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

Ad- Valorem (Percentage) Taxes Direct Indirect A tax on income A tax on expenditure Flat (Specific) Ad- Valorem (Percentage) 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

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.

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

An ad-Valorem (Percentage) tax S2 P S1 With an Ad-Valorem tax, the supply shifts further to the left at higher prices. P2 P1 D Q

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

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.

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

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

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

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.

The effect of a subsidy on supply 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. S Price S - Subsidy Subsidy passed to consumers as lower prices Pe PSubsidy Ps Subsidy retained by producer D Q1 Q2 Quantity Subsidy given out to Producers

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.

P= 10 ; Q= 60

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

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)

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.

Example Rent Controls Staples Bread 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. Bread

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

Problems Long lines Black market, where products are sold at higher prices. Favoritism

Government’s attempts to reduce the shortage The government can solve these problems either through: A. Shifting the demand curve to the left (which defies the purpose) OR B. Shifting the supply curve to the right Subsidies Direct provision Releasing previously stored stock A rationing scheme could be used e.g. ration coupons Opportunity Cost If the government spends money supporting such industries, it may have to reduce spending on other areas, like bridges and railways.

Government’s attempts to reduce the shortage If the government subsidized the products, produced it or released stored stocks, the supply will shift to the right and a new equilibrium will be created at Pmax. P S2 S1 PE Pmax Qs Qd D Q2 Q1 Q Shortage

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.

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.

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

The minimum wage D S L W (by workers) Wmin The minimum wage results in excess supply of labor, i.e. unemployment Qs W* (by firms) Qd Surplus

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

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

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