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 Taxes
Indirect tax – tax on
 An indirect tax is a tax on expenditure
spending
 Government taxes the firm
which increases its costs

Price
S + tax
 The supply curve shifts
vertically by the amount of the S
tax tax
 Less product is supplied at
every price P2
 The price increase P1
 There are two types of indirect
tax
 This diagram illustrates a D
specific tax Q2 Q1 Quantity
 The shift is vertically upward
of the amount of the tax
 An example would be the tax specific tax – a fixed
on a packet of cigarettes amount of tax that is
imposed on a product
e.g. $1 per unit
Indirect Taxes Indirect tax – tax on
expenditure
A percentage tax
S + tax
increases as the

Price
selling price tax S

increases as shown
in the diagram P2
P1
An example would
tax
be VAT in the UK D
(currently 20%) 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
What effect will the tax have
on consumers, producers,
government and the market
as a whole?

Price
S + tax
 Let’s use the specific tax as
an example S

 Before the tax the firm’s XY

revenue is Q1xP1 (the blue P2

square) P3
P1
 When the tax of XY is
charged the firm would like
to pass it all onto the D
consumer by raising the Q3 Q1 Quantity
price to P2
 At that price we can see
there is an excess of supply
 The price falls to a new
equilibrium at P3
What effect will the tax Burden of the tax
– who pays the tax
have on consumers,
producers, government

Price
S + tax
and the market as a
whole? S
XY
 The price is now P3
and has increased from P3
P1
P1
C
 The consumer is paying
D
a higher price
Q2 Q1 Quantity
 We can see that the tax
burden is roughly Consumer tax
shared about ½ and ½
Producer tax
What effect will the tax
have on consumers,
producers,

Price
S + tax
government and the
market as a whole? S
XY
The producer is now
only receiving C per P3
P1
unit C

The firm’s revenue D

was Q1P1 (blue) Q3 Q1 Quantity

The firm’s revenue

has decreased to
Q3C (yellow)
What effect will the tax
have on consumers,
producers, government

Price
S + tax
and the market as a
whole? S
XY
 The government gains
tax revenue of XY x Q3 P3
P1
(quantity x tax (purple))
C
 The market falls in size
D
from Q1 to Q3 which
Q3 Q1 Quantity
could mean
unemployment in that in
that industry (derived
demand for labour)
HL bit!
The tax burden & elasticity
 The outcome of the share of tax
burden, the amount of S + tax (XY)
producer/government revenue and
the size of the market depends on
the PED and PES S

Price
 Firstly we will look at what happens
when the PED is relatively elastic X
and the PES is inelastic
 Initially equilibrium is at P1Q1
 With the specific tax of XY the P2
supply curve shifts to S+tax P1 Y
 There is a new equilibrium of P2Q2
 The consumer pays P1P2Q2 in tax
C
 The producer pays CP1Q2 in tax
 We can see that the producer is D
paying much more of the tax
Q2 Q1
 This is because the PED elastic; Quantity
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
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

Price
 With the specific tax of XY the S + tax (XY)
supply curve shifts to S+tax
 There is a new equilibrium of P2Q2 S

 The consumer pays P1P2Q2 in tax X

 The producer pays CP1Q2 in tax P2
 We can see that the consumer is
P1
paying much more of the tax Y
C
 This is because the PED is
inelastic; the firm knows that if the
consumer is not sensitive to price; D
if the price is increased the
consumer % demand will not Q2 Q1 Quantity
change as much as the % change
in price
 The consumer bears most of the
burden of the tax
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
Pajholden videos
• Indirect taxation
– http://www.youtube.com/watch?v=t9N4La0-
k9c
Subsidies (for all)
Subsidy
 When a subsidy is given to a firm
it’s costs are lowered and
therefore it will supply more.
 Percentage subsidies are rare so
Subsidy – an amount of money
paid by the government to a firm
per unit of output

Price
we concentrate on specific S
subsidies
S+subsidy
 The supply curve shifts to the
right as seen in the diagram subsidy
 It shifts by the amount of the
subsidy P1
 There are several reasons why P2
government gives subsidies
 To lower the price of essential
goods to increase consumption
D
(e.g. milk)
 To guarantee the supply of goods Q1 Q2 Quantity
in an industry the government
believes is necessary e.g. coal
 To help producers compete
overseas (protection of
industries)
Subsidy
 We can see that when
the subsidy is given to
the firm the price
Subsidy – an amount of money
paid by the government to a firm
per unit of output

Price
S
reduces from P1 to P2
which is not the whole S+subsidy

subsidy subsidy

 If the whole subsidy P1

was given the price P2
would drop to P3 (HL - P3
depending on
elasticities) D

 We can now look at Q1 Q2 Quantity

the effect on producer

revenue, consumer
expenditure and
government spending
Producer Revenue Subsidy – an amount of money
Prior to the subsidy paid by the government to a firm
per unit of output
the firm would be

Price
making P1Q1 in S

revenue (blue box) S+subsidy

If a subsidy of WZ is D W
given by the P1
P2 Z
government
The firm is now D
making Q2D (yellow Q1 Q2 Quantity
plus box) in revenue
Revenue has
increased by the
yellow amount
Consumer expenditure
 Prior to the subsidy
consumers could buy Q1 at
the price of P1
 They can now buy Q1 at
Subsidy – an amount of money
paid by the government to a firm
per unit of output

Price
S
the price of P2 so they
S+subsidy
make a saving of P1-P2 x
Q1 (pink box)
 However they will purchase D W
more units at the lower P1
P2 Z
price of Q2-Q1
 The extra expenditure is
Q2-Q1 x P2 (purple box) D
 Total expenditure may
Q1 Q2 Quantity
increase or fall depending
upon relative savings and
extra expenditure
Government
expenditure
 Government expenditure is
the shaded area DWP2Z
 This money has to be found
Subsidy – an amount of money
paid by the government to a firm
per unit of output

Price
S
somewhere S+subsidy
 There is an opportunity cost
 Government can either take D W
this away from other areas P1
of spending (building P2 Z
infrastructure, providing
public services)
 Or it must raise taxes D
(unpopular with voters) Q1 Q2 Quantity
 Or it could borrow money
and increase debt
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
Pajholden videos
• Indirect taxation
– http://www.youtube.com/watch?v=t9N4La0-
k9c
• Subsidies
– http://www.youtube.com/watch?v=NykcR3Rhy
R4
Mjmfoodie video
• Price floors and ceilings
http://www.youtube.com/watch?v=XgBPAucs-
W4