Lavergne 1
Emile Lavergne
IB2 Economics
August 22nd 2011
Indirect Taxes, Subsidies and Price Controls
Indirect taxes:
Definition- a tax placed on the selling price of a product. This raises the firm’s costs
and therefore shifts the supply curve for the product vertically upwards by the
amount of the tax. This means that less of the product will be supplied at every
price.
-
There are two types of indirect taxes: Specific taxes and Percentage taxes
-
Specific Taxes – This is a specific (fixed) amount of tax that is put on the
product. At every unit sold there is one fixed value added such as $0.50. This
makes the whole supply curve move vertically by the fixed value, or for this
example: $0.50. [In the graph below, the indirect tax is shown, the original
cost for the
product was
shown by the
S1
curve, with the
indirect taxes
the
whole supply
curve moved
up
by the value of
the
tax ($0.50). ]
Lavergne 2
-
Percentage tax (a.k.a. Valorem Tax) – A tax that is a percentage of the price
sold. This means that the tax is a set percentage of the price of the final sale
value, as more is bought, the
amount of the tax increases.
If the percent is 10%, then at
$10 the tax is $1 and at $20
the tax is $2. The graph
below shows how the supply curve moves vertically at a slant with S2 being
the supply curve after the percentage tax.
-
Taxes have repercussions:
o Either the producer bears the cost
of the tax or the tax gets passed onto
the consumer.
o The Burden is represented by the
graph to the right.
o If split evenly between the
producers and the consumers, the
area of X, Y, P1, C represents the tax
burden: The white part being what
the consumers have to pay and the blue part representing the profit
lost by the producer. The whole area represents the revenue of the tax
received by the government.
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o The blue part (not in the area) represents the profit lost as the price
equilibrium increased due to taxes effectively reducing demand,
which reduced the producer’s profit.
o The quantity supplied will be smaller because taxes increase the costs
of production.
o This graph and outcomes are what happens when taxes are imposed
on a market in which the P.E.S. (Price Elasticity of Supply) and the
P.E.D. (Price Elasticity of Demand) are equal.
o An example of this might be a movie ticket, neither extremely inelastic
nor extremely elastic, the tax burden will most likely be split between
the producer and consumer evenly.
-
In a market with a relatively elastic P.E.D. and a relatively inelastic P.E.S.
o P.E.D. > P.E.S.
o Producers have to
take on more of the
tax burden so they do
not lose all of their
customers. The
burden of the tax
passed onto the
customers reduced
the quantity
demanded greatly so
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if the producer passed on more then they would lose a lot of business.
o For example take a tax on pens; there are many other type of writing
utensils available (pencils, markers, crayons, typing etc…) so the pen
makers should cover more of the tax or else people will simply buy
another writing utensil.
-
In a market with a relatively inelastic P.E.D. and a relatively elastic P.E.S.
o P.E.D. < P.E.S.
o Since the P.E.D.
is relatively
inelastic, the
producers can
afford to pass
on the majority
of the tax
burden onto
the consumers. On top of that, the P.E.S. is relatively elastic and
therefore the producer has more of a need to pass on the tax burden
onto the customers.
o For example, if a sin tax is imposed on cigarettes, then the producer
can afford to pass on the tax to the consumers, as they are most likely
addicted and therefore have a relatively inelastic P.E.D.
Lavergne 5
Subsidies:
-
Subsidy- An amount of money paid by the government to a firm, per unit of
production.
-
Reasons for subsidies:
o To lower the price of goods the government considers essential, such
as milk. The government hopes the lower price will increase
consumption
o To guarantee the supply of products the government considers are
necessary for the economy, energy, basic food, or industries that
create too much employment and can’t risk losing its employees.
o Protecting home industries by helping producers to compete with
overseas trade.
-
Subsidies are mostly given in specific subsidies (and the IB book ignores
percentage subsidies so if the man doesn’t think it’s important, ill skip over
it). A specific subsidy is a specific amount of money given for every unit of the
good. It is a set value and therefore
moves the supply curve downwards
(lower price) at every price. For
example if the specific subsidy is $5,
then the whole supply curve is moved
down by $5. S1= price before the
subsidy S2= price after the subsidy.
Lavergne 6
-
If you look at
the more
detailed graph
(the one with
the colors) you
can see that
although the
subsidy
reduced the price from $260 to $180, due to the demand curve and the
increase in demand the new equilibrium price is $220. This is because the
demand is neither relatively inelastic nor relatively elastic.
-
However, if the P.E.D. were elastic (PED>PES) the demand curve would be
more horizontal
and as a result, the
demand would be
greatly increased
deu to the subsidy.
For example in the
graph to the right,
which examines a
subsidy on
biscuits, the price
is only reduced by $1 when the subsidy was $5. The subsidy does not greatly
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affect the price yet since the PED is relatively elastic, the little decrease in
price greatly increases demand.
-
If the opposite situation were considered and the PED was relatively inelastic
(PED<PES), the more vertical demand curve would make it so the subsidy
would reduce the prices more yet the demand wouldn’t increase as much.
Take the graph to the
right; the subsidy is
mostly passed onto
the
consumer because
since the demand is
relatively inelastic,
more incentive is
needed to increase
demand. If we use the
same subsidy as above and say that the subsidy is $5, the consumers in this
case would see a $4 decrease in price and the producer a $1 reduction in
costs. Yet the demand barely increased.
-
Here is an overview of the examples discussed:
o PED=PES, the subsidy is split 50/50 between consumer and
producers
o PED>PES, the price falls by less than half of the subsidy
o PED<PES, the price falls by more than half of the subsidy.
Lavergne 8
Price Controls:
-
A price control is a government-imposed limit on the maximum or minimum
amount a good is to be sold at (price ceilings and price floors)
-
A minimum price may be instituted to protect the producer as the
government sees their employment and job security is important.
o A price minimum is a price floor; the price may not go below a certain
value. This value is above the equilibrium price. This means that there
will be surpluses as the producers will not be able to sell all of their
products. For example if the
government considers that car
makers are to be protected by
the artificially high prices, the
car makers will build as much as
they usually do yet they will not
sell all of what they produced.
This will create a surplus in the goods as portrayed in the graph
above.
o A price maximum is a price ceiling: the price may not go above a
certain price. This is
most likely done to
protect the consumer;
if the government
considers a good is
Lavergne 9
indispensible (basic food, insurance etc.) the price will be kept
artificially low. The price ceiling will be put below the equilibrium
price, which will create a shortage of goods (demand>supply). The
producers will be losing profits and the consumer will demand more
than is available. For example if the government considers the price of
Band-Aids to be too expensive, they will institute a price ceiling and
there will be a shortage (as illustrated by the graph above).
Lavergne 10
Quiz
1. The government considers that bread is too expensive what do they do?
a. Impose a price minimum
b. Impose a sin tax on bread
c. Impose a price maximum
d. Reduce the demand for bread by saying its unhealthy
2. The FDA discovers that the abuse of alcohol is bad for oneself and has bad
consequences on society, yet the demand is inelastic. What do they do?
a. Subsidize alcohol
b. Impose a price ceiling on alcohol
c. Tax alcohol
d. Subsidize domestic alcohol
3. Imports of foreign cars are proving to create a great competition for local
carmakers. The Government should:
a. Tax domestic carmakers
b. Subsidize domestic carmakers
c. Subsidize foreign carmakers
d. Impose a tax on cars
4. The government believes that the popcorn industry is very important to the
local economy, they should:
a. Subsidize the chip makers
b. Impose a tax on popcorn
c. Subsidize domestic popcorn makers
d. Impose a price floor on domestic popcorn
e. B or C either one works, I don’t really care which one you pick.
5. A subsidy on a relatively inelastic supply market will:
a. Decrease equilibrium price by more than half of the subsidy
b. Increase equilibrium price by more than half of the subsidy
c. Greatly increase demand
d. A and C are both correct answers
6. A price ceiling will cause:
a. A surplus in goods
b. A shortage in gods
c. It will have no effect on the market
d. It will decrease demand
7. A price floor doesn’t cause:
a. A surplus in goods
b. A decrease in demand
c. An increase in demand
d. Nothing
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8. A tax on a market with relatively elastic demand does:
a. Increase demand
b. Have the same effect as a subsidy on a market with a relatively
inelastic demand
c. Decrease demand
d. I’m out of inspiration; did you see how long these notes are?
9. Hey, I’m the government, at breakfast I discovered that cereal is the bee’s
knees and I think everyone should have access to it. What type of price
control should I set up and why, what negative consequences will this have, if
any?
10. Later in my day I realize that cigarettes are yucky and bad for you, yet they
are extremely inelastic. I want people to stop using them and I want to make
myself a little money. What should I do and why, detail the procedure I
should take and the impact it will have on my revenue and the consumer’s
price.
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