Micro 12 - Government Intervention in markets 2: Indirect taxation and subsidies

Question 1

What is meant by internalising an externality?

Answer 1

Internalising an externality makes the external costs part of the price mechanism

Question 2

What is a subsidy?

Answer 2

A subsidy is money paid by the government to the producer of a good to make it cheaper than it would be otherwise

Question 3

Why may governments provide a subsidy?

Answer 3

Governments sometimes provide subsidies to encourage demand for a good

Question 4

What is an indirect tax?

Answer 4

An indirect tax is a tax placed on a good by the government to reduce the demand for it as the presence of a tax on the good aims to discourage people from buying it as the tax raises its market price

Question 5

What is the relationship between taxes and subsidies and supply curves?

Answer 5

Taxes and subsidies lead to shifts in the supply curves of goods/services which cause prices to change. The changes in price lead to an extension or contraction in demand

Question 6

Who is the benefit of subsidies received by?

Answer 6

The benefit of subsidies is received partly by the producer and partly by the consumer

Question 7

How do subsidies affect markets?

Answer 7

Subsidies encourage increased production and a fall in price, which leads to an increase in demand. So a subsidy shifts the supply curve to the right

Question 8

What are the amounts of the subsidy gained by producers and consumers dependent on?

Answer 8

The producer gain and consumer gain is dependent on the price elasticities of demand and supply

Question 9

What is the cost to the government of a subsidy equal to?

Answer 9

The cost to the government of a subsidy is equal to the consumer gain + the producer gain

Question 10

What area on a diagram is indicated by the consumer gain of a subsidy?

Answer 10

The consumer gain is rectangle represented by the fall in price from the original equilibrium price to the new lower price after the subsidy has been introduced

Question 11

Why is the consumer gain on a diagram represented by the by the difference between the equilibrium and lower price after a subsidy?

Answer 11

As consumers gain by paying less for the good than they would have if there was no subsidy

Question 12

What area on a diagram is indicated by the producer gain of a subsidy?

Answer 12

The producer gain is the rectangle represented by the difference between the maximum price consumers are willing and able to pay and the original equilibrium price

Question 13

Why is the producer gain on a diagram represented by the difference between the maximum price consumers are willing and able to pay and the original equilibrium price?

Answer 13

As producers gain by receiving extra revenue from the government that they can keep

Question 14

Is the consumer gain from a subsidy greater when the demand curve is more price elastic or inelastic?

Answer 14

The consumer gain is greater when the demand curve is more price inelastic

Question 15

Is the producer gain from a subsidy greater when the demand curve is more price elastic or inelastic?

Answer 15

The producer gain is greater when the demand curve is more price elastic

Question 16

What effect do indirect taxes have on a market?

Answer 16

Taxes increase the price of a good which leads to a reduction in demand. Taxation shifts the supply curve to the left

Question 17

Who is the burden of taxes received by?

Answer 17

The burden of a tax is imposed both on consumers and producers

Question 18

What is the proportion of the burden incurred from a tax on producers and consumers dependent on?

Answer 18

The proportion of the burden from a tax incurred on consumers and producers depends on the price elasticities of demand and supply

Question 19

What is the revenue received by the government from a tax equal to?

Answer 19

The consumer burden + the producer burden

Question 20

On a diagram showing a subsidy where do the consumer and producer gain rectangles end at in terms of their length?

Answer 20

At the new equilibrium quantity after the subsidy. (Q2)

Question 21

On a diagram showing a tax where do the consumer and producer burden rectangles end at in terms of their length?

Answer 21

At the new equilibrium quantity after the subsidy. (Q2)

Question 22

On a diagram showing a subsidy which one of the two rectangles are the consumer and producer gain?

Answer 22

• The top rectangle is the producer gain
• The bottom rectangle is the consumer gain

Question 23

On a diagram showing an indirect tax which one of the two rectangles are the consumer and producer burden?

Answer 23

• The top rectangle is the consumer burden
• The bottom rectangle is the producer burden

Question 24

On a diagram what is the area represented by the consumer burden of a tax?

Answer 24

The consumer burden is represented by the rise in price from the original equilibrium price to the new higher price after the tax

Question 25

On a diagram why is the consumer burden on a tax represented by the rectangle between the equilibrium price and the new price after the tax?

Answer 25

As consumers lose out by paying more for the good than if the tax wasn’t in place

Question 26

On a diagram what is the area represented by the producer burden of a tax?

Answer 26

The producer burden is represented by the difference between the equilibrium price and the minimum price producers are willing and able to supply at

Question 27

On a diagram why is the producer burden on a tax represented by the rectangle between the equilibrium price and the minimum price suppliers are willing to supply at?

Answer 27

As producers lose out by some of the revenue to the government

Question 28

Is the consumer burden from a tax greater when the demand curve is more price elastic or inelastic?

Answer 28

The consumer burden of a tax is greater when the demand curve is more price inelastic

Question 29

Is the producer burden from a tax greater when the demand curve is more price elastic or inelastic?

Answer 29

The producer burden of a tax is greater when the demand curve is more price elastic

Question 30

Draw two diagrams showing a subsidy on a good with price elastic and inelastic demand

Answer 30

See page 30 in revision guide

Question 31

Draw two diagrams showing a tax on a good with price elastic and inelastic demand

Answer 31

See page 31 in revision guide

Question 32

What are the two types of indirect tax?

Answer 32

• Specific taxes
• Ad valorem taxes

Question 33

What are specific taxes?

Answer 33

Specific taxes are a fixed amount that’s charged per unit of a particular good no matter what the price of that good is

Question 34

What are ad valorem taxes?

Answer 34

Ad valorem taxes are charged as a proportion of the price of a good

Question 35

What direct taxes?

Answer 35

Direct taxes are imposed on individuals or organisations

Question 36

Do the two types of indirect taxes affect supply curves in the same or different ways?

Answer 36

Different ways

Question 37

How does a specific tax affect a supply curve?

Answer 37

A specific tax causes a parallel shift of the supply curve. The tax is the same fixed amount at a low price and a high price

Question 38

How does an Ad valorem tax affect a supply curve?

Answer 38

An Ad valorem tax causes a non-parallel shift of the supply curve with the biggest impact being on higher price goods. The tax is a smaller amount at a low price compared to a high price

Question 39

Which goods do governments often put indirect taxes on?

Answer 39

Governments often put indirect taxes on goods that have negative externalities

Question 40

What is the aim of an indirect tax being imposed on a good with negative externalities?

Answer 40

The aim of this taxation is to internalise the externality that the good produces i.e. make the producer and/or consumer of the product cover the cost of its externalities

Question 41

What can the revenue received by the government from a tax on a good be used for?

Answer 41

The revenue made by the government from taxes can be used to offset the effect of the externalities

Question 42

What is the tax per unit on a diagram equal to?

Answer 42

The distance between the two supply curves

Question 43

How can the government revenue from a diagram be calculated?

Answer 43

Tax per unit * number of units sold

Question 44

What will the amount of tax passed on to the consumer depend on?

Answer 44

The price elasticity of demand

Question 45

What are the advantages of indirect taxes?

Answer 45

• The cost of the negative externalities is internalised in the price of the good which may reduce demand for a good and the level of its production reducing the effects of the negative externalities
• If demand isn’t reduced, there’s still the benefit that the revenue gained from the tax can be used by the government to offset the externaliites

Question 46

What are the disadvantages of indirect taxes?

Answer 46

• It can be difficult to put a monetary value on the cost of the negative externalities
• For goods where demand is price inelastic the demand isn’t reduced by the extra cost of the tax
• Indirect taxes usually increase the cost of production which reduces a product’s international competitiveness
• Firms may choose to relocate and sell their goods abroad to avoid the indirect taxation. This would remove their contributions to the economy such as payment of tax and the provision of employment

Question 47

How may governments use subsidies?

Answer 47

The government may pay subsidies with the aim of encouraging the production and consumption of goods and services with positive externalities

Question 48

What does the proportion of a subsidy given to producers and consumers depend on?

Answer 48

The proportion of a subsidy given to producers and consumers depends on the elasticity of the supply and demand curves

Question 49

What are the advantages of subsidies?

Answer 49

• The benefit of goods with positive externalities is internalised i.e. the cost of these externalities is covered by the government subsidy, so the price of the goods is reduced from what it would be in the absence of the subsidy
• Subsidies can change preferences - producers will supply goods with positive externalities and consumers will consume them and receive the benefits from them
• The positive externalities are still present
• Subsidies can support a domestic industry until it grows to the point that it can exploit economies of scale and become internationally competitive

Question 50

What are the disadvantages of subsidies?

Answer 50

• It can be difficult to put a monetary value on the benefit of the positive externalities
• Any subsidy has an opportunity cost
• Subsidies may make producers inefficient and reliant on subsidies. The subsidy means that producers have less incentive to reduce costs or innovate
• The effectiveness of subsidies depends on the elasticity of demand
• The subsidised goods and services may not be as good as those they’re aiming to replace