government-intervention-indirect-taxation-and-subsidies

Using Indirect Taxes to Correct Market Failure

• An indirect tax is an expenditure tax that is paid when goods and services are purchased

• Indirect taxes are levied by the government to solve market failure and/or to raise government revenue

  • Government revenue is used to fund government provision of goods/services e.g education

• Indirect taxes are levied by the government on producers, increasing the cost of production for firms

  • Costs can be transferred on to consumers via higher prices

  • Higher prices reduce quantity demanded (QD) and discourage the consumption of specific goods or services, for example demerit goods or products that generate negative externalities

Diagram: Impact of an Indirect Tax

Diagram analysis

• The initial equilibrium is at P₁Q₁

• The government places a specific tax on a demerit good

  • The supply curve shifts upward from S₁→S₂ by the amount of the tax

• The new equilibrium is at P₂Q₂

• The price the consumer pays has increased from P₁ to P₂

• The price the producer receives has decreased from P₁ to P₃

• The government receives tax revenue = (P₂ – P₃₎ x Q₂

• Producers and consumers each pay a share or (incidence) of the tax

  • The consumer incidence of the tax is equal to area A: (P₂ – P₁) x Q₂

  • The producer incidence of the tax is equal to area B: (P₁ – P₃₎ x Q₂

• The final price is higher and QD is lower, resulting in a deadweight loss to society

Evaluating the use of Indirect Taxes 

Using Subsidies to Correct Market Failure

• A producer subsidy is a per unit amount of money given to a firm by the government

• Subsidies are used by governments to solve market failure by attempting to increase the output and consumption of specific goods or services, for example, merit goods

  • A subsidy reduces the costs of production and encourages an increase in the output of a good or service

  • Producers keep some of the subsidy and pass the rest on to consumers in the form of lower prices

  • Lower prices of a product encourage increased consumption

  • The distribution of the subsidy between producers and consumers is determined by the price elasticity of demand (PED) of the product

Diagram: Impact of a Subsidy

Diagram analysis

• The original equilibrium is at P₁Q₁

• The subsidy shifts the supply curve from S → S + subsidy

  • This increases the QD in the market from Q₁ → Q₂

• The new market equilibrium is P₂Q₂

  • This is a lower price and higher QD in the market

• Producers receive P₂ from the consumer PLUS the subsidy per unit from the government

  • Producer revenue is therefore P₃ x Q₂

  • Producer share of the subsidy is marked B in the diagram

• The subsidy decreases the price that consumers pay from P₁ → P₂

  • Consumer share of the subsidy is marked A in the diagram

• The total cost to the government of the subsidy is (P₃ – P₂) x Q₂

Evaluating the use of Subsidies