Government Intervention
- Indirect Taxes and Subsidies-
Also remember PRICE CONTROLS
(studied earlier)
Multiple Tasks of the Government
• Design Laws
– Constitutional, Corporate, Criminal, Torts, Commercial,
Industrial, Labor, International, etc.
• Design Regulations and Rules
– e.g. property rights, copyrights, patents, minimum wage
legisilation and rules on working conditions, etc.
• Provide publicly funded goods
– Parks, education, roads and construction, health care, etc.
• Provide assistance in the form of subsidies and grants
• To fund these tasks, need to tax citizens
– Consumption (indirect), corporate and income (direct)
• Intervene to set fixed prices
– Price ceiling and price floors; fixed exchange rates to
dollar
• …
Why do we need Taxes?
• As a method to discourage consumption of goods
that are harmful for the individual and society e.g.
tobacco, marihuana, alcohol, etc.
• To redistribute income to reduce the inequality
of the economy (“for whom” to produce)
• As a method to correct other market failures and
to help achieve allocative efficiency
• As a source of government revenue
• …
Indirect and Direct Taxes
• Indirect tax
– taxes imposed on the spending of the goods and
services
– they are paid by the consumers but are paid/filed
to the government by the firms and for this reason
called the “indirect tax”
• Direct tax
– payment of tax made and filed directly to the
government
• e.g. personal income tax paid out of WAGES
• e.g. corporate taxes paid out of PROFITS
Two Types of Indirect Tax
• 2 main types:
– Specific (per unit) tax – a fixed/absolute amount
of tax per unit of goods and services sold
– e.g. Yen 100 on a pack of cigarettes
– Ad valorem tax – fixed percentage on the price of
the good or services e.g. consumption tax in
Japan is now 8%.
What happens to the market when
indirect tax is imposed?
• When indirect tax is imposed on a good, it is paid to
the government by the firm. This implies that for
every level of Q of good firm is willing and able to
supply, it must receive a price that is higher than the
price they are willing and able to sell (definition of
supply) by the amount of tax
•  this leads to an upward
(vertical) shift of supply curve
by the amount of tax
Effect of an Indirect tax Group VI
Market outcomes for an ad valorem tax?
Quantitative analysis of effects +
Welfare Effects
 second side of handouts
Welfare Effects
• As you can see, the consumer and producer
surplus have both decreased with the indirect tax
Consequences of indirect taxes on
consumers, producers, and the government
• Consumers are affected in two ways:
– increase in price from P* to Pc
– decrease in the quantity they buy from Q* to Qt
–  both of them makes consumers worse off as they
are now receiving less of the good and paying more
for it (consumer surplus has decreased!)
• Producers are affected in two ways:
– decrease in the price they receive from P* to Pp
– decrease in the quantity of output they sell from Q*
to Qt
–  firms are also worse off as less total revenue
(continued)
• The government
– On the other hand, the government gains as they
receive revenue equal to (Pc – Pp) x Qt
– They now have a positive government budget
• Others
– The lower amount of output produced means that
fewer workers are needed to produce it
– There may be a increase in the level of unemployment
• Society as a whole
– is worse off as there is an underallocation of
resources (some of the scarce resources are not used
and wasted) to the production of the good (Qt < Q*)
Important Role of Price Elasticities of
Demand and Supply
• The consequence of the tax is shared between
the consumers and producers as they both
endure a decrease in surplus
• This burden of a tax is referred to as tax incidence
• And the distribution of this burden (who bears
more and less) between the consumers and
producers depends on the price elasticity of the
demand and supply of the good being taxed
Effect of Demand Elasticity on the
outcome
• The more ELASTIC the demand
• (i) a __________________incidence of the tax is
placed on the consumer
• i.e. the change in price is _______________
• And a _______________ incidence of the tax is
placed on the producer (firm)
• (ii) the government revenue is ____________
• (iii) the change in quantity is ______________
Incidence of Indirect Tax and
Price Elasticity of Demand
Group III
• Applying the same methodology above, when demand is
………… (unresponsive), most of the tax burden is on
consumers while when the demand is …………, most of the
tax burden is on producers
Incidence of Indirect Tax and
Price Elasticity of Supply
New H/O+ graphs
• Similarly, when supply is inelastic (unresponsive), most of
the tax burden is on producers while when the supply is
elastic, most of the tax burden is on consumers
And when putting PED and PES together…
• The more elastic the curve is, the more of the tax
incidence (burden) will fall on the other side
–
–
–
–
With elastic demand  producers have higher incidence
With elastic supply  consumers have higher incidence
With inelastic demand  consumers have higher incidence
With inelastic supply  producers have higher incidence
• More elastic (responsive)  less burden!
• In general, the tax burden falls proportionately more on
the group whose activities are less responsive to price
changes
– i.e. the low elasticity entails that they do not respond by
changing their buying and selling activities substantially with the
imposition of tax and thus must bear relatively larger
proportion.
Introducing Subsidies
What are subsidies?
• A subsidy is a form of financial or other support given to
an economic sector (or firm or individual) generally with
the aim of promoting economic and social policies
• Subsidies may take the form of direct cash transfers
(or other forms such as lower interest loans, tax
relief, direct provision of goods, etc.)
Why government grant subsidies?
• Any guesses?
– Subsidies can be used to increase revenues and growth of certain
and particular producers e.g. agricultural products, hybrid cars,
green business, part of Industrial Policy
– Subsidies can be use to make certain goods (e.g. necessities)
affordable to low income consumers
– Subsidies can be used to encourage production and consumption
of particular goods and services that are believed to be desirable
for society (e.g. education, vaccination, etc.)
– Subsidies can be used encourage exports of particular goods to
earn more revenue abroad effects on international trade
– Subsidies can be used to improve allocative inefficiency
(depending on the good and case). The notion of positive
externality
– Can become very controversial e.g. subsidies for fossil fuels or oil
can stimulate economic growth (more income) but will harm the
environment!
Real Life Example
• Subsidies granted for the production of Hybrid
and Electric cars
How do we model and analyze subsidies?
- How does government decide on a subsidy? • First, in IB we focus only on subsidies in the form
of direct cash payments
– Also known as fixed subsidies as fixed amount of
money per unit of output is granted  exercise on second sheet
• This means that for each unit of the output the
firm is willing and able to produce, it sets a lower
price than the original price (they were willing
and able to sell for) by the amount of the subsidy
• This is represented with a downward (vertical),
parallel shift of the supply of the curve by the
amount of the subsidy as shown below…
•
Group VI
• Mathematically, the new supply curve is: Qs = c + d (P + s)
• As you can see, this is equivalent to a rightward shift of the
supply curve (but NOT by the amount of subsidy), meaning
that for each price, the firm is now willing and able to supply
more output because COSTS are effectively lower
• Shade in cost of subsidy to government, incidences, changes in
CS and in PS;
Illustrating the Consumer, Producer and
Community Surpluses (Efficiency Analysis)
• Before the subsidy, the community surplus is at the maximum
and MB = MC, indicating the achievement of allocative efficiency
• After the subsidy, the consumer surplus and producer surplus
both increase as shown in the shaded areas below
Calculations of Incidences, Costs etc
Impacts of Subsidies on Market
Outcomes (P and Q)
Group I VI (Mond)
• Adding the demand curve and comparing the two
equilibriums, it is evident that:
– Equilibrium Q consumed and produced increases
– Equilibrium P falls to Pc which is the price paid by
consumers
– Since the vertical distance between the two supply curves
represents the subsidy per unit output for the producers,
the firm receives Pp
– The amount of subsidy granted by the government is (Pp –
Pc) x Qsb
– And finally, comparing the two equilibrium quantities, it is
evident that there is an overallocation of resources to the
production of the good as Qsb > Q*  allocative
inefficiency
Looking at the Impacts on Various Stakeholders
• Consumers:
– decrease in price from P* to Pc
– increase in the quantity they buy from Q* to Qsb
–  both of them makes consumers better off as they are now
receiving more of the good by paying less for it (consumer
surplus has increased!) incidence on consumer
• Producers:
– increase in the price they receive from P* to Pp
– increase in the quantity of output they sell from Q* to Qsb
–  firms are also better off as the increase in price and
quantity translates to increase in total revenue and (likely) to
profits  incidence on producer
(continued)
• The Government
– On the other hand, the government loses as they pay the subsidy amount equal to (Pc
– Pp) x Qsb
– They now have a smaller government budget and have to decrease other expenditures
or raise taxes
• Others
– The increase in output produced means that more workers are needed to produce it
– There may be a decrease in the level of unemployment
• Society as a whole
– is worse off as there is now an overallocation of resources to the production of the
good (Qsb > Q*)
– More output is produced than what the consumers and society demand (case of
excess supply, MB < MC)
– If education and health care are subsidised  benefits for society
• Foreign producers
– If the subsidy is granted on exports (goods sold to other countries), lowers price and increases
quantity of exports.
– This is a positive for domestic producers but negative for producers for other countries who may
not be able to compete with the low price subsidized exports e.g. Toyota Hybrid sold in the US, the
Ford Hybrid might have difficult time
–  accusations of dumping
(continued )
• Now, at the same time consumers and producers gain,
the government loses because of the negative effects
on the budget and the alternative uses
– The government expenditure is (Pp – Pc) x Qsb
– Which is exactly equal to the gains in consumer and
producer surplus plus the triangle “a”
– The government thereby spent more than the benefits
given to the society
– This area “a” is the welfare loss and originates from the
overproduction of the goods (overallocation of the
resources) beyond the socially optimal point (Q*)
• The government intervention introduced inefficiency in the
markets (interaction between the D and S)
• It could have also protected (productively) inefficient firm,
wasting resources
• The government budget can be used for other causes…