Government intervention: Indirect taxes

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Aim of imposing indirect taxes: the government does such spending in order to raise tax revenues and to internalise externalities, to achieve the optimum level of output.

A specific tax: a fixed amount of tax that is imposed on a product, which shifts the supply curve vertically upwards by the amount of tax.

An ad valorem tax: the tax is a percentage of the selling price and so the supply curve will shift by an increasing amount as the price of the product rises.

When either specific taxes or valorem taxes are imposed, the market will shrink in size (decrease in quantity), thus possibly lower the level of employment in the market, since firms might employ fewer people. (Curve shifts up because it increases costs of production.)

Producer: revenue falls from P1Q1 to P3Q2.

Consumer: price per unit increases from P1 to P2

Tax burden for producers: Q2(P1- P3)

Tax burden for consumers: Q2(P2- P1)

Tax revenue for government: tax burden for consumers + tax burden for producers

Producers and consumers suffer: producers incur greater average costs, meaning that they partially pass this onto consumers

Tax reduces output: shifting supply to the left means a lower quantity is supplied, this means that the market size shrinks

Government benefits: taxes increase government revenue

Tax raises prices: tax shifts demand to the left and raises equilibrium, meaning higher prices

Tax Incidence and Price Elasticity of Demand and Supply (HL)

If a good with inelastic demand is taxed, the tax burden can be easily passed on to the consumer (PED is less than PES)

This means the tax burden on the consumer (C) is greater than the tax burden on the producer (P).

As shown in this diagram, the producer would like to raise the price to P4, to pass all the tax burden onto consumers. However, this would cause excess supply, so prise falls to a new equilibrium at P2.

If a good with elastic demand is taxed, the tax burden on the consumer (C) is less than the tax burden on the producer (P). (PED is more+ than PES)

In this second scenario, the producer would like to increase the price to P4, to pass all the tax burden on to consumers. However, this would cause excess supply, so price falls to a new equilibrium of P2. This is where enough consumers would continue to buy but not all of the tax burden is taken by the producer.

Example:

Qd = 2,000 – 200P

Qs = -400 + 400P

The price when there is no quantity supplied:

Qs = -400 + 400P

0 = -400 + 400P

400 = 400P

P = 1

Quantity demanded when the price is zero:

Qd = 2000 – 200P

Qd = 2000 – 200(0)

Qd = 2000

Qd = 2000 – 200P

The price when there is no quantity demanded:

0 = 2000 – 200P

200P = 2000

P = 10

Quantity supplied when the price is zero:

Qs = -400 + 400P

Qs = -400 + 400(0)

Qs = -400

A specific tax of $1.50 is imposed on the product.

Original consumer surplus = ((6*12000)/2) =$3600

New consumer surplus = ((5*1000)/2) =$2500

Original producer surplus = ((4*12000)/2) =$2400

New producer surplus = (1.5*1000) + ((2.5*1000)/2) = $2750

Original community surplus = 3600 + 2400 =$6000

New community surplus = 2500 + 2750 = $5250

Equilibrium has shifted from $4 and 1200 units to $5 and 1000 units.

Original producer revenue = 1200 * 4 = $4800

New producer revenue = 1000 * 3.5 = $3500

Original consumer expenditure = 1200 * 4 = $4800

New consumer expenditure = 5 * 1000 = $5000

Government revenue = 1000 * 1.50 = $1500

Producer tax burden = 1000 * 0.50 = $500

Consumer tax burden = 1000 * 1 = $1000

Subsidies

Subsidy: an amount of money paid by the government to a firm per unit of output. This causes the supply curve to shift to the right by the amount of subsidy.

Aims of subsidies

To ensure consumers can afford necessary goods: the price of the product will be lowered so that more consumers are able to buy.

For instance in Malaysia millions is being spent in order to subsidise food and fuel to keep prices low. Like sugar which is an essential ingredient in Asian cooking. (July 2012).

Protectionism: subsidies are used to help domestic firms become more competitive in the international markets therefore increasing export revenue. This is in order to address a balance of payment deficit.

For example the USA subsidises their steel industry, in order to protect it against countries, such as Brazil, where steel can be produced more cheaply.

To ensure consumers buy merit goods: merit goods are goods or services which are provided for the benefit of society.  They are usually under-consumed and under-supplied, this is a result of information failure about the private and external benefits the good can have. Therefore, the government subsidises them in order to make more consumers willing and able to consume.

Examples of merit goods are pensions, healthcare, insurance and education. In Columbia for instance health insurance is subsidised.

Guarantee the supply of products: the government may believe that some industries need to be supported by lowering their average costs of production. This may be in order to ensure them for future times such as war. Also this could be to provide employment.

For instance the power supply in India is most states is subsidised as the government believes it is necessary for the economy.

When subsidies are provided, the market will expand in size (increase in quantity), thus possibly raise the level of employment in the market, since firms might employ more people. (Curve shifts down because costs of production decrease).

Producer: revenue increases from P1Q1 to P3Q2.

Consumer: price per unit decreases from P1 to P2

Cost to government: P3P2Q2

The total cost of the subsidy exceeds the benefit of the consumers and producers so there is a loss of welfare, a deadweight loss

Subsidies may undermine foreign firms. For instance developed countries may have subsidised farming making their products cheaper than underdeveloped countries.

Firms may become inefficient as they are not competing against foreign firms.

There is an opportunity cost as the government spending on the subsidy could have been put to other projects

Subsidies and linear functions (HL)

Qd = 2,000 – 200P

Qs = -400 + 400P

A subsidy of $1.50 per unit output is imposed on the product.

Price when quantity supplied is zero:

Qs = -400 + 400P

0 = -400 + 400P

400 = 400P

P = 1

Price when quantity demanded is zero:

Qd = 2000 – 200P

0 = 2000 – 200P

200P = 2000

P = 10

Quantity demanded when price is zero:

Qd = 2000 – 200P

Qd = 2000 – 200(0)

Qd = 2000

Quantity supplied when price is zero:

Qs = -400 + 400P

Qs = -400 + 400(0)

Qs = -400

Equilibrium has shifted from $4 and 1200 units to $5 and 1000 units.

Original producer revenue = 1200 * 4 = $4800

New producer revenue = 1400 * 4.5 = $6300

Original consumer expenditure = 1200 * 4 = $4800

New consumer expenditure = 4800 + (200 * 3) =$5400

Government expenditure = 1400 * 1.50 = $2100

Original consumer surplus = ((6*12000)/2) =$3600

New consumer surplus = ((7*1000)/2) =$3500

Original producer surplus = ((4*12000)/2) =$2400

New producer surplus = (3*200) + ((3*1000)/2) = $2100

Original community surplus = 3600 + 2400 =$6000

New community surplus = 3500 + 2100 = $4600

Maximum prices

Maximum prices: the government sets a price below the equilibrium price to prevent producers from raising the price above it.

Prices are set in order to protect consumers from the high prices of merit and/or necessary goods because these would be underprovided in a free market.

For instance, during food shortages the government may impose a maximum price on the cost of wheat in order to ensure that food prices a low enough for all income levels to afford. Also in London maximum prices have been used in order to keep the rent lower than the market equilibrium in attempt to ensure affordable accommodation is available for those on low incomes.

When a maximum price at Pmax is put emplace by the government, below the equilibrium price of Pe, there is an excess demand of Qs to Qd. This is because at the new price the quantity demanded is Qd, but the quantity supplied is Qs. S1 is the supply of rented housing at the maximum price in the long run. It gets more elastic as people will stop letting houses as they cannot justify the opportunity cost.

The excess demand from maximum price may result in shortages. This could lead to the emergence of a black market or parallel underground market, where the products are sold at a higher price than the maximum price but less than the equilibrium price.

Non-price rationing systems may emmerge and involve long queues or reservations if working on a first come first serve basis in order to determine which consumers to serve.

Welfare: there is a deadweight loss of BCE. This is because consumer surplus has changed from AEPe to ACBPmax whilst producer surplus has decreased from 0EPe to 0BPmax, as a result of the maximum price imposed. It is therefore not allocative efficient as community surplus is not maximised.

In this diagram, the government has shifted the supply curve from S to S1 by subsidizing, direct provision or using stores to reach the equilibrium at Pmax Qd.

However, these methods can be very expensive and so there is an opportunity cost as the government may have to reduce its expenditure on other industries, like health or education.

Maximum prices and linear functions (HL)

Quantity demanded: 25 units

Quantity supplied: 10 units

Shortage: 15 units

Original consumer expenditure: 6.80 *17 = $115.60

New consumer expenditure: 10 * 5 = $50

Additional revenue from selling on the black market: (6.80-5)*17 = $30.60

Minimum prices

Minimum price: price set above the equilibrium price by the government, which prevents producers from reducing their prices to below it.

Prices are set in order to protect the supply of products that the government believes are important, such as agricultural products. This may be because their products are subject to large price fluctuations or there is a lot of foreign trade. Minimum prices also protect workers as they act as a minimum wage, which ensures that workers earn enough to lead a reasonable existence. Other reasons include for strategic importance and to prevent rural urban migration.

When a minimum price at Pmin is put emplace by the government, above the equilibrium price of Pe, there is an excess supply of Qs to Qd. This is because at the new price the quantity demanded is Qd, but the quantity supplied is Qs.

Minimum prices usually result in a supply surplus. The government may therefore deal with it by increasing demand through advertising, restricting the amount of imports, selling the product cheaply abroad (undermines foreign farmers) or buying the product up themselves and storing or burning it, which can be very expensive. For instance, some EU countries do this and it is referred to as wine lakes and butter mountains.

Other methods to deal with the surplus affect the supply of a product. These are usually quotas which limit how much a producer is legally allowed to produce. The EU calls these method a set aside policy.

Welfare: there is a welfare deadweight loss of BCE. This is because consumer surplus has decreased from AEPe to ACPmin whilst producer surplus has changed from 0EPe to 0ECPmin, as a result of the minimum price imposed. It is therefore not allocative efficient as community surplus is not maximised.

Minimum prices and linear (HL)

Quantity demanded: 23 units

Quantity supplied: 10 units

Surplus: 13 units

Original consumer expenditure: 6.80 *17 = $115.60

New consumer expenditure: 10 * 8 = $80

Government expenditure to but surplus: (23-10) * 8 =$104

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