Taxes and Subsidies

Question 1

What is a tax?

Answer 1

A method of raising revenue by governments to pay for spending/programs

A tax can be placed on either the buyer (affecting the demand curve) or the supplier (affecting the supply curve)

Regardless of which side the tax targets, both groups are going to end up paying a certain price

Question 2

What is a tax on buyers, and how does it impact producers and consumers?

Answer 2

The introduction of a tax on buyers decreases the demand curve, creating a new equilibrium point where consumers are buying less

At this new point, the consumer’s real willingness to pay is given by the original demand curve

However, a part of that price goes to the government in the form of tax (the difference between the original demand curve and the supply curve)

Government revenue can be expressed as the size of the tax times the number of units that are sold

The tax results in an increase in price, meaning that consumers have to pay a higher amount for the product

At the same time, the effect of the tax means that producers are also getting a lower price for the goods that they do sell

The difference between PC and PS is the size of the tax

A tax results in a deadweight loss as it means that markets are not operating as efficiently as they could be

Question 3

What is a tax on sellers, and how does it impact consumers and producers/

Answer 3

A tax on producers will increase the cost of production, increasing marginal costs of production and decreasing supply, and creating a new equilibrium point where producers supply less

At this point, the producer’s real marginal costs of production are given by the original supply curve

However, the price demanded by producers (PC) incorporates the revenue that the government gains from tax

The price that consumers pay is greater than the original price before tax

The price that producers receive is less than the original price before tax

Once again, the tax results in a deadweight loss to the market

Question 4

Why do we use the ‘tax wedge’ to express the impact of taxes?

Answer 4

It doesn’t matter which side of the market the tax is placed on – they both end up bearing the burden of the tax

When we graph a tax, we’re going to use the tax ‘wedge’ method

Question 5

What is a subsidy?

Answer 5

A subsidy can be considered as a negative tax

It can be given to either the buyer (affecting the demand curve) or on the seller (affecting the supply curve)

As with the tax, the end effect is the same

Question 6

Why do we use a subsidy wedge?

Answer 6

Operates in an inverse manner to the tax wedge

The price that producers receive for their products goes up, and the price that consumers have to pay goes down

The difference between the price that suppliers receive and the price that consumers pay is the size of the subsidy

The cost of the subsidy is the size of the subsidy, times the number of units consumed

Question 7

True or False - Taxes and Subsidies Create Inefficiencies in the Market

Answer 7

True

Question 8

Outline the welfare impacts of a tax

Answer 8

Question 9

Outline the welfare impacts of a subsidy

Answer 9

Overall total surplus decreases by area F, which represents the DWL

This is because it leads to overproduction and using resources in a market where it is better used elsewhere

Question 10

What is the rule regarding taxes and elasticity?

Answer 10

The more inelastic the side of the market, the greater proportion of tax burden falls on them

Because elasticity is about the responsiveness of the quantity demanded to changes in price

Question 11

Explore the impact of a tax on a market with inelastic demand

Answer 11

Question 12

Explore the impact of a tax on a market with inelastic supply

Answer 12

Question 13

What determines the deadweight loss of a tax or subsidy?

Answer 13

The size of the deadweight loss generated from taxes (and subsidies) is determined in part by the size of the tax, and in part by the elasticities of supply and demand

The greater the elasticity, the greater DWL a tax will cause

Question 14

How should a government go about trying to tax efficiently?

Answer 14

Taxes and subsidies generate DWL as they induce buyers and sellers to change their behaviour – they artificially lower or raise the price of a product, enticing consumers and firms to buy/produce more or less than they otherwise would

If a government’s goal is to maximise revenue while minimising their economic disruption, they should tax an inelastic market

Question 15

What is the relation between tax revenue and tax size?

Answer 15

A bigger tax will not always result in an increase in government revenue

This is because, as a tax increases, the government will make more on it, but it will result in less and less of the quantity being traded on the market

Question 16

What determines where the benefits of a subsidy flow?

Answer 16

The ‘burden’ of the subsidy is determined by the relative elasticities of the supply and the demand curves

In this case burden is a positive increase in surplus

Question 17

What is a lump sum tax?

Answer 17

A fixed fee

One off, not linked to levels of production

It is included in the fixed costs of production

A lump sum tax will result in the average total cost curve shifting up

Without a change in marginal revenue, this will result in firms making an economic loss

This means that the introduction of a lump sum tax will likely result in firms exiting the market and the establishment of a higher market price

Question 18

What is a per unit tax?

Answer 18

Affects the variable cost of production

This will lead to a proportional increase in Average Total Cost and Marginal Cost

Firms will shift the amount they produce so that MR = MC, but this will still be at a point where they are making an economic loss

This will result in firms producing less and exiting the market, until a new market price is established that reaches the minimum of the new ATC

Question 19

What is a lump sum subsidy?

Answer 19

Reduces the fixed costs of production

A lump sum subsidy will result in the ATC curve shifting down

Without a change in marginal revenue, this will result in firms making economic profits

This means that the introduction of a lump sum subsidy will likely result in firms entering the market and the establishment of a lower market price

Question 20

What is a per unit subsidy?

Answer 20

Reduces the variable costs of production

This will lead to a proportional decrease in Average Total Cost and Marginal Cost

Firms will shift the amount they produce so that MR = MC, which will be at a point where they are producing the same amount of output but making an economic profit

This will result in firms producing more and entering the market, until a lower market price is established