Price Mechanism Part 3 Flashcards
Indirect taxes, forms and impact
Taxes on goods and services and paid to tax authorities indirectly by supplier of goods and services
Specific tax is indirect tax of fixed sum per unit sold while ad valorem tax is indirect tax of certain percentage of price of good.
Indirect taxes increase cost of production for firms, leading to upward shift of supply curve. Supply decreases represented by an upward shift of supply curve by amount of tax.
Specific tax and ad valorem tax specific impact
Specific tax is a fixed amount of tax to be paid per unit and is the same for all prices. Hence, it shifts supply curve vertically upwards by amount of tax.
Ad valorem tax is tax pegged at certain percentage of price of good. As prices rises, amount of tax to be paid rises, resulting in upward pivotal shift of supply curve.
Effect of indirect tax on equilibrium price (depending on PED)
Relatively low PED:
With the tax, supply curve shifts upwards.
Price increases while quantity demanded decreases less than proportionately.
Government receives a relatively larger tax revenue.
Consumers’ surplus and producers’ surplus will both fall, but loss of consumers’ surplus > loss of producers’ surplus
Consumers more negatively affected by indirect tax
Relatively high PED:
With tax, supply curve shifts upwards.
Price increases while quantity demanded decreases more than proportionately.
Government receives a relatively smaller tax revenue.
Consumers’ surplus and producers’ surplus will both fall.
Loss of consumers’ surplus < loss of producers’ surplus
Producers more negatively affected by indirect tax
Impact on social welfare
Loss of consumer surplus because demand of consumers remained the same (willing and able…), actual price consumers have to pay is more and also quantity consumed is decreased.
Producer surplus drop because actual price retained from selling of goods fell and quantity sold falls.
Increase in government revenue which contributes to society’s welfare
Change in society’s welfare = Change in consumer surplus + Change in producer surplus + Change in government revenue
Overall loss to society’s welfare, constituting a deadweight loss to society because not all losses are recouped by government.
Deadweight loss represents welfare benefits that are lost to society because resources not allocated efficiently, loss of benefits due to under-allocation of scarce resources to production of good.
Direct taxes and impact
Taxes on income and wealth and paid to tax authorities directly by economic agent with income/ wealth
Disposable income of consumers reduces, fall of purchasing power, affects willingness and ability of households to consume goods and services, leading to shift of demand curve
Indirect subsidies, types and impact
Granted by tax authorities indirectly to suppliers of goods and services
Specific subsidy subsidises a fixed sum per unit sold, resulting in parallel downward shift.
Ad valorem subsidy is pegged at a certain percentage of price of good, where as price rises, amount of subsidy granted rises, resulting in downward pivotal shift of supply.
When indirect subsidy is granted, supply curve shifts downwards by amount of subsidy
Effects of PED on equilibrium price after indirect subsidy
Relatively low PED:
- Supply curve shifts downwards
- Price decreases while quantity demanded increases less than proportionately
- Government expenditure on subsidy is relatively huge
- Consumers’ surplus and producers’ surplus will increase
- Gain of producers’ surplus > gain of consumers’ surplus
- Producers more positively affected by indirect subsidy
Relatively high PED:
- Supply curve shifts downwards
- Price decreases while quantity demanded increases more than proportionately
- Government expenditure on subsidy is relatively small
- Consumers’ surplus and producers’ surplus will increase
- Gain of consumers’ surplus > gain of producers’ surplus
- Consumers more positively affected by indirect subsidy
Effect of indirect subsidy on welfare
Consumer surplus rose because maximum price consumers willing and able to pay did not change, but the actual price they have to pay has decreased and they also see a rise in quantity of good consumed
Producer surplus rose because actual price producers receive from selling of goods rose and quantity of good sold rose
However, gains did not fully recover the government expenditure and society experiences a deadweight loss (welfare benefits that lost to society because resources not allocated efficiently)
Over-allocation of scarce resources to production of good arising from indirect subsidy provided by government
Direct subsidy
Granted by tax authorities directly to economic agent with income. wealth, leads to rightward shift of demand curve
Minimum price and reasons
Price floor set above market equilibrium price
- Protect producers’ incomes especially when prices are volatile
- Create a surplus which can be stored in preparation for future shortages
- Prevent workers’ wage rates from falling too much
How is surplus created
Factors determining size of surplus
At higher prices, quantity demanded decreases (demand law) while quantity supplied increases (supply law), creating a surplus and market would be in disequilibrium.
- Level at which price floor is set- higher price floor, the greater the surplus
- Price elasticity of demand and supply- greater the PED/ PES, the greater the surplus
- Changes in demand/ supply- demand decrease/ supply increase, the greater the surplus
Effect of minimum price on welfare
ASSUME GOVERNMENT PURCHASES ALL SURPLUS
Loss in consumer surplus because price consumers have to pay increases and quantity of goods consumed decreases
Gain in producer surplus because price producers receive rises and quantity of goods sold increases
Government expenditure on surplus constitutes a deadweight loss to society, leading to overall loss of society’s welfare (if products can be resold/ redistributed, deadweight loss incurred by society is significantly smaller)
Maximum price and reasons
Price ceiling that prohibits producers from selling above the price, set below market equilibrium price
Maximum price imposed with aim of achieving some form of equity, make goods and services more affordable OR authorities judge that consumers are exploited by businesses using monopoly power
How is shortage created
At lower prices, quantity demanded increases (law of demand) and quantity supplied decreases (law of supply), shortage created and market in disequilibrium
- Level at which price ceiling is set- Lower the price ceiling, greater the shortage
- PED/ PES- Greater the value of PED/ PES, greater the shortage
- Demand/ Supply- If demand increase/ supply decrease, greater shortage
Effect of maximimum price on welfare
Consumer supply changes because price they have to pay falls but quantity of food consumed decreases
Those consumers who are able to obtain food at the price benefits from price ceiling, but welfare of consumers is uncertain
Producer surplus falls, loss in producer surplus because price producers receive fell, and quantity of good sold decreases
Overall loss to society’s welfare, constituting a deadweight loss to society
Need for alternative forms of non-price rationing (shortages result in restriction of sales, long queues, or limited coupons, hurting the group of people the policy is intended to help)
Undergound market emerges too (People ignore government’s price ceiling and sells illegally at free market prices
