Indirect Taxes

Indirect Taxes: Incurred by households and firms only when buying/selling goods and services,
raising cost of production and lowering market supply. Specific Taxes: A type of indirect tax
that is set at a fixed $/unit e.g. alcohol tax of $40/litre.
Ad Valorem: A type of indirect tax that is set at a percentage of the selling price e.g. VAT
at 20%.

Indirect Tax: Ad Valorem

A specific tax results in a porollcl shift in

the supply curve upwards, causing a rise in
the equilibrium price and a fall in
equilibrium quantity.

Consumers pay price Pi while producers

receive price P2f with the government
collecting tax revenues of （P2 - Pi） x Qi.
There is a constant per unit tax represented
by the vertical distance between the two
supply curves.

There will be a deadweight loss due to

underproduction if the market were originally
allocatively efficient.

An ad valorem tax results in a pivoted shift

in the supply curve upwards, causing a rise
in the equilibrium price and a fall in
The Overall Impact of Indirect Taxes

• Producers: Producers suffer

Indirect Tax: Impact on Consumer & Producer Surplus
from lower revenues as they
receive a lower price and sell a
smaller amount of output.
Producers lose producer surplus,
contributing to area b of the
deadweight loss. The change in
producer surplus is calculated as
[y2 x（Po - P4） x Qo] - [y2 x（P2
- P4） x Qi]. Producer revenues
is P2 xQi.
• Consumers: Consumers suffer from
higher prices and the consumption of a lower amount of output, reducing consumer
utility. Consumers lose consumer surplus, contributing to area a of the deadweight
loss. The change in consumer surplus is calculated as [!4 x（P3 - Po） x Qo] - [!
4x（P3 -Pi） x Qi]. Consumer expenditure is Pi x Qi.
• Government: Governments benefit from a rise in tax revenues. Tax revenues is calculated
as（P〕- P2） x Qi.
• Workers: There would be a rise in unemployment as the demand for workers falls with the
lower equilibrium output.
• Society: Society suffers from a fall in social welfare if the market were originally
efficient due to the underallocation of resources, resulting in a deadweight loss of
area （a+b）. Social welfare can improve if the market were originally inefficient and
there were overconsumption or overproduction. Deadweight loss is calculated os % x
（P】-P2） x（Qo- Qi）.
Elasticity and Indirect Taxes

The tax incidence refers to the share of the tax revenue between consumers and
producers.
Consumer tax incidence:（Pi - Po） x Qi and producer tax incidence:（Po - P2） x Qi

The more inelostic the PED, the greater the The more elastic the PED, the smaller the
consumer burden from the indirect tax as they consumer burden from the indirect tax as they
are less responsive to the rise in price. are more responsive to the rise in price.

Impact of a Tax w/ Inelastic PES

The more inelostic the PES, the greeter the The more elastic the PES, the smaller the
producer burden from the indirect tax as they producer burden from the indirect tax as they
are less responsive to the rise in price. are more responsive to the rise in price.

• Source of government revenue: The government collects tax revenues from indirect taxes.
• Discourage the consumption of harmful goods: The fall in equilibrium quantity from indirect
Why do Governments Impose Indirect Taxes?

taxes discourages consumers from consuming harmful (demerit) goods such as cigarettes
and alcohol.
• Redistribute Income: Indirect taxes on luxury goods will force higher income households
to pay more taxes on the purchases of these goods.
• Improve allocative efficiency by correcting negative externalities: Negative externalities result in
allocative inefficiency from overconsumption/overproduction; indirect taxes can reduce
the equilibrium quantity and improve allocative efficiency.
Subsidies
Subsidies: Cash payments by the government to firms to lower their cost of production and lower
the price of the good or service sold.

A subsidy results in a parallel shift in the

supply curve downwards, causing a fall in the
equilibrium price and a rise in equilibrium
quantity.

Consumers pay price Pi while producers receive

price P2/ with the government spending（P2 -
Pi） x Qi on the subsidies. There will be a
deadweight loss due to overproduction if the
market were originally allocatively efficient.

The Overall Impact of Subsidies

• Producers: Producers benefit from higher revenues as they receive a higher price and
sell a greater amount of output. They gain producer surplus equivalent to the area （b
+ c）. The change in producer surplus is calculated as x（P2 - P4）x Qi] -忸 x（Po -
P4）x Qo]. Producer revenue = P2 x Qi.
• Consumers: Consumers benefit from lower prices and the consumption of a greater amount
of output, increasing consumer utility. They gain consumer surplus equivalent to the
area （e + f）. The change in consumer surplus is calculated as [V2 x（P3 一 Pi） x Qi]
一 [% x（P3 一 Po） x Qo]. Consumer expenditure = P】x Q】.
• Government: Governments suffer from a rise in expenditures equivalent tO（P2 - Pi） X
Qi.
• Workers: There would be a fall in unemployment as the demand for workers rises with the
higher equilibrium output.
• Society: Society suffers from a fall in social welfare if the market were originally
efficient due to the overallocation of resources, resulting in a deadweight loss of
the area d, % x（P2 - Pi） x（Qi - Qo）. Social welfare can
 improve if the market were originally inefficient and underconsumption and
underproduction exists.

Why Governments Impose Subsidies?

• Increase revenues and incomes of producers: Producers enjoy a higher price and greater output
with subsidies.
• Make certain goods more affordable for lower income groups: Lower income groups can enjoy lower
prices for necessities such as food and rent.
• Encourage production and consumption of goods and services that are desirable for consumers: Consumers
can be encouraged to consume more desirable (merit) goods such as vaccines by
lowering the price of the good.
• Support growth of particular industries in the economy: Subsidies increases the output of
certain markets.
• Encourage exports of particular goods: Subsidies lower cost of production and prices of
exports, making them more export competitive relative to other countries.
• Improve allocative efficiency by correcting positive externalities: Positive externalities result in
allocative inefficiency from underconsumption/underproduction; subsidies can increase
the equilibrium quantity and improve allocative efficiency.
 Price Controls: Price
Ceiling
Price Ceiling: A legal maximum price for a good or service, set below the market equilibrium
price.

• With a price ceiling, quantity demanded

rises to Q2 while quantity supplied falls
to Q】due to the law of demand and supply.
• Consumers benefit from a lower price of Pmax
but suffer from a shortage; not all
consumers will be able to buy the total
amount of the good/service desired.
Nonetheless lower prices could improve the
equitability in consumption.
• Producers suffer from a loss of revenue.
• Workers will get unemployed due to the fall
in output to Qi

Consequences on the Economy

• Shortages: Quantity demanded exceeds quantity supplied; the market would not be able to
achieve equilibrium.
• Non-price rationing: The shortage forces the rationing of scarce good without the price
mechanism, such as through a balloting system or by forcing consumers to queue to
obtain the good on a first-come-first- serve basis. This could also lead to corruption
and favoritism.
• Underground/Black Markets: At Qb consumers are willing to pay up to Pi to obtain the scarce
good/service. Underground markets could arise where the good/service is bought legally
at Pmax and illegally resold at Pi for profit.
• Underallocation of resources: Qi is lower than the free market equilibrium

• Negative welfare impacts: Society suffers from a deadweight loss (loss of welfare) due to
the underallocation of resources. Consumers and producers lose surplus as MB exceeds MC
at Qb

Price Floor: A legal minimum price for a good or service, set above the market equilibrium price.
 Price Controls: Price
Floors

• With a price floor, quantity demanded falls to Q〕while quantity supplied rises to Q2 due to
the law of demand and supply.
• Consumers suffer from a higher price of Pmin and consume a smaller quantity at Qi z
resulting in a fall in consumer utility.
• Producers benefit from a higher selling price but not all producers will be able to sell
the maximum amount of output they desire unless the government buys up the surplus, in
which case they will benefit from higher revenues that increases from P ox Qo to Pmin x Q2.
• The government would spend（Q2 一 Qi） x Pmin to buy up the surplus.
• Workers are likely to gain employment due to the rise in output to Qi
• Firms in other countries that do not enjoy price floors would be forced to sell at lower
prices and thus reduce production, resulting in an underallocation of resources in these
countries.
Consequences on the Economy (Price Floor + Government Purchase of Agricultural Products)

• Surpluses: Quantity supplied exceeds quantity demanded; the market would not be able to
achieve equilibrium.
• Government measures to dispose of surpluses: Increased government cost from having to either
store the surplus, subsidize to export the surplus or provide it as aid to developing
countries.
• Firm inefficiency: Firms have no incentive to minimize costs since they are guaranteed a
high minimum selling price, resulting in a wastage of resources.
• Overallocation of resources: Q2 is higher than the free market equilibrium.
• Negative welfare impacts: Society suffers from a deadweight loss (red shaded area) due to
the underconsumption of the good; consumers and producers lose surplus as MB exceeds
MC at Qi. The deadweight loss expands by the black shaded area with government
spending as the total government expenditure of(Q2 - Qi) x Pmin does not fully add to
producer surplus, resulting in a wastage of resources and worsens society's welfare.
Minimum Wage (Price Floor in the Labour Market)

• With a minimum wage, quantity demanded of

labour falls to Qi while quantity supplied
of labour rises to Q2, due to the law of
demand and supply.
• Firms suffer from higher wages as it raises
cost of production and lowers profits, as
reflected by the loss of employer surplus.
• Some workers benefit from higher wages; but
others suffer from higher unemployment (surplus
labour).
• Consumers will suffer from higher prices
due to higher cost of production in
various markets.

Consequences on the economy

• Labour surplus and unemployment: The surplus workers result in (structural) unemployment,
as there are more workers willing to work than there are jobs available at Wmin.
• Illegal workers below the minimum wage: workers might choose to accept wages lower than the
minimum wage if they were desperate to gain employment
• Misallocation of labour resources: Firms will hire fewer workers, lower than the equilibrium
employment.
• Misallocation of resources in product markets: Higher cost of production results in falling
supply and underallocation of resources towards the production of goods and services.
• Negative welfare impacts: Loss of employer and worker surpluses due to the underallocation
of labour resources in the market, resulting in a deadweight loss to society.
Setting Fixed Prices
When some firms set fixed prices in advance that cannot be changed by market forces. This
usually occurs when supply is fixed (e.g. concerts, sporting events etc.)

A fixed price that is set too high would that is set too low would result in a
result in a surplus of output A fixed price shortage of output.