Incidence of Indirect Taxes
Inelastic Demand
Elastic Demand
S1
Price
S1
Price
S
S
P1
P
P1
Consumer
Producer
P
Consumer
Producer
D
D
Q1Q
Q1
Quantity
Q
Quantity
With Inelastic Demand, the producers are able to With Elastic Demand, the producers cannot
increase the price of their product without much increase the price of their product without the
change in the quantity demanded. This increase quantity demanded increasing a lot. Therefore
in price would make the consumers pay a higher the producers must pay for the majority of the
proportion of the indirect tax.
tax by themselves.
Key:
Government Tax
Per Unit Amount of
Revenue
Tax
Inflation
Inflation – a general increase in prices and fall in the purchasing value of money.
Demand-Pull Inflation – occurs when aggregate demand exceeds current supply in the economy.
Increased aggregate demand
does not always cause
inflation. If the economy is
producing low levels of output
and has lots of spare capacity,
there will be no impact for the
price level, yet output can
increase.
As resources begin to get used
up, firms are in greater
competition with each other
for the use of them. Increases
in aggregate demand will
therefore increase the price
level but also increase output.
Price Level
Price Level
AS
If the economy is at full
capacity, an increase in
aggregate demand will only
cause an increase in the price
level, and no extra output can
be made.
Price Level
AS
AS
AD1
AD
AD1
AD
AD
AD1
Real GDP
Real GDP
Real GDP
Cost-push Inflation – occurs when the price level is pushed up by increases in the costs of
production. Firms will increase their prices to maintain their profit margins.
AS1
AS
AD
Monetary inflation – occurs when an economy increases the money supply. It can be classified as a
form of demand-pull inflation. Increases in the money supply cause a decrease in interest rates.
Decrease in interest rates cause an increase in aggregate demand.
Quantity Theory of Money – Money Supply x Velocity of Circulation = Price Level x No. of
Transactions
Velocity of Circulation – how many times $1 travels around the economy
Harmful Effects of Inflation






The value of money decreases – in the case of hyperinflation, value of money decreases so
severely and people may lose confidence in the currency
Redistributes income – workers with strong bargaining power may be able to negotiate
wage increase, while those with few skills may be unable to get pay rises. Borrowers pay
back less in ‘real terms’ than what they borrowed. High income earners can take steps to
avoid the effects of inflation.
Extra costs on firms – time spent anticipating future price changes and reprinting prices
Shoe leather costs – these are costs involved with moving money between financial
institutions searching for interest rates above inflation rates
Decreases business confidence – fluctuating inflation rates affect firm’s confidence about
the future. This affects investment decisions and may stagnate long run economic growth.
May harm the balance of payments position – if a country has high levels of inflation, their
exports will be expensive. This makes them lee competitive and sales overseas will decrease.
As imports are cheaper, consumers will want to buy these over domestic goods.
Beneficial Effects of Inflation


May encourage firms to expand – a low, stable level of demand-pull inflation makes firms
optimistic about future sales
Can prevent unemployment – workers may accept a percentage increase in their wages less
than the percentage increase in the price level. This will ensure firms maintain profit margins
and keep employees.
Prices
Price Indices – used to show the change in the general price level over time. The two main types of
price indices are The Consumer Price Index and The Retail Price Index.
Consumer Price Index – a measure of price inflation affecting consumers. It is calculated from the
movement in the average price of a ‘basket’ of goods and services purchased by the ‘typical’
household in a country from a sample of different retail outlets.
Constructing a Price Index
1. Select a ‘base year’ – this is a standard year with no ‘dramatic’ changes in price. The base
year is always allocated a value of 100.
2. Find out how households spend their money – this is done by a government administrated
‘Family Expenditure Survey’. Certain goods and services are selected to make up the
‘basket’. Weights are allocated to reflect the proportion of income spent on each good or
service.
3. Find out price changes – this is done by government officials gathering information from
companies, outlets etc. Government then creates estimates of price changes based on this
information
4. A weighted price index is constructed
PRICE INDEX =
5. Calculate the rate of Inflation
INFLATION RATE =
Example:
Year
Base Year
Year 2
Products
Food
Travel
Clothing
Food
Travel
Clothing
Average Price
$60
$20
$40
$70
$40
$48
Weighting
60%
10%
30%
60%
15%
25%
Weighted Average Price
0.60 x $60 = $36
0.10 x $20 = $2
0.30 x $40 = $12
0.60 x $70 = $42
0.15 x $40 = $6
0.25 x $48 = $12
Price index
Inflation rate
Total WAP
$36 + $2 + $12
= $50
$42 + $6 + $12
= $60