ib economics - indirect taxes, subsidies, and price controls

Indirect taxes, subsidies, and price controls:

Indirect taxes, subsidies, and price controls IB Economics

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

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Indirect Taxes An indirect tax is a tax on spending Government taxes the firm which increases its costs The supply curve shifts vertically by the amount of the tax Less product is supplied at every price The price increase There are two types of indirect tax This diagram illustrates a specific tax The shift is vertically upward of the amount of the tax An example would be the tax on a packet of cigarettes Indirect tax – tax on expenditure S P1 specific tax – a fixed amount of tax that is imposed on a product e.g. $1 per unit Quantity S + tax Q2 D Q1 tax P2 Price

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Indirect Taxes A percentage tax increases as the selling price increases as shown in the diagram An example would be VAT in the UK (currently 20%) Indirect tax – tax on expenditure A percentage tax (Ad Valorem) – the tax is the percentage of the selling price. As the price rises the tax will rise Quantity S + tax Q2 D Q1 S tax P1 P2 tax Price

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What effect will the tax have on consumers, producers, government and the market as a whole? Let’s use the specific tax as an example Before the tax the firm’s revenue is Q1xP1 (the blue square) When the tax of XY is charged the firm would like to pass it all onto the consumer by raising the price to P2 At that price we can see there is an excess of supply The price falls to a new equilibrium at P3 S P1 Quantity S + tax Q3 D Q1 XY P2 P3 Price

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What effect will the tax have on consumers, producers, government and the market as a whole? The price is now P3 and has increased from P1 The consumer is paying a higher price We can see that the tax burden is roughly shared about ½ and ½ Burden of the tax – who pays the tax S P1 Quantity S + tax Q2 D Q1 XY P3 C Consumer tax Producer tax Price

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What effect will the tax have on consumers, producers, government and the market as a whole? The producer is now only receiving C per unit The firm’s revenue was Q1P1 (blue) The firm’s revenue has decreased to Q3C (yellow) S P1 Quantity S + tax Q3 D Q1 XY P3 C Price

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What effect will the tax have on consumers, producers, government and the market as a whole? The government gains tax revenue of XY x Q3 (quantity x tax (purple)) The market falls in size from Q1 to Q3 which could mean unemployment in that in that industry (derived demand for labour) S P1 Quantity S + tax Q3 D Q1 XY P3 C Price

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Time for you to do some work!! Read through pages 63-64 Complete the student workpoint P65 Complete Exam Q’s 1 on P75 Only 1a if you are SL 1a and b if you are HL (after the next slides)

HL bit!:

HL bit!

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The tax burden & elasticity The outcome of the share of tax 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 P1P2Q2 in tax The producer pays CP1Q2 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 S P1 Quantity S + tax (XY) Q2 D Q1 X P2 C Y Price

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The tax burden & elasticity Now we will look at what happens when the PED is relatively inelastic and the PES is elastic 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 P1P2Q2 in tax The producer pays CP1Q2 in tax We can see that the consumer is paying much more of the tax 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 The consumer bears most of the burden of the tax S P1 Quantity S + tax (XY) Q2 D Q1 X P2 C Y Price

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

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Time for you to do some work!! Read through pages 65-66 / make notes Complete the student workpoint Cover the answers of the assessment advice (P67), see if you can answer the question and then check your answers Now you can complete 1b from P75

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Pajholden videos Indirect taxation http://www.youtube.com/watch?v=t9N4La0-k9c

Subsidies (for all):

Subsidies (for all)

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Subsidy When a subsidy is given to a firm it’s costs are lowered and therefore it will supply more. Percentage subsidies are rare so we concentrate on specific subsidies The supply curve shifts to the right as seen in the diagram It shifts by the amount of the subsidy There are several reasons why government gives subsidies To lower the price of essential goods to increase consumption (e.g. milk) To guarantee the supply of goods in an industry the government believes is necessary e.g. coal 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+subsidy P2 Quantity S Q1 D Q2 subsidy P1 Price

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Subsidy We can see that when the subsidy is given to the firm the price reduces from P1 to P2 which is not the whole subsidy If the whole subsidy was given the price would drop to P3 (HL - depending on elasticities) 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+subsidy P2 Quantity S Q1 D Q2 subsidy P1 Price P3

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Producer Revenue Prior to the subsidy the firm would be making P1Q1 in revenue (blue box) If a subsidy of WZ is given by the government The firm is now making Q2D (yellow plus box) in revenue Revenue has increased by the yellow amount Subsidy – an amount of money paid by the government to a firm per unit of output S+subsidy P2 Quantity S Q1 D Q2 P1 Price D W Z

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Consumer expenditure Prior to the subsidy consumers could buy Q1 at the price of P1 They can now buy Q1 at the price of P2 so they make a saving of P1-P2 x Q1 (pink box) However they will purchase more units at the lower price of Q2-Q1 The extra expenditure is Q2-Q1 x P2 (purple box) 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+subsidy P2 Quantity S Q1 D Q2 P1 Price D W Z

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Government expenditure Government expenditure is the shaded area DWP2Z This money has to be found somewhere There is an opportunity cost Government can either take this away from other areas of spending (building infrastructure, providing public services) Or it must raise taxes (unpopular with voters) 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+subsidy P2 Quantity S Q1 D Q2 P1 Price D W Z

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

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Pajholden videos Subsidies http://www.youtube.com/watch?v=NykcR3RhyR4

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Time for you to do some work!! Read through pages 68-69 / Make notes Complete all of the student workpoints (only one if you are SL) Complete Exam Q 2a and b on P75

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Price Controls Watch the mjmfoodie video http://www.youtube.com/watch?v=XgBPAucs-W4

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Time for you to do some work!! Read through pages 70-74 / Make notes Miss out the assessment advice on P72 if you are SL Complete all of the student workpoints (one extra if you are HL) Complete Exam Q 3a and b on P75 Complete the Data Response Question on P76

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Pajholden videos Indirect taxation http://www.youtube.com/watch?v=t9N4La0-k9c Subsidies http://www.youtube.com/watch?v=NykcR3RhyR4 Mjmfoodie video Price floors and ceilings http://www.youtube.com/watch?v=XgBPAucs-W4