producers, the consumers, producers, the

government and the market?government and the market?P

D

S1

Q1

P1

S2

P2

Q2

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.

Q

Who pays for the Tax?Who pays for the Tax?

► The tax causes an increase in the equilibrium The tax causes an increase in the equilibrium price. price. The consumer bears The consumer bears some some of the tax burden.of the tax burden.

► The producer—usually—does not pass the entire The producer—usually—does not pass the entire tax burden to the consumer. Why??tax burden to the consumer. Why?? The producer realizes that an increase in the The producer realizes that an increase in the

price will result in reduced quantity demanded price will result in reduced quantity demanded (The law of demand).(The law of demand).

► The tax could generally be subdivided into 2 The tax could generally be subdivided into 2 parts: The consumer’s burden and the producer’s parts: The consumer’s burden and the producer’s burden. Call them C and S respectively.burden. Call them C and S respectively.

The consumer’s burdenThe consumer’s burden

P

QD

S1

P1

P2

S2

C

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.

The Producer’s burdenThe Producer’s burden

P

QD

S1

P1

P2

S2

S

S represents the producer’s burden and is equal to the remaining part of the tax.

P

Q

D

P1

P2

S2

S1 The Tax revenue is equal to the product of the tax per unit with the quantity sold

Tax RevenueTax Revenue

Q1Q2

Tax Revenue

Why give a subsidy?Why give a subsidy?► A subsidy is the amount of money paid by A subsidy is the amount of money paid by

the government to the producers to lower the government to the producers to lower the producer’s costs of production.the producer’s costs of production.

► Governments extend subsidies…Governments extend subsidies… To lower prices of essential goods, for example To lower prices of essential goods, for example

bread, in hope of increasing their consumption.bread, in hope of increasing their consumption. To guarantee the supply of products that the To guarantee the supply of products that the

government thinks are necessary for the government thinks are necessary for the economy, such as oil and food.economy, such as oil and food.

To protect industries supplying a lot of To protect industries supplying a lot of employment that would be lost otherwise employment that would be lost otherwise causing further economic and social problems.causing further economic and social problems.

To enable producers compete with overseas To enable producers compete with overseas trade, thus protecting domestic industries.trade, thus protecting domestic industries.

Price

Quantity

PSubsidy

Subsidy given out to Producers

Pe

Ps

S - Subsidy

D

S

Q1

Subsidy passed to consumers as lower prices

Subsidy retained by producer

The effect of a subsidy on supply

Q2

The subsidy causes an increase in supply, which in turn causes a decrease in the equilibrium price from Pe to PSubsidy. The lower price causes an extension in demand from Q1 to Q2.

The effect of subsidy on The effect of subsidy on supplysupply► The subsidy will shift the supply curve to the The subsidy will shift the supply curve to the

right by the amount of the subsidy because it right by the amount of the subsidy because it reduces the costs of production for the firm. reduces the costs of production for the firm.

► The subsidy will cause the price to drop and The subsidy will cause the price to drop and the quantity demanded to increase.the quantity demanded to increase.

► The price will not fall by the full amount of The price will not fall by the full amount of the subsidy; however, consumers get to buy the subsidy; however, consumers get to buy more units at a lower price.more units at a lower price.

► The amount of the subsidy involves an The amount of the subsidy involves an opportunity cost to the government. The opportunity cost to the government. The money must be taken away from other money must be taken away from other governmental projects, or it may raise taxes governmental projects, or it may raise taxes in the future.in the future.

Equilibrium

0

5

10

15

20

25

0 20 40 60 80 100 120 140

Quantity

Pri

ce

P= 10 ; Q= 60

In equilibrium…In equilibrium…

►The quantity The quantity demanded is demanded is equal to the equal to the quantity suppliedquantity supplied

►No shortageNo shortage►No surplusNo surplus►No tendency for No tendency for

the price to the price to changechange

DQ

S

PE

P

QE

Price ControlsPrice Controls►The free market does not always lead The free market does not always lead

to the best outcomes for all producers, to the best outcomes for all producers, consumers or the society in general, consumers or the society in general, and so governments intervene in the and so governments intervene in the market to correct the situation.market to correct the situation.

►Two forms of government intervention Two forms of government intervention in markets are:in markets are: Price ceiling or Maximum (low)Price ceiling or Maximum (low) Price floor or Minimum (high)Price floor or Minimum (high)

Price CeilingPrice Ceiling►A price ceiling is a legal maximum A price ceiling is a legal maximum

imposed by the government to imposed by the government to help reduce the price of help reduce the price of necessities and/or merit goods. necessities and/or merit goods. The price is not allowed to exceed The price is not allowed to exceed the price ceiling.the price ceiling.

►The price ceiling is imposed below The price ceiling is imposed below the equilibrium price.the equilibrium price.

ExampleExample►Rent ControlsRent Controls

Governments may attempt to impose Governments may attempt to impose maximum prices on rented accommodation maximum prices on rented accommodation to ensure affordable accommodation for to ensure affordable accommodation for those on low incomesthose on low incomes

►StaplesStaples Governments may set maximum prices in Governments may set maximum prices in

agricultural and food markets to ensure low-cost agricultural and food markets to ensure low-cost food for the poor.food for the poor.

►BreadBread

Price ceilingPrice ceiling

DQ

P S

QdQs

PmaxPmax

PE

Shortage

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

ProblemsProblems►Long linesLong lines►Black market, where products Black market, where products

are sold at higher prices.are sold at higher prices.►FavoritismFavoritism

Government’s attempts to Government’s attempts to reduce the shortagereduce the shortage

► The government can solve these problems either through:The government can solve these problems either through: A. Shifting the demand curve to the left (which defies the A. Shifting the demand curve to the left (which defies the

purpose)purpose) OROR B. Shifting the supply curve to the rightB. Shifting the supply curve to the right

• SubsidiesSubsidies• Direct provisionDirect provision• Releasing previously stored stockReleasing previously stored stock

► A rationing scheme could be usedA rationing scheme could be used e.g. ration couponse.g. ration coupons

► Opportunity CostOpportunity Cost If the government spends money supporting such If the government spends money supporting such

industries, it may have to reduce spending on other areas, industries, it may have to reduce spending on other areas, like bridges and railways.like bridges and railways.

Government’s attempts Government’s attempts to reduce the shortageto reduce the shortage

DQ

P S1

QdQs

PmaxPmax

PE

Shortage

If the If the government government subsidized the subsidized the products, products, produced it or produced it or released stored released stored stocks, the stocks, the supply will shift supply will shift to the right and a to the right and a new equilibrium new equilibrium will be created at will be created at Pmax.Pmax.

S2

Q2Q1

Price FloorPrice Floor►A price floor is a legal minimum A price floor is a legal minimum

imposed by the government to imposed by the government to help increase the income of help increase the income of producers of goods and services producers of goods and services deemed important. The price is not deemed important. The price is not allowed to fall below the price floor.allowed to fall below the price floor.

►The price floor is imposed above The price floor is imposed above the equilibrium price.the equilibrium price.

ExamplesExamples►Price supports for commodities ( agricultural and industrial raw Price supports for commodities ( agricultural and industrial raw

materials), whose prices are subject to large fluctuations or to protect materials), whose prices are subject to large fluctuations or to protect them from foreign competition.them from foreign competition.

►The minimum wage set to protect workers and ensure that they earn The minimum wage set to protect workers and ensure that they earn enough to lead a reasonable life.enough to lead a reasonable life.

Price floorPrice floor

DQ

P S

QsQd

Pmin

PE

Surplus

At Pmin, At Pmin, there is a there is a surplus. The surplus. The quantity quantity supplied by supplied by producers, Qs producers, Qs exceeds the exceeds the quantity quantity demanded, demanded, Qd.Qd.

The minimum wageThe minimum wage

D

S

L

W

W*

(by firms)

(by workers)

Wmin

SurplusQsQd

The minimum wage results in excess supply of labor, i.e. unemployment

Government Intervention Government Intervention ► To eliminate the surplus, the government attempts to:To eliminate the surplus, the government attempts to:

Buy the surplusBuy the surplus In the case where the surplus is bought there is a number of options In the case where the surplus is bought there is a number of options

available to deal with the stocksavailable to deal with the stocks► It can be stored ; however, some items (fresh ones) cannot be It can be stored ; however, some items (fresh ones) cannot be

stored for long periods of time and can therefore be stored for long periods of time and can therefore be immediately ruled out. Even the ones that can be stored will immediately ruled out. Even the ones that can be stored will result in high storage costs.result in high storage costs.

► It can be destroyed, but this is considered to be wasteful.It can be destroyed, but this is considered to be wasteful.► It can be sold to other countries; however, selling the stock It can be sold to other countries; however, selling the stock

abroad could be regarded as dumping and therefore not abroad could be regarded as dumping and therefore not welcomed by other countries. welcomed by other countries.

► It can be given as overseas assistance, but this encourages the It can be given as overseas assistance, but this encourages the overdependence of LDCs on MDCs and discourage them from overdependence of LDCs on MDCs and discourage them from pursuing their own growth strategiespursuing their own growth strategies . .

Limit producers by quotasLimit producers by quotas Advertise to create more demandAdvertise to create more demand

ProblemsProblems►The minimum wage results in The minimum wage results in

unemployment unemployment ►Price floors imposed on commoditiesPrice floors imposed on commodities

Taxpayers will bear the burden of Taxpayers will bear the burden of this policy as the government will this policy as the government will need to buy the surplus need to buy the surplus

Higher prices paid by consumersHigher prices paid by consumers

The EndThe End