Indirect taxes subsidies and price controls IB Economics

Indirect taxes, subsidies, and price controls IB Economics

Learning Objectives Ø By the end of this section you should be able to Ø Define and give examples of an indirect tax Ø Explain the difference between a specific tax and a percentage tax Ø Explain the importance of elasticity in understanding the effect of a specific tax on the demand for, and supply of, a product Ø Explain how the imposition of an indirect tax may affect consumers, producers and government Ø Define a subsidy Ø Explain how the granting of a subsidy may affect consumers, producers and government Ø Explain, distinguish between, illustrate and give examples of maximum and minimum price controls Ø Discuss the consequences of price controls on the stakeholders in a market Ø HL - Explain the significance of the elasticity of demand supply in assessing the incidence of an indirect tax Ø HL – using equations of linear functions, show and explain the effects of indirect (specific) taxes on a market Ø HL - illustrate and calculate how the incidence of tax differs for consumers, producers and government Ø HL – using equations of linear functions, show and explain the effects of subsidies on a market Ø HL – calculate the effects of minimum and maximum prices from diagrams

Indirect tax – tax on expenditure S + tax Price Indirect Taxes Ø An indirect tax is a tax on spending Ø Government taxes the firm which increases its costs Ø The supply curve shifts vertically by the amount of the tax Ø Less product is supplied at every price Ø The price increase Ø There are two types of indirect tax Ø This diagram illustrates a specific tax Ø The shift is vertically upward of the amount of the tax Ø An example would be the tax on a packet of cigarettes S tax P 2 P 1 D Q 2 Q 1 Quantity specific tax – a fixed amount of tax that is imposed on a product e. g. $1 per unit

Indirect tax – tax on expenditure S + tax Price Indirect Taxes Ø A percentage tax increases as the selling price increases as shown in the diagram Ø An example would be VAT in the UK (currently 20%) tax S P 2 P 1 tax D Q 2 Q 1 Quantity A percentage tax (Ad Valorem) – the tax is the percentage of the selling price. As the price rises the tax will rise

S + tax Price What effect will the tax have on consumers, producers, government and the market as a whole? Ø Let’s use the specific tax as an example Ø Before the tax the firm’s revenue is Q 1 x. P 1 (the blue square) Ø When the tax of XY is charged the firm would like to pass it all onto the consumer by raising the price to P 2 Ø At that price we can see there is an excess of supply Ø The price falls to a new equilibrium at P 3 S XY P 2 P 3 P 1 D Q 3 Q 1 Quantity

Burden of the tax – who pays the tax S + tax Price What effect will the tax have on consumers, producers, government and the market as a whole? Ø The price is now P 3 and has increased from P 1 Ø The consumer is paying a higher price Ø We can see that the tax burden is roughly shared about ½ and ½ S XY P 3 P 1 C D Q 2 Q 1 Consumer tax Producer tax Quantity

S + tax Price What effect will the tax have on consumers, producers, government and the market as a whole? Ø The producer is now only receiving C per unit Ø The firm’s revenue was Q 1 P 1 (blue) Ø The firm’s revenue has decreased to Q 3 C (yellow) S XY P 3 P 1 C D Q 3 Q 1 Quantity

S + tax Price What effect will the tax have on consumers, producers, government and the market as a whole? Ø The government gains tax revenue of XY x Q 3 (quantity x tax (purple)) Ø The market falls in size from Q 1 to Q 3 which could mean unemployment in that industry (derived demand for labour) S XY P 3 P 1 C D Q 3 Q 1 Quantity

Time for you to do some work!! ØRead through pages 63 -64 ØComplete the student workpoint P 65 ØComplete Exam Q’s 1 on P 75 ØOnly 1 a if you are SL Ø 1 a and b if you are HL (after the next slides)

HL bit!

The tax burden & elasticity Ø The outcome of the share of tax Ø Ø Ø Ø S + tax (XY) S Price Ø 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 P 1 P 2 Q 2 in tax The producer pays CP 1 Q 2 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 X P 2 Y P 1 C D Q 2 Q 1 Quantity

Price The tax burden & elasticity Ø Now we will look at what happens when the PED is relatively inelastic and the PES is elastic Ø Initially equilibrium is at P 1 Q 1 Ø With the specific tax of XY the supply curve shifts to S+tax Ø There is a new equilibrium of P 2 Q 2 Ø The consumer pays P 1 P 2 Q 2 in tax Ø The producer pays CP 1 Q 2 in tax Ø We can see that the consumer is paying much more of the tax Ø 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 Ø The consumer bears most of the burden of the tax S + tax (XY) S X P 2 P 1 Y C D Q 2 Q 1 Quantity

The rules Ø When PED = PES the burden of tax will be equal between the consumer and producer Ø When PED is greater than PES the burden of tax will be greater for the producer Ø When PED is less than PES the burden of tax will be greater for the consumer Ø This is why governments like to place taxes on products that have relatively inelastic demand such as alcohol or cigarettes Ø The market will not reduce in size too much because consumers are price insensitive which protects unemployment Ø And still there will be large tax revenues

Time for you to do some work!! ØRead through pages 65 -66 / make notes ØComplete the student workpoint ØCover the answers of the assessment advice (P 67), see if you can answer the question and then check your answers ØNow you can complete 1 b from P 75

Pajholden videos • Indirect taxation – http: //www. youtube. com/watch? v=t 9 N 4 La 0 k 9 c

Subsidies (for all)

Subsidy Price Ø When a subsidy is given to a firm it’s costs are lowered and therefore it will supply more. Ø Percentage subsidies are rare so we concentrate on specific subsidies Ø The supply curve shifts to the right as seen in the diagram Ø It shifts by the amount of the subsidy Ø There are several reasons why government gives subsidies Ø To lower the price of essential goods to increase consumption (e. g. milk) Ø To guarantee the supply of goods in an industry the government believes is necessary e. g. coal Ø 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 S+subsidy subsi dy P 1 P 2 D Q 1 Q 2 Quantity

Subsidy Price Ø We can see that when the subsidy is given to the firm the price reduces from P 1 to P 2 which is not the whole subsidy Ø If the whole subsidy was given the price would drop to P 3 (HL depending on elasticities) Ø 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 S+subsidy subsi dy P 1 P 2 P 3 D Q 1 Q 2 Quantity

Producer Revenue Price Ø Prior to the subsidy the firm would be making P 1 Q 1 in revenue (blue box) Ø If a subsidy of WZ is given by the government Ø The firm is now making Q 2 D (yellow plus box) in revenue Ø Revenue has increased by the yellow amount Subsidy – an amount of money paid by the government to a firm per unit of output S S+subsidy D P 1 P 2 W Z D Q 1 Q 2 Quantity

Consumer expenditure Price Ø Prior to the subsidy consumers could buy Q 1 at the price of P 1 Ø They can now buy Q 1 at the price of P 2 so they make a saving of P 1 -P 2 x Q 1 (pink box) Ø However they will purchase more units at the lower price of Q 2 -Q 1 Ø The extra expenditure is Q 2 -Q 1 x P 2 (purple box) Ø 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 S+subsidy D P 1 P 2 W Z D Q 1 Q 2 Quantity

Government expenditure Price Ø Government expenditure is the shaded area DWP 2 Z Ø This money has to be found somewhere Ø There is an opportunity cost Ø Government can either take this away from other areas of spending (building infrastructure, providing public services) Ø Or it must raise taxes (unpopular with voters) Ø 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 S+subsidy D P 1 P 2 W Z D Q 1 Q 2 Quantity

Evaluation of Subsidies Ø The issue of the opportunity cost Ø Does the subsidy allow firms to be inefficient Ø In a free market they might have to be more efficient to compete (on price) Ø Although the subsidy allows consumers to pay a lower price they may also be the taxpayers that are funding the subsidy Ø Subsidies can lead to overproduction Ø There is a great deal of international debate about subsidies given to farmers in high income countries Ø This leads to overproduction and is damaging to farmers in developing countries that cannot compete Ø High income countries are accused of dumping their products in developing countries (we will learn more about this later)

Pajholden videos • Subsidies – http: //www. youtube. com/watch? v=Nykc. R 3 Rhy R 4

Time for you to do some work!! ØRead through pages 68 -69 / Make notes ØComplete all of the student workpoints (only one if you are SL) ØComplete Exam Q 2 a and b on P 75

Price Controls ØWatch the mjmfoodie video Ø http: //www. youtube. com/watc h? v=Xg. BPAucs-W 4

Time for you to do some work!! ØRead through pages 70 -74 / Make notes ØMiss out the assessment advice on P 72 if you are SL ØComplete all of the student workpoints (one extra if you are HL) ØComplete Exam Q 3 a and b on P 75 ØComplete the Data Response Question on P 76

Pajholden videos • Indirect taxation – http: //www. youtube. com/watch? v=t 9 N 4 La 0 k 9 c • Subsidies – http: //www. youtube. com/watch? v=Nykc. R 3 Rhy R 4 Mjmfoodie video • Price floors and ceilings Øhttp: //www. youtube. com/watch? v=Xg. BPAucs. W 4