Correcting Market Failure Subsidies and Taxation

Subsidies and Taxation Aim to change relative prices Given to the producer Used to help re-distribute income Used to help firms compete Numerous examples – state benefits, free school meals, working tax credits, agriculture, transport, regional development, housing, employment, education.

Subsidies and Taxation Effects of Subsidies: Shifts supply curve to right Reduces price to consumer Increases output – market failure is perceived as a lack of output Long term effects on market – distorts price signals Who benefits – depends who gets the subsidy and how it is used! Welfare effects: cost of the subsidy to the taxpayer minus the value of the benefits received Impact on relative consumer and producer surplus

Subsidies and Taxation Price S £14 Total Cost of the Subsidy S + Subsidy £10 Amount of subsidy per unit (£4) 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? First we look at the market before the subsidy The subsidy will encourage suppliers to offer more for sale at every price £7 D 500 700 Quantity Bought and Sold

Subsidies and 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? Incidence – who pays? Producer/consumer – price elasticity of demand

Subsidies and Taxation Effects of a tax: Increases price Reduces consumption/output Welfare effects: Burden of tax on producer and consumer – changes in producer and consumer surplus Tax yield minus the cost of the tax

Subsidies and Taxation Effects of Taxation: Distortion of the market Influence on behaviour Extent of the effect dependent on the degree of elasticity – number of substitutes, addictiveness of the product, proportion of income devoted, time scale Creation of underground markets – smuggling, booze cruises, etc. Increases business costs – competitiveness? Raises revenue to help pay for government services

Incidence of a tax on petrol Price p per litre S + tax S Amount of tax = 3p per litre 76.8 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! Some of the tax is passed on to the consumer in the form of higher prices – this is the burden of tax The amount of the tax is the vertical distance between the two supply curves The tax effectively increases the cost of production shifting supply to the left Petrol has an inelastic demand curve Tax burden of producer D 50 Quantity Bought and Sold (000s litres per day) 49.5

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