Micro 12 - Government Intervention, Taxation and Subsidies Flashcards
The impact of an indirect tax - diagram explanation
> When the government imposes an indirect tax on a good or service, this incurs an additional cost on the producer for every unit produced.
Tax increases the cost of production for each unit sold and so supply is reduced, represented by a shift from S to S+tax, causing a contraction along the demand curve from Q to Q+tax and an increase in price from P to Ptax.
The value of tax per unit is the difference between the price that the firms would have charged at Q+tax prior to the tax and the price firms charge at Q+tax after the tax. This is the vertical distance between S and Stax.
The amount of revenue the government receives is equal to the vertical distance between S and Stax multiplied by the number of units now sold, Qtax. This is identified by the shaded region.
The impact of a subsidy - diagram explanation
> When the government subsidises a good or service, this reduces the cost of each additional unit produced.
The reduced cost allows firms to increase supply, represented by a shift from S to S+sub, causing an extension along the demand curve from Q to Q+sub and a reduction in price from P to Psub.
The subsidy paid per unit is the difference between the price that firms would have charged at Qsub (the new level of output) prior to the subsidy and the price firms charge at Qsub after the subsidy. This is the vertical distance between S and S+sub.
The amount of money the government has to pay is equal to the vertical distance between S and S+sub multiplied by the no. of units now sold, Qsub. Shaded.
Welfare loss from tax and subsidy
> When we ignore the possibility of externalities, there has been a DWL incurred by both the subsidy and indirect tax.
Tax - welfare loss
> This is the unused welfare gain that can’t be exploited between the new equilibrium at Qtax and the original equilibrium at Q.
It is the difference between MPC (S) and MPD (D) as the market goes beyond the original equilibrium.
This is the total benefit minus total cost of the units no longer being consumed, thanks to the indirect tax.
Subsidy - welfare loss
> This is the growing distance between the MPC (S) and the MPB (D) as the market produces beyond the original market equilibrium.
It is the difference between the total cost incurred by each unit produced beyond Q and the total benefit enjoyed from each successive unit consumed beyond Q.
Reasons why gov. introduce tax
- Reduce demand for demerit goods.
- Correct market failure.
- Revenue.
Reasons why gov. introduces subsidy
- Increase demand for merit goods.
- Correct market failure.
- Protect an industry, prevent job losses.
Positive externalities in consumption, subsidy - diagram explanation
> The introduction of a subsidy reduces the marginal costs for the producer of providing merit goods to the market.
This results in a rightward shift of supply from MSC=MPC=S to MPC+sub as the supplier can now afford to supply more to the market.
This leads to a price fall from Pm to Psub
and quantity demanded and supplied increases from Qm to Q, which is the socially optimal level.
Even though consumers are not on the socially optimal demand curve at MSB, shifting the supply curve makes them consume at Q by reducing the price to Psub.
This helps to solve under-consumption of merit goods as the cost of consuming goods with positive externalities is covered by the government subsidy.
The quantity of merit goods supplied to the market has also increased, which means the welfare loss associated with the under-consumption of merit goods has also fallen/been eliminated.
This leads to the market becoming more allocatively efficient.
Negative externalities in consumption, tax - diagram explanation
> The introduction of a tax increases the marginal costs for the producer of providing de-merit goods to the market.
This results in a leftward shift of supply from MSC=MPC=S to MPC+tax as the supplier cannot afford to supply as much to the market.
This leads to a price rise from Pm to Ptax
and quantity demand and supplied falls from Qm to Q, which is the socially optimal level.
Even though consumers are not on the socially optimal demand curve at MSB, shifting the supply curve makes them consume at Q by raising the price to Ptax.
This helps to solve over-consumption of de-merit goods as the true cost of consuming such goods is now in line with the social cost, so the external cost is internalised to the producer.
The quantity of de-merit goods supplied to the market has also fallen, which means the welfare loss associated with the consumption of de-merit goods has also fallen/been eliminated.
This leads to the market becoming more allocatively efficient.
Positive externalities in production, subsidy - diagram explanation
> The introduction of a subsidy reduces the marginal costs for the producer of producing goods/services with positive externalities in production.
This results in a rightward shift of supply from MPC=S to MPC+sub as the supplier can now afford to supply more to the market.
This leads to a price fall from Pm to P* and output increases from Qm to Q*
QP is the socially optimal level whereby the market is allocatively efficient
Even though producers are not on the socially optimal supply curve at MSC, shifting the producers from MPC to MPC+sub encourages them to produce at QP by reducing the price
This helps to solve under-production of goods/services with positive externalities in production, as the cost of producing goods with positive externalities is covered by the government subsidy.
This means the welfare loss associated with under production of goods/services with positive externalities in production has fallen/been eliminated.
Negative externalities in production, tax - diagram explanation
> The introduction of a tax increases the marginal costs for the producer of producing negative externalities.
This results in a leftward shift of supply from MPC=S to MPC+tax as the supplier cannot afford to produce as much.
This leads to a price rise from Pm to P* and output falls from Qm to Q.
PQ* is the socially optimal level whereby the market is allocatively efficient.
Even though producers are not on the socially optimal supply curve at MSC, shifting the producers from MPC to MPC+tax forces them to produce at QP by raising the price.
This helps to solve over-production of goods with negative externalities in production as the true cost of producing such goods is now in line with the social cost, so the external cost is internalised to the producer.
This means the welfare loss associated with negative externalities in production has fallen/been eliminated.
Subsidy problems
- V. expensive
- Difficult to predict necessary size as price isn’t the only determinant of demand, e.g. some people don’t like veg.
- sometimes producers absorb some of the subsidy.
Tax problems
- Problems determining exact amount of tax, because it’s difficult to estimate the true cost of the market failure associated with a demerit good/negative externality.
- Producers may not always pay the full amount of the tax, i.e. burden of tax is shared with the consumer and in this instance, supply may not reduce.
- The PED for many demerit goods is inelastic so consumption may not be reduced by as much as intended, with the result that production is higher than intended.
- Indirect taxes are regressive in their nature so more likely to hurt low-income earners.
- There are costs associated with policing and enforcing the tax.
Possible pro of tax
> Revenue from tax can be hypothecated into helping improve education or awareness.
Q. Explain why there is market failure in the food industry.
- Intro: explain why there’s merit + demerit goods. State your planned conclusion.
- Indirect tax to correct market failure. Diagram.
- Problems with indirect tax. Context.
- Conc 1. Will tax succeed alone? What success depends upon. Revenue hypothecated.
- Subsidies correct market failure. Diagram. Can it be used alongside a tax.
- Why subsidies not as successful as would hope in this context. Not like fruit+veg. Money spent on awareness instead.
- Conc 2. Can subsidies help? What does it depend upon?
- Main conclusion. Food vouchers - ‘nudging them’ so influences them more. Nudge = form of choice architecture so having a physical voucher may help promote increased social welfare through increased consumption of healthy foods without coercing families + this would also avoid the regressive nature of a tax on unhealthy food, especially as taxes are usually perceived as shoves by consumers, hindering their effectiveness further.
