9 - Government Intervention, Part 2

Question 1

Reason for indirect taxes

Answer 1

• Generally to generate government revenue
• Imcreases cost of production, reflected on the price
• Include VAT, the excise tax on tobacco, alcohol, petrol

Question 2

Types of indirect taxes

Answer 2

• Specific Tax
• Ad valorem tax

Question 3

What is a specific tax (indirect tax)

Answer 3

Indirect tax on a good levied at a certain amount per unit of good, irrespective of price

• Fixed amount for each unit of a good or service sold, such as cents per kilogram

Question 4

What is a Ad valorem tax (indirect tax)

Answer 4

Indirect tax of a percentage of price of good (VAT)

• E.g. VAT is charged at 20% in the UK. A 20% ad valorem tax increases production costs by 20% at each level of output

Question 5

How would you see specific tax and ad valorem tax on a graph

Answer 5

Specific tax is parallel to the supply curve

Ad valorem tax is a diagonal line from the origin (where the supply curve starts) and goes above the supply curve (not parallel)

Question 6

What would Tax do to a supply curve

Answer 6

Shift supply curve upwards (left)

Question 7

What type of tax is an excise tax

Answer 7

A specific tax

Question 8

What happens to price and quantity when tax is imposed

Answer 8

Price increases, quantity decreases (new equilibrium) when supply curve shifts up

Question 9

Tax is directly paid by who and indirectly paid by who

Answer 9

Directly paid by suppliers, indirectly paid by consumers as price increases

Question 10

What’s an excise tax

Answer 10

Amount paid by either the consumer or producer per unit of good at the point of sale

Question 11

What happens to consumer and producer surplus when tax is imposed

Answer 11

They both decrease as consumers now pay a price above equilibrium price and producers receive a price lower than equilibrium

Question 12

What is a tax wedge

Answer 12

Difference between what consumers take, and what producers receive

Question 13

What’s incidence of tax

Answer 13

Measure of the effect of a tax on the prices consumers pay and sellers receive in a market

Question 14

Formula for sellers (producers) share of the tax

Answer 14

P* - (P2 - Tax) / Tax

Question 15

Formula for consumers (Buyers) share of the tax

Answer 15

P* - P2 / Tax

Question 16

What does incidence of tax depend on

Answer 16

Elasticity of Demand of the good and the supply of the good

Question 17

When demand curve is inelastic who is the incidence of tax carried by

Answer 17

Carried by consumers

• Because customers are less responsive by change in price as this could be due to no substitutes. Therefore, when price increases due to tax, customers just pay it as they have no choice of substitute

Question 18

When demand curve is elastic who is the incidence of tax carried by

Answer 18

Carried by producers

• This is because consumers have substitutes to change to therefore are responsive to changes in price, therefore suppliers will have to pay for the tax directly; will not be able to pass it on to consumers

Question 19

When supply curve is elastic who is the incidence of tax carried by

Answer 19

Carried by consumers IF supply curve is elastic

• Because when supply is perfectly elastic it means elasticity of supply is infinite
• Meaning, producers are willing to supply anywhere above the equilibrium price but nothing below
• Therefore, producers can pass on burden of tax to consumers as price is above equilibrium

Question 20

When supply curve is inelastic who is the incidence of tax carried by

Answer 20

Burden is carried by producers

• Perfectly inelastic supply means elasticity of supply is 0
• Quantity of supply is fixed even if price increases, therefore supply cannot move much if not at all therefore producers carry the incidence of tax

Question 21

What are subsidies

Answer 21

Sum of money granted by the government

• Negative taxes

Question 22

What will subsidies cause price and quantity to do

Answer 22

Subsidies will cause market price to fall and quantity to increase

Question 23

Cost of subsidy to government depends on 2 things…

Answer 23

• Size of the per unit paid by the government (size of subsidy)
• Equilibrium Quantity after subsidy is introduced (produce more, better for government)

Question 24

What happens to consumer and producer surplus when there’s a subsidy

Answer 24

They both increase

• When Tax happens they both decrease (subsidy and taxes are polar opposites)

Question 25

Is there a deadweight loss when a subsidy is given

Answer 25

Yes however can be recovered through tax

Question 26

Advantages of subsidies

Answer 26

• Creates Low price, high quantity - This helps low income families
• Help create jobs, as to produce more, will need more input (labour)
• Help control inflation

Question 27

Disadvantages of subsidies

Answer 27

• Subsidy money is used to improve production, however could be used for something else (Opportunity cost, as could spend this money on education, healthcare etc)