2.10 - Indirect Taxes & Subsidies - notes

The purpose and effects of subsidies

Subsidies are payments made by the government to producers of certain goods or services. These payments aim to lower the production costs, making the products more affordable and encouraging greater consumption. For example, governments might subsidise renewable energy equipment to promote its use and support environmental goals.

How subsidies influence supply and demand

• Subsidies reduce the cost of production for firms, which encourages them to increase output.
• This causes the supply curve to shift to the right, leading to a lower market price.
• The fall in price results in an extension of demand, meaning more consumers buy the product at the new, cheaper price.
• Overall, subsidies lead to higher production levels and increased demand for the subsidised goods.

How subsidies affect producers and consumers

The benefits of a subsidy are shared between producers and consumers, but the split depends on the price elasticity of demand (PED) and supply. The diagrams below show this for two markets that differ only in the elasticity of demand. In each, the market starts in equilibrium at price Pₑ and quantity Qₑ, where the demand curve D meets the supply curve S. The subsidy shifts the supply curve from S to S₁: the price falls from Pₑ to P₁ and the quantity bought rises from Qₑ to Q₁, giving a new equilibrium at point Y. Point W sits directly above Y on the original supply curve S, at price V - the price producers effectively receive once the subsidy is added - and point X marks the original price Pₑ at the new quantity Q₁.

Sharing of subsidy benefits based on elasticity

• Inelastic demand - When demand does not change much with price (low PED), consumers gain more from the subsidy: most of it is passed on as the large fall in price from Pₑ to P₁, while the quantity bought rises only slightly from Qₑ to Q₁.

• Elastic demand - When demand changes significantly with price (high PED), producers gain more: the price falls only slightly from Pₑ to P₁, but they sell a much larger quantity Q₁ and keep the bigger gap between Pₑ and V on every unit, boosting their revenue.

Breakdown of subsidy gains

• Consumer gain - The fall in price from Pₑ to P₁, which allows buyers to purchase the good for less than before. On each diagram it is the light grey rectangle P₁PₑXY.
• Producer gain - The extra revenue producers receive from the government payment: they are left with price V per unit rather than Pₑ, which helps cover their costs and encourages continued production. On each diagram it is the dark grey rectangle PₑVWX.
• The government's total expenditure on the subsidy covers the full amount provided and equals the sum of these consumer and producer gains - the whole box P₁VWY.

The purpose and effects of indirect taxes

Indirect taxes are charges imposed by the government on specific goods or services, added to the price paid by consumers. These taxes aim to discourage consumption of harmful or undesirable products, such as tobacco or high-sugar drinks, by making them more expensive.

How indirect taxes influence supply and demand

• Indirect taxes raise the cost of production or sale for firms, as they must pay the tax to the government.
• This causes the supply curve to shift to the left, resulting in a higher market price.
• The rise in price leads to a contraction in demand, meaning fewer consumers are willing or able to buy the product at the increased price.
• Overall, indirect taxes reduce production and consumption of the taxed goods, while generating revenue for the government.

How indirect taxes affect producers and consumers

The burden of an indirect tax is shared between producers and consumers, but the division depends on the price elasticity of demand (PED) and supply. The diagrams below show this for two markets that differ only in the elasticity of demand. With no taxation the market is in equilibrium at price Pₑ and quantity Qₑ, where the demand curve D meets the supply curve S, but the tax disrupts this: supply shifts from S to S₁, the price rises from Pₑ to P₁ and the quantity falls from Qₑ to Q₁, giving a new equilibrium at point V. Directly below V, point W marks the original price Pₑ, and point X sits on the original supply curve S at price Y - the amount producers are left with per unit once the tax has been paid to the government.

Sharing of tax burden based on elasticity

• Inelastic demand - When demand is not very responsive to price changes (low PED), consumers bear a larger share of the tax burden because they continue buying despite the price rise: most of the tax is passed on as the jump from Pₑ to P₁.

• Elastic demand - When demand is highly responsive to price changes (high PED), producers bear a larger share as they absorb more of the cost to avoid losing too many sales: the price rises only slightly from Pₑ to P₁, while producers take the bigger fall from Pₑ down to Y.

Breakdown of tax burdens and government revenue

• Consumer burden - The portion of the tax that consumers pay through higher prices, shown by the rise from Pₑ to P₁. On each diagram it is the light grey rectangle P₁PₑWV.
• Producer burden - The portion of the tax that producers absorb, reducing their profit margins: they are left with Y per unit instead of Pₑ. On each diagram it is the dark grey rectangle PₑYXW.
• Government revenue - The total tax collected, which equals the tax rate multiplied by the quantity sold after the tax is imposed (Q₁) - the whole box P₁YXV.
• Deadweight loss - The reduction in economic efficiency caused by the tax, representing lost consumer and producer surplus that is not captured as government revenue.