1.2.9 Indirect taxes and subsidies Flashcards
What is an indirect tax?
An indirect tax is a tax imposed by the government that increases the supply costs faced by producers. The
amount of the tax is always shown by the vertical distance between the two supply curves. Because of the tax, less can be supplied at each price level.
What are examples of indirect tax?
How does indirect tax affect the demand curve?
An indirect tax will increase the price of a product reducing the quantity demanded i.e. there is a MOVEMENT ALONG THE DEMAND CURVE (curve doesnt shift)
How does the impact of a tax depends upon the price elasticity of demand?
- An indirect tax on suppliers will have no effect on market price if demand is perfectly elastic, although
the equilibrium quantity will fall significantly - An indirect tax on suppliers will be passed onto consumers in full if demand is perfectly elastic i.e.
there will be no change in the equilibrium quantity but a large increase in equilibrium price
What are types of indirect tax?
Specific
Ad valorem
What is specific tax
A specific tax is a set tax per unit e.g. a £5 tax per unit– this causes a parallel shift in the supply curve
What is ad valorem tax?
An ad valorem tax is a percentage tax e.g. 20% on the unit price – this causes a pivot shift i.e. non-parallel
shift in the supply curve
What happens to indirect tax when PED is elastic?
If co-efficient of price elasticity of demand >1 i.e. PED is elastic, most of an indirect tax will be absorbed
by the supplier. Economists say that the “incidence” of the tax is mostly borne by suppliers.
What happens to indirect tax when PED is inelastic?
If co-efficient of price elasticity of demand is inelastic most of an indirect tax can be
passed on to the consumer. Economists say that the “incidence” of the tax is mostly borne by
consumers.
What happens when there is perfectly inelastic demand and elastic supply?
- Perfectly Inelastic Demand: All of the tax is paid by the consumer
- Perfectly Elastic Supply: All of the tax is paid by the consumer
Explain the effect of an ad valorem tax on supply curve
- The effect of an ad valorem tax is to cause a pivotal shift in the supply curve
- This is because the tax is a percentage of the unit cost of supplying the product.
- So, a good that could be supplied for a cost of £50 will now cost £60 when VAT of 20% is applied
- A different good that costs £400 to supply will now cost £470 when the same rate of VAT is applied
- The absolute amount of the tax will go up as the market price increases
What are subsidies and how does it affect the supply curve?
A subsidy is any form of government support—financial or otherwise—offered to producers and (occasionally)
consumers. It does not have to be repaid. A subsidy paid to producers causes an outward shift of the supply
curve leading to a lower equilibrium price and an increase in the quantity traded. This is because it is intended to lower production costs.
What are examples of subsidies?
What does a subsidy look like on a graph?
Explain this graph.
The shaded area shows the total amount spent by the government on the subsidy.
Consumers benefit from lower prices (P2 is lower than P1….and so the total benefit to consumers is the
rectangle bounded by this price difference). Producers also benefit and get to keep some of the subsidy
themselves (the difference between P1 and P3).
What are economic and social justifications for a subsidy?
Show how subsidies are affected by PED
A subsidy causes an outward shift of supply and – other factors remaining constant – will lead to a lower
market price and an expansion of quantity demanded. Both consumer and producer surplus will increase
following a subsidy.
