2.9. TAXES AND SUBSIDIES
Taxes
The government can interfere in the market by introducing taxes and subsidies. When a tax is placed on a good the good becomes more expensive and hence discourages the consumption of the taxed good. A subsidy is a payment by the government to make consumption cheaper and therefore increases the level of consumption. Usually the taxes and subsidies are placed on the producer.
The diagram shows a tax being placed on a good. Initially the market’s supply is S and the market demand is D. This leads to an equilibrium at a price of P* and an output of Q*. Then the government decides to place a tax onto this good. The tax causes the supply curve to shift up by the full amount of the tax. The tax here is Pt-Pa and the supply curve shifts up by this amount. As supply has shifted there is now a new equilibrium, where prices are higher at Pt and output is lower at Qt. The tax has had its desired effect because now less of the good is consumed in the market. The government gains some revenue from this tax. The government revenue can be worked out by multiplying the tax by the quantity sold and is therefore (Pt-Pa) x Qt, which is area PtACPa. Despite the price in the market being Pt when the tax is introduced, firms receive this price minus what the tax is and receive a price of Pa per unit sold. We can see what proportion of the tax falls on the consumer and the producer and this is done by comparing what the price is for the economic agent now compared to what the price was for the economic agent before. Before the price was P* and now the price is Pt, this means that consumers see their price increase and the amount of the tax that they pay is area PtABP*. Producers now receive a lower price for their good and therefore they pay the area P*BCPa of the tax. The more inelastic demand is, the greater proportion of the tax falls on the consumer as can be seen in the diagram below.
The government can interfere in the market by introducing taxes and subsidies. When a tax is placed on a good the good becomes more expensive and hence discourages the consumption of the taxed good. A subsidy is a payment by the government to make consumption cheaper and therefore increases the level of consumption. Usually the taxes and subsidies are placed on the producer.
The diagram shows a tax being placed on a good. Initially the market’s supply is S and the market demand is D. This leads to an equilibrium at a price of P* and an output of Q*. Then the government decides to place a tax onto this good. The tax causes the supply curve to shift up by the full amount of the tax. The tax here is Pt-Pa and the supply curve shifts up by this amount. As supply has shifted there is now a new equilibrium, where prices are higher at Pt and output is lower at Qt. The tax has had its desired effect because now less of the good is consumed in the market. The government gains some revenue from this tax. The government revenue can be worked out by multiplying the tax by the quantity sold and is therefore (Pt-Pa) x Qt, which is area PtACPa. Despite the price in the market being Pt when the tax is introduced, firms receive this price minus what the tax is and receive a price of Pa per unit sold. We can see what proportion of the tax falls on the consumer and the producer and this is done by comparing what the price is for the economic agent now compared to what the price was for the economic agent before. Before the price was P* and now the price is Pt, this means that consumers see their price increase and the amount of the tax that they pay is area PtABP*. Producers now receive a lower price for their good and therefore they pay the area P*BCPa of the tax. The more inelastic demand is, the greater proportion of the tax falls on the consumer as can be seen in the diagram below.
As you can see from the diagrams, the more inelastic demand is, the greater the proportion of the tax falls on the consumer than the producer. We have an extreme case when demand is perfectly inelastic and when this is the case the whole tax is paid by the consumer through an increase in the price. Petrol and diesel tend to have inelastic demand and this is why they are good revenue generators for the government. Another good revenue generator for the government is the taxation on cigarettes but the main motivation for taxing cigarettes is to decrease the amount that individuals consume and move consumption towards the socially optimal level.
SubsidiesGovernment can also give firms subsidies. If the government believes that the socially optimal level for a certain good should be higher, they can grant subsidies (or tax breaks) to firms producing these goods. The subsidies shift the supply curve downwards by the exact value of the subsidy because firms are willing to supply more of a product for a given price (/will require a lower price to provide the same quantity to the market). This shift of the supply curve outwards results in output rising and the price falling. This would be the aim of a government because they want to encourage a greater amount of consumption of the goods.
On the diagram the initial equilibrium in the market is where S1 and D intercept each other and this leads to a price of P* and an output of Q*. The government then introduces a subsidy, which cause the supply curve to shift downwards by the value of the subsidy. This leads to a new equilibrium whereby prices are lower (Ps) and output is larger (Qs). The value of the subsidy in this market is the difference between the two supply curves and is Pa-Ps. The cost to the government of this subsidy is the value of the subsidy (Pa-Ps) multiplied by the level of output (Qs) and this area is given by PaECPs. Like before, we can see who benefits the most from the subsidy. Firms before received a price of P*, but now they receive a price of Ps plus the subsidy value; this means that firms now receive a price of Pa for selling this good. Therefore, firms benefit by the area PaEBP* from the subsidy. Consumers used to pay P* for the good and now they pay a lower price of Ps for the goods. This means that consumers benefit by the area P*BCPs. The greater the inelasticity of demand the more consumers will benefit compared to producers. Alternatively, the more elastic demand is the less consumers benefit from the subsidy relative to producers.
On the diagram the initial equilibrium in the market is where S1 and D intercept each other and this leads to a price of P* and an output of Q*. The government then introduces a subsidy, which cause the supply curve to shift downwards by the value of the subsidy. This leads to a new equilibrium whereby prices are lower (Ps) and output is larger (Qs). The value of the subsidy in this market is the difference between the two supply curves and is Pa-Ps. The cost to the government of this subsidy is the value of the subsidy (Pa-Ps) multiplied by the level of output (Qs) and this area is given by PaECPs. Like before, we can see who benefits the most from the subsidy. Firms before received a price of P*, but now they receive a price of Ps plus the subsidy value; this means that firms now receive a price of Pa for selling this good. Therefore, firms benefit by the area PaEBP* from the subsidy. Consumers used to pay P* for the good and now they pay a lower price of Ps for the goods. This means that consumers benefit by the area P*BCPs. The greater the inelasticity of demand the more consumers will benefit compared to producers. Alternatively, the more elastic demand is the less consumers benefit from the subsidy relative to producers.
Firms benefit more when demand is elastic and consumers benefit more when demand is inelastic.