Indirect taxes, subsidies, and
price controls
IB Economics
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
Indirect tax – tax on
expenditure
Price
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
S + tax
S
tax
P2
P1
D
Q2 Q1
Quantity
specific tax – a fixed
amount of tax that is
imposed on a product
e.g. $1 per unit
Indirect tax – tax on
expenditure
S + tax
Price
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%)
tax
S
P2
P1
tax
D
Q2
Q1
Quantity
A percentage tax (Ad
Valorem) – the tax is the
percentage of the selling
price. As the price rises the
tax will rise
Price
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 + tax
S
XY
P2
P3
P1
D
Q3 Q1
Quantity
Burden of the tax
– who pays the tax
Price
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
S + tax
S
XY
P3
P1
C
D
Q2 Q1
Consumer tax
Producer tax
Quantity
Price
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 + tax
S
XY
P3
P1
C
D
Q3 Q1
Quantity
Price
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 + tax
S
XY
P3
P1
C
D
Q3 Q1
Quantity
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!
The tax burden & elasticity
S + tax (XY)
S
Price
 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 P1Q1
 With the specific tax of XY the
supply curve shifts to S+tax
 There is a new equilibrium of P2Q2
 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
X
P2
Y
P1
C
D
Q2
Q1
Quantity
Price
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 P1Q1
 With the specific tax of XY the
supply curve shifts to S+tax
 There is a new equilibrium of P2Q2
 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 + tax (XY)
S
X
P2
P1
Y
C
D
Q2 Q1
Quantity
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
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
Pajholden videos
• Indirect taxation
– http://www.youtube.com/watch?v=t9N4La0k9c
Subsidies (for all)
Subsidy
Price
 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
S+subsidy
subsidy
P1
P2
D
Q1 Q2
Quantity
Subsidy
Price
 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
S+subsidy
subsidy
P1
P2
P3
D
Q1 Q2
Quantity
Producer Revenue
Price
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
S+subsidy
D
P1
P2
W
Z
D
Q1 Q2
Quantity
Consumer expenditure
Price
 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
S+subsidy
D
P1
P2
W
Z
D
Q1 Q2
Quantity
Government
expenditure
Price
 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
S+subsidy
D
P1
P2
W
Z
D
Q1 Q2
Quantity
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)
Pajholden videos
• Subsidies
– http://www.youtube.com/watch?v=NykcR3Rhy
R4
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
Price Controls
Watch the mjmfoodie video
http://www.youtube.com/watc
h?v=XgBPAucs-W4
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
Pajholden videos
• Indirect taxation
– http://www.youtube.com/watch?v=t9N4La0k9c
• Subsidies
– http://www.youtube.com/watch?v=NykcR3Rhy
R4
Mjmfoodie video
• Price floors and ceilings
http://www.youtube.com/watch?v=XgBPAucsW4