IB Economics

Indirect Taxes,
Subsidies and Price
Controls
 Taxes

Direct Indirect
A tax on income A tax on expenditure

Flat (Specific) Ad- Valorem

An indirect tax of an absolute (Percentage)
(constant) amount levied per An indirect tax, which is
unit of a commodity ex: a tax of expressed as a proportion
$5 per unit. (percentage) of the price
►Excise tax: e.g cigrettes

►They impose for several reasons

►These taxes are a sources of government revenue
►These taxes are a method to discourage consumption of goods that
are harmful for the individual
►These taxes can be used to redistribute income
►These taxes are a method to improve the allocation of resources by
correcting negative externalities
• Consumers: increase in the price of the good and decrease in
the quantity they buy
• Producers: fall in the price they receive and by the fall in the
quantity of output they sell
• The government: positive for the govt budget
• Workers: lower amount of output means less work:
unemployment
• Society as a whole: worse off as a result of the tax, there is
an under allocation of resources to the production of the
good (Qs < Q*)
• An indirect tax is a tax imposed upon
expenditures.
• An indirect tax acts as an extra cost on
the producer; therefore, it manages to
shift its supply curve to the left.
• An indirect tax is placed on top of the
selling price; hence, raising the
products price and reducing the
quantity demanded.
 S2
With a flat
P
S1
tax, there is
a parallel
$5
shift of the
P2 supply curve
P1 leftwards by
$5 the amount
of the tax, in
D
this case $5.
Q
 S2
P S1
With an Ad-
Valorem tax,
P2 the supply
P1 shifts further
to the left at
higher
prices.
D
Q
 S2 The tax causes a
P S1 decrease in supply,
which in turn causes an
increase in the
P2 equilibrium price from
P1 to P2. The higher
P1
price causes a
contraction in demand
from Q1 to Q2. This
contraction in market
D size might pose an
unemployment problem.
Q2 Q1 Q
• The tax causes an increase in the equilibrium price.
• The consumer bears some of the tax burden.
• The producer—usually—does not pass the entire tax
burden to the consumer. Why??
• The producer realizes that an increase in the price will result in reduced
quantity demanded (The law of demand).
• The tax could generally be subdivided into 2 parts:
The consumer’s burden and the producer’s burden.
Call them C and S respectively.
 The tax is the
S2 vertical distance
P S1 between the 2
supply curves.
C represents the
P2
P1
C consumer’s burden
and is equal to the
increase in price
from P1 to P2.
D
Q
 S2
P S1
S represents
the producer’s
P2 burden and is
P1
S equal to the
remaining part
of the tax.
D
Q
 S2
P
S1 The Tax
revenue is
P2 equal to the
P1 Tax Revenue product of the
tax per unit with
the quantity
sold
D

Q
Q2 Q1
• It refers to assistance by the government to individuals or
groups of individuals such as firms, consumers, industries or
sectors of an economy.
• Subsidies can be used to increase revenues of producers.
• Subsidies can be used to make certain goods (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
consumers.
• Subsidies can be used to encourage exports of particular products.
• Subsides can be used to support the growth of particular industries in
an economy
• Biochemical, fossil fuels, textiles etc
• Subsidies are a method to improve the allocation of resources by
correcting positive externalities.
 The effect of a subsidy on
supply
The subsidy causes an
increase in supply,
Price S
S - Subsidy
which in turn causes a
decrease in the
Pp Subsidy retained
by producer equilibrium price from
Pe
Subsidy passed to
Pe to PSubsidy. The lower
consumers as
lower prices price causes an
extension in demand
D from Q1 to Q2.
Q1 Q2 Quantity

Subsidy given out to Producers

• The subsidy will shift the supply curve to the right by the
amount of the subsidy because it reduces the costs of
production for the firm.

• The subsidy will cause the price to drop and the quantity
demanded to increase.

• The price will not fall by the full amount of the subsidy;
however, consumers get to buy more units at a lower price.

• The amount of the subsidy involves an opportunity cost to the

government. The money must be taken away from other
governmental projects, or it may raise taxes in the future.
• Consumers:
• Consumers are affected by the fall in price of the good and increase in
quantity demanded.
• Producers:
• Producers are better off, because they receive a higher price and produce a
larger quantity.
• The government:
• The government pays the subsidy, which is a burden on its budget. (how do
they get revenues to give subsidies)
• Workers:
• Firms hire more workers to produce extra output.
• Society as a whole
• Society as a whole becomes worse off because there is an over allocation of
resources to the production of the good.
• In addition society is worse off because the higher price received by
producers protects relatively inefficient ones.
• Foreign producers
• If the subsidy is granted on exports, it lowers price and increases the quantity
of exports. It is negative for the producers of other countries.
• The quantity demanded is
P
equal to the quantity supplied S
• No shortage
• No surplus
• No tendency for the price to P
E
change

D
Q
QE
• The free market does not always lead to the
best outcomes for all producers, consumers
or the society in general, and so
governments intervene in the market to
correct the situation.

• Two forms of government intervention in

markets are:
• Price ceiling or Maximum (low)
• Price floor or Minimum (high)
• A price ceiling is a legal maximum
imposed by the government to help
reduce the price of necessities and/or
merit goods. The price is not allowed
to exceed the price ceiling.
• The price ceiling is imposed below the
equilibrium price.
• Rent Controls
• Governments may attempt to impose maximum prices on
rented accommodation to ensure affordable
accommodation for those on low incomes

• Staples
• Governments may set maximum prices in agricultural and food
markets to ensure low-cost food for the poor.
 P S At Pmax, there is a
shortage. The quantity
demanded by buyers,
Qd exceeds the quantity
PE
supplied, Qs.
Pmax

D
Q
Qs Qd
Shortage
• Long lines
• Black market, where products are sold
at higher prices.
• Favoritism
• The government can solve these problems either through:
A. Shifting the demand curve to the left (which defies the purpose)
OR
B. Shifting the supply curve to the right
• Subsidies
• Direct provision
• Releasing previously stored stock
• A rationing scheme could be used
• e.g. ration coupons
• Opportunity Cost
• If the government spends money supporting such industries, it may
have to reduce spending on other areas, like bridges and railways.
 If the government
P S1 S2
subsidized the
products, produced
it or released stored
PE stocks, the supply
Pmax will shift to the right
and a new
D equilibrium will be
Q created at Pmax.
Qs Qd
Shortage
Q1 Q2
• A price floor is a legal minimum imposed
by the government to help increase the
income of producers of goods and
services deemed important. The price is
not allowed to fall below the price floor.
• The price floor is imposed above the
equilibrium price.
• Price supports for commodities ( agricultural and industrial raw materials),
whose prices are subject to large fluctuations or to protect them from foreign
competition.

• The minimum wage set to protect workers and ensure that they earn enough to
lead a reasonable life.
 Price floor

P S At Pmin, there
Pmin is a surplus.
The quantity
PE
supplied by
producers, Qs
exceeds the
D
Q quantity
Qd Qs
demanded, Qd.
Surplus
W S (by workers)
Wmin
The minimum
wage results in
W* excess supply of
labor, i.e.
unemployment
D (by firms)
Qd Qs
L
Surplus
• To eliminate the surplus, the government attempts to:
• Buy the surplus
• In the case where the surplus is bought there is a number of options available to deal
with the stocks
• It can be stored ; however, some items (fresh ones) cannot be stored for
long periods of time and can therefore be immediately ruled out. Even
the ones that can be stored will result in high storage costs.
• It can be destroyed, but this is considered to be wasteful.
• It can be sold to other countries; however, selling the stock abroad could
be regarded as dumping and therefore not welcomed by other countries.
• It can be given as overseas assistance, but this encourages the
overdependence of Least Developed Countries on More Developed
Countries and discourage them from pursuing their own growth
strategies.
• Limit producers by quotas
• Advertise to create more demand
• The minimum wage results in
unemployment
• Price floors imposed on commodities
•Taxpayers will bear the burden of this
policy as the government will need to buy
the surplus
•Higher prices paid by consumers
The End