1.3: Government Intervention

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    Definitions

     

    1. Indirect tax is a tax on expenditure that is ‘hidden’. It raises the firm’s costs and shifts the supply curve for the product vertically upwards by the amount of tax.
    2. Specific tax is an indirect tax where a specific amount is added to the selling price of each unit. It is represented as a vertically upward, parallel shift of the supply curve.
    3. Ad valorem tax is an indirect tax where a percentage is added to the selling price of each unit. It is represented as a vertically upward, divergent shift of the supply curve.
    4. Subsidy is the amount of money paid by the government, per unit of output, aiming at lowering costs and increasing the production and consumption of the product. It is represented by a downward shift of the supply curve by the amount of subsidy.
    5. Maximum price (price ceiling) is a price usually set by an authority below the equilibrium determined price. Prices are not allowed to rise above this price, and it is aimed at protecting consumers from higher prices. Maximum price may be imposed in markets where the product is a necessity or a merit good. Examples include agricultural and food markets and housing rentals.
    6. Minimum price (price floor) is a price usually set by an authority above the market equilibrium price. The market price cannot go below this price, as they are usually implemented to protect producers, particularly those producing essential products. Examples include agricultural products in the EU.

     

    Indirect tax

    • Taxes imposed upon expenditure.
    • Raises the firm’s cost and shifts the supply curve upwards.

    ●       Two types of indirect tax:

    ❖      Specific tax

    • Specific, fixed amount of tax that is imposed upon a product.
    • Shifts the supply curve upwards by the amount of tax.

    ❖      Ad valorem tax

    • Tax is a % of the selling price.
    • Supply curve will shift upwards, and the gap between the supply curve and the supply curve with tax gets bigger as the price of the product rises.

     

     

    ●       Evaluation:

    • Only means of reaching the poor. – contributing to the economy.
    • Reduce the consumption of demerit goods.
    • Indirect taxes on necessities and merit goods = increase in revenue.
    • Discourage industries when raw materials are taxed.
    • Shops charge more for products so that there’s more revenue, regardless of indirect tax imposed on those products.
    • Rich and poor people pay the same amount of money, which is seen unfair by the society.

    ●       Incidence of indirect tax

    • When PED is elastic and PES is inelastic, i.e. PED > PES, there’s more tax burden for producers than for consumers as producers can’t pass the burden to consumers because if they did, consumers would stop buying the product.
    • When PED is inelastic and PES is elastic, i.e. PED < PES, there’s more tax burden for consumers than for producers as only few customers would stop buying the products as the product is a need, not a want.
    • When PED and PES are equal, the tax burden is equal to both consumers and producers.

    Subsidy

    • Amount of money paid by the government to a firm per unit of output.
    • Shifts the supply curve downwards by the amount of subsidy.
    • Same incidence effect as indirect taxes in terms of PED and PES.

    • Producer revenue: 0 + Pe + X + Qe → 0 + P1 + Z + Q1.
    • Consumer expenditure → P1 + Pe + X + 0.5Y → Qe + Y + Z + Q1.
    • Government spending → 0 → P1 + D + W + Z.

    ●       Evaluation:

    • There’s an opportunity cost involved with spending on the subsidy in terms of spending on other government-related projects.
    • Firms might become inefficient if they don’t have to compete with foreign producers in a free market.
    • Part of the subsidy also goes to taxpayers → Raises the question on who pays the taxes to the government.
    • Subsidy → Overproduction of products → Damaging for farmers, especially the ones in developing countries.
    • High-income farmers are occasionally blamed for dumping their products in developing countries for lower production costs.

     

    Maximum price controls/Price ceiling

    • Situation where the government sets a price below the equilibrium price.
    • PRevents producers from raising the price above the equilibrium.
    • Usually set to protect consumers.
    • Normally imposed in markets for necessity or a merit good.
    • Leads to excess demand → Shortage of the product.

    ●       Evaluation:

    • Excess demand → Emergence of a black market, where the product is sold at high price between maximum price and equilibrium price.
    • Long line of queues → Producers decide who they are allowed to buy the products they are selling.
    • Governments could decrease demand of the product until it reaches equilibrium.
      • Reduces consumption → Goes against the purpose of maximum price.
    • Governments could also increase supply of the product until it reaches equilibrium.
      • This can be done through providing subsidies, governments producing the product themselves or releasing some of the stored goods into the market.
      • This could lead to an opportunity cost as firms could use the money for the above options for other use in the economy.

     

    Minimum price/Price floor

    • Situation where the government sets a minimum price above the equilibrium price.
    • Prevents producers from reducing the price below it.
    • Usually set to raise incomes for producers for products for merit goods and to protect workers by setting minimum wage.
    • Lead to excess supply → Surplus for the product.

    ●       Evaluation:

    • Excess supply → High levels of stock for firms → Higher production costs.
    • Governments could eliminate excess supply by buying up the surplus products at the minimum price → Shifts the demand curve to the right.
    • Governments could then store the surplus, destroy it or sell it abroad.
    • Destroying the products would be wasteful since it can be used for future use when the firms run out of shortage of the product.
    • Selling surplus abroad → Angry reactions from foreign governments as they feel that the products are being dumped and will harm domestic industries.
    • Opportunity cost in spending on the surplus and on funding for other merit goods.
    • Minimum price can be maintained by limited quotas or advertising/restricting the supplies of the imported products through protectionist policies → Increases demand for the domestic products.
    • Firms might think they don’t have to be cost-conscious → Inefficiency and wastage of resources.
    • Firms might produce more of the protected product than they should and less of other products that they could produce more efficiently.

     

     

     

     

     

     

     

     

     

     

    Paper 3 Questions

     

    Indirect tax

     

    A country has a competitive demand for cigarettes. Demand for cigarettes is given by Qd = 30 – 2P and supply for cigarettes by Qs = 10 + 3P, where P is price in $ and Qd and Qs are the quantity of cigarettes demanded and supplied per day.

     

    1. Calculate the equilibrium price and quantity in the cigarette market.

    1. The government imposes an indirect tax of $5 per unit of cigarette packet sold. Draw the new supply curve in the diagram.

    1. State the new supply curve. Use the demand function and the new supply curve to calculate the post-tax equilibrium price and quantity.

     

    1. Calculate the consumer surplus, producer surplus, government revenue and loss of consumer and producer surplus.

    1. Calculate the amount of tax paid by consumers and producers.

    Subsidy

     

    Demand for textbooks is given by Qd = 80 – 3P and supply for cigarettes by Qs = 40 + 2P, where P is price in $ and Qd and Qs are the quantity of textbooks demanded and supplied per day.

     

    1. Calculate the equilibrium price and quantity in the textbook market.

    1. The government imposes an subsidy of $10 per unit of textbook sold. Draw the new supply curve in the diagram.

     

    1. State the new supply curve. Use the demand function and the new supply curve to calculate the post-subsidy equilibrium price and quantity.

    1. Calculate the change in consumer expenditure and producer revenue.

    1. Calculate the the total expenditure by the government.

    Minimum price

     

    The government decides to impose a minimum price on cigarettes at $11.

     

    1. Draw the minimum price on the graph below

     

    1. Calculate the excess supply (surplus) of cigarettes.

    1. Calculate the change in consumer expenditure