Government intervention - IB Economics

Chapter 5
Unit 1.3
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CPS GLOBAL SCHOOL _ IB ECONOMicS -
MONICA

Three Direct Methods of
Intervention:
 Taxes‘
 Subsidies
 Price controls
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INDIRECT TAXES
 Tax -> charge placed on an individual, firm, payable to the govt under
punishment of Law
 Indirect Taxes – placed on G&S.
 Govt collects revenues from supplier after supplier has collected from
purchaser ->indirect (collected from consumer)
Types:
1. Specific Tax -> amt of tax is absolute value . Eg. $2 for every pack of
cigarette.
2. Ad valorem tax-> amt of tax is a percentage of the sale. Eg. VAT on
19% on Sale of Goods.
Excise Tax -> Taxing of one type of Good -> either specific/ad valorem in
nature.
IT -> collected directly from individual.
Increase in Taxes -> Decrease Profits for firms -> Decrease in
Supply-> Left shift of Supply Curve
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Shifts in supply curve due to tax:
 Specific Tax:
Specific/fixed amount, per-unit tax, flat rate tax.
Supply curve -> Shifts upward/left exactly by the amount
of Tax. Parallel shift. Amount Same.
 Ad Valorem Tax:
Tax on % of the Purchase/sale price. Higher price ->
Higher Tax
Supply Curve shifts upward or left by the amount of tax.
Distance between supply curves grow as price
increases
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The effect of Taxes: stakeholder
consequences:
 Taxes shift price –Supply shifts to the Left -> Pe
increases.
 Taxes reduce output. Smaller quantities.
 Market size shrinks
 Consumers suffer-> High price and less quantity
 Producers suffer ->extra costs, less o/p and less profits.
 Governments benefit -> inc revenues
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TAX INCIDENCE:
 Consequences of the Tax on all the affected parties.
 Who suffers the Tax burden (or incidence) of the tax?
 Shared by both consumers and producers to different
degrees.
 What happens when
PED is similar to PES
PED > PES
PED < PES
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PED similar to PES:
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Consumers and Producers share the Tax
burden
When producers increase the Price to
the new Ptax from Pe , Consumers will
also decrease the demand as they will
reduce Consumption. To the new Qtax
P increased to Ptax, Q decreases to Qtax
The Tax to be paid lies equally between
the producer and consumer surplus area.
Both loose out on their profits and hence
share the burden equally.
Mkt size reduced from Qe to Qtax ->
causes a welfare loss, a loss of
benefit/utility to participants ->
DEADWEIGHT LOSS

Tax Incidence, PED > PES
 Change in demand/change in
price > change in
supply/change in price.
 Change in Demand > Change
in Supply (i.e.) Demand is
more elastic than Supply.
 Consumers more responsive ->
Less tolerant To price changes –
More burden on the Producers.
 Govt -> Less Revenue
 Market size -> Reduces,
employment -> declines
 Decrease in Quantity and
larger deadweight loss
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Tax Incidence, PED < PES
 Supply is more elastic than
demand.
 Demand – rigid, consumers-
relatively inelastic
 Quantity decreased very little.
 Price increased much more.
Consumers – less responsive –
more tolerant to price changes.
More tax burden on the
Consumers.
 Inelastic Demand – Govt earns
more revenue. Consumers –
unresponsive
 Mkt size reduces very little.
Employment less affected.
Deadweight loss is smaller
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Elasticity of
Demand
More burden on Deadweight Loss Govt revenue
More Elastic More on producers Greater Lesser
More Inelastic More on
Consumers
Lesser Greater
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More Tax when PED is inelastic -> Ideal
Addictive goods – frequent targets to excise tax. Consumers – less responsive.

 Producer tax burden = (Pe –P1) * Qtax
 Consumer tax burden = (Ptax-Pe) * Qtax
 Total Tax revenue to Govt = Producer tax burden +
Consumer Tax Burden
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Subsidies
 Payment from the govt to an individual /firm for
purpose of increasing purchase / supply of a good.
Motivations:
 To increase consumption of some goods, by lowering
P-> Positive externality
 To support a particular industry by helping with pdn
costs. Industry -> imp for econ security, political
influence.
 Address balance of payments deficit by increasing
export revenue. Lower costs to make good more
competitive in the global mkt.
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Shifts in the supply curve:
 Subsidizing -> S curve shifts
right and downwards by the
amt of subsidy.
 Firms -> costs of pdn –less,
pdn at every price more
profitable.
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Price controls: Max price controls
Price ceilings (Max
price) -> a max legally
allowable price for a G/S set
by the govt.
 Govt sets Low price ->
affordable to poorer residents.
 Prevents P to rise to a higher
equilibrium
 Govt -> CEILING on price of a
good
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Effects of price ceilings:
 Shortages -> low P Inc D and Dec S – SHORTAGE.
New entrants cant access.
 Rationing -> detn who receives the pdt. Govt created
ration card / voucher -> receive pdt. Scarce goods
 Reduced Mkt size -> O/P reduced to Qs decrease in P
from Pe . Dec in Mkt surplus.
 Elimination of allocative efficiency -> MB =MC and D
= S situation eliminated. Mkt price set by govt.
 Informal (Black) mkt -> buy pdt informally on the
black mkt. P more than Pe
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Examples of price ceilings
 Rice, bread and other staples -> basic food items. Inc
in black mkt prices.
 Rent control – laws – dec cost of housing for lower
income. Renters – middleman pay to owners but bid
higher. Owners -> sublet @ P b/w Pmax and Pe.
Unsafe / poor quality housing.
 Housing subsidy. Subsidize for low income housing .
Costly – dep on size of shortage.
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Price controls: Min price controls
 Price floors (Min price) -
> Min legally allowable
price for a good set by
the govt. Govt artificially
increases price of some
goods. Govt -> good is
imp / necess. Support
empl in a particular
indistry.
 Not binding / effective if
MP > Eq price.
3/21/2020 CPS GLOBAL SCHOOL _ IB ECONOMicS - MONICA

Effects of price floors
 Surplus -> Qs > Qd
 Reduced mkt size -> only amt Qd is purchased.
Decrease in consumer and producer surplus.
 Cost inefficiency -> higher costs of pdn. Resources –
devoted to other things.
 Allocative inefficiency -> higher P -> MC > MB. Mkt
overproduces.
 Informal (Black) markets -> Firms choose to sell below
Pe which is illegal.
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Price floors : Example - Agriculture
 Applied on agri crops -> support pdn
and increase farmers income.
 Producer and consumer surplus
comes down and there s a surplus ->
Pmin *(Qs - Qd)
 Govt purchases excess surplus cant be
reinvested -> affect P
 Sold to other countries -> other
countries with surplus protest.
 Distributed as foreign aid -> admin
costs high.
 Surplus -> waste of resources.
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Price floors : Example – Min wages
 Legal min price for labor set by
govt.
 Inc std of living. Inc min wage
(Price for labor) -> worst wage
laborer can afford basic necessities.
 Qd -> redn in labor. Qs -> new
entrants inc seeking jobs. Prev not
ready at We. Surplus of labor –
unemp
 Qd -> no of laborers who enjoy
higher wage Wmin. Firms resort to
illegal hiring.
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Fixed prices
 F -> set a fixed price on their own – agreement / custom.
Depending on G/S -> P blaced below or above Equilibrium.
Supply fixed -> tickets at cinema, sporting events. S –
Perfectly inelastic.
 D – varies =>
 D> S -> SHORTAGE.
D < S -> SURPLUS
Surplus – excess seats sold on black.. Shortages -> buyers pay
more to get tickets.
 Cinemas – diff theatres – Qd small -> smaller venue.
Sporting stadiums – prices as per kind of seats.
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