GOVERNMENT

INTERVENTION
OBJECTIVES

◼ Explain and give examples of an indirect tax

◼ Explain and illustrate how the imposition of an indirect tax may affect consumers, producers and the government

◼ Explain the importance of elasticity in understanding the effect of a specific tax on demand for, and supply of, a
product
GOVERNMENT INTERVENTION IN MARKETS

◼ Support households

◼ Support firms

◼ Influence consumption or production

◼ Protect consumers from the problem associated with monopoly power,

◼ Promote well-being and equity

◼ Earn government revenue to use for other purposes

THE EFFECT OF AN INDIRECT TAX ON THE
SUPPLY OF A PRODUCT
An indirect tax is one imposed upon expenditure. It is placed
upon the selling price of the product, so it raises the firm’s costs
and shifts the product's supply curve vertically upwards by the
amount of the tax.

Due to this shift, fewer products can be offered at any given

price
THE EFFECT OF AN INDIRECT TAX ON THE
DEMAND FOR A PRODUCT

To discourage the consumption of certain goods. The

government may place an extra tax over goods that may be
considered undesirable

Due to this increase in the price, fewer products can be

demanded at any given price
THE EFFECT OF AN
INDIRECT TAX ON
THE SUPPLY OF A
PRODUCT

◼ Specific taxes: (fixed)

This is a fixed amount of tax

imposed on a product, for
example, $1 per unit. This causes
a vertical shift of the curve
upwards by the amount of the
tax.
THE EFFECT OF AN
INDIRECT TAX ON
THE SUPPLY OF A
PRODUCT
◼ Percentage tax: (ad valorem)

This is when the tax is a percentage of

the selling price, and the supply curve
shifts according to that percentage.
The difference between the supply
curves S1 and S2 will be greater as the
price increases. If the percentage is
20% on a price of $5, the tax will be
$1. But if the price is $10, the tax will
be $2, and the gap between the
supply curves is wider due to the
percentage of the tax.
 When an indirect tax is imposed on a product, the effects on
consumers, producers, government, and the market should be
considered.

What would happen to the price consumers have to pay?

THE EFFECT
OF A TAX IN What would happen to the amount received by the producer?

THE
ECONOMIC How much tax will the government receive?

AGENTS What will happen to the size of the market and its employment?

We take a supply and demand curve, assuming that the

government imposes a specific tax on a product.
THE EFFECT OF ◼ The market is in equilibrium with Qe; supply and demand have

AN INDIRECT a price of Pe. After the Xy tax per unit, the supply curve shifts
upward from S1 to S2; producers must increase the price to P2,

TAX IN THE and this cost is entirely borne by consumers.

EQUILIBRIUM
◼ At this price, there is an excess supply, and the price must fall
to reach the new equilibrium at the price of P1, where Q1 is

MARKET
demanded and supplied.
Price S1 + Tax
Excess of
supply
S1

P2

P1 w

Pe x

C y

Q1 Qe
Quantity
THE EFFECT OF INDIRECT TAXES.
PRODUCER REVENUES:
◼ The market is in equilibrium, with Qe offered and demanded
at a price of Pe. After the XY tax is imposed per unit, the
supply curve shifts vertically upward from S to S + tax.

◼ Producers would like to raise the price to P2 and thus

transfer the entire cost of the tax to consumers. However, as
observed at that price, there is an excess supply, and
therefore the price has to fall to reach a new equilibrium,
which has a price of P1, where Q1 is demanded and
supplied.

◼ The product price for consumers increases from Pe to P1,

which is their share of the tax, and is approximately half of
the total XY tax. }

◼ Producers now receive C per unit, after paying the XY tax to

the government. Thus, they contribute the rest of the tax,
PeC per unit. Producer revenues fall from 0PeWQe to 0CYQ1.
THE EFFECT OF INDIRECT TAXES
GOVERNMENT TAX REVENUES

◼ It is observed that the government will receive tax

revenue equal to CP1 XY, and the market size falls
from producing units Qe to producing units Q1.

◼ This could well have implications for the level of

employment in the market, as businesses might
employ fewer people.

◼ The government collects taxes equal to CP1XY, and

the market decreases from Qe to Q1, where there
may be a higher unemployment rate, as less
manpower is needed.
THE EFFECT OF AN INDIRECT TAX

TAX BURDEN

It shows that, in this case, the burden of the indirect tax

is fairly evenly distributed between consumers and
producers.
 S + Tax
PED > PES
Price
S

Tax burden by consumers

P1 Tax burden by producers

Pe

Q1 Qe Quantity

Graph 1: Tax Burden Will Be Greater for the Producer Than for the Consumer
CHANGES IN THE TAX BURDEN ACCORDING TO PED AND PES
◼ PED is relatively elastic, and the price elasticity of supply is
relatively inelastic, meaning that the value of PED > PES.

◼ The market is in equilibrium with Qe supplied and demanded at

a price of Pe. After the XY tax per unit is imposed, the supply
curve shifts vertically upward from S to S + tax. Producers would
like to raise the price to P2 and transfer the entire cost of the tax
to consumers. However, at that price, there is an excess supply,
and therefore, the price has to fall until a new equilibrium is
reached at a price of P1, where Q1 is both demanded and
supplied.

◼ In this case, producers cannot pass on much of the tax burden

because demand is highly elastic, and too many consumers
would stop buying the product. Therefore, producers must bear
the brunt of the tax burden. The product price for consumers
increases slightly from Pe to P1.

◼ Producers now receive C per unit, after paying the XY tax to the
government. Hence, they bear the majority of the tax burden,
PeC per unit. Producer revenues fall significantly, from 0PeWQe
 Price S + Tax
PED < PES
S

P1 Tax burden for consumers

Tax burden for producers

Pe
C

Q1 Qe Quantity

Graph 2: Tax Burden Will Be Lower for the Producer Than for the Consumer
 CHANGES IN THE TAX BURDEN ACCORDING TO PED AND PES
◼ Price elasticity of demand (PED) is relatively inelastic, and the
price elasticity of supply (PES) is relatively elastic, meaning that
PED < PES.

◼ The market is in equilibrium with Qe supplied and demanded at a

price of Pe. After the XY tax per unit is imposed, the supply curve
shifts vertically upward from O to O + tax. Producers would like to
raise the price to P2 and transfer the entire cost of the tax to
consumers. However, at that price, there is an excess supply, and
therefore, the price has to fall until a new equilibrium is reached at a
price of P1, where Q1 is both demanded and supplied.

◼ Producers can pass on much of the tax burden because demand is

quite inelastic, and few consumers would stop buying the product.
Consumers bear the majority of the tax burden, and the price of the
product for them increases substantially from Pe to P1. Therefore,
they contribute the majority of the tax, P1Pe per unit. Producers now
receive C per unit, after paying the XY tax to the government.
Producer revenues fall slightly, from 0PeWQe to 0CYQ1.

◼ The government will receive high tax revenues equal to CP1 XY, and
the market size will decrease from producing units Qe to producing
units Q1. This will again have implications for the level of employment
 ◼ Exactly, that's why governments tend to impose
indirect taxes on products with relatively
THE EFFECT OF inelastic demand, such as alcohol and

AN INDIRECT cigarettes. By doing so, demand changes by a

proportionally smaller amount than the change
TAX in price, allowing the government to generate
high revenues without causing a significant
drop in employment.
CHANGES IN
THE TAX
BURDEN ◼

ACCORDING TO
PED AND PES
EXERCISE
◼ A product has a relatively inelastic demand and a relatively elastic supply. Draw a diagram to depict this and then
illustrate the effect of imposing a percentage tax on the product. Label the diagram carefully and indicate the areas
corresponding to:

a) Original producer's revenue

b) Producer's revenue after tax imposition

c) Tax revenue received by the government

d) Amount of tax paid by consumers

e) Amount of tax paid by producers.

f) Would it be wise for a government to tax a product with such elasticities? Explain your answer.
 PED < PES

Pric O + Tax
e

P1

Pe
C

0 < PED < 1 = D

Inelastic Q1 Qe Quantity
1< PED < α = Elastic
(units)
0 < PES < 1 =
Inelastic
TAXES with linear functions
Step 1 Calculate the equilibrium point
Step 3: Illustrate the market with the original Qd and QS
Qd=Qs
Step 4: Calculate the new equilibrium point and draw
2000-200P=-400+400P the new supply curve in the graph

P=4 Qd=2000-200P
Q=1200 Qs1=-1000+400P
The government impose a tax of $1.5 dollar per unit. 2000-200P= -1000+400P

Step 2: Calculate the new supply function 3000=600P

P=5
Qs=-400+400(P-1,5)
Qs1=-400+400P-600 Q=1000
Qs1=-1000+400P
P E.P initial E.P after
tax ($1.5)
P= $4 P= $5
Q= 1.200 Q=1.000

7 S + tax

6 S

1
D
0
Q
200 400 600 800 1000 1200

Step 5:Calculate the change in consumer expenditure
Expenditure in the E.P initial = $4 * 1200 = $4.800
Expenditure in the E.P final = $5 * 1000 = $5000
The consumer expenditure increases by $200
Step 6: Calculate the change in producer revenue
Producer revenue in the E.P initial = $4 * 1200 = $4800
Producer revenue after the tax = ($5-$1.5) * 1000 =
2.5 * 1000 = $3.500
The difference is $4800-$3500=$1.300
the producer revenue decreases by $1.300
Step 7: Calculate the revenue received by the
government
$1.5 * 1000 = $1500
Step 8: Calculate the tax burden for consumers and
producers
for consumers:
The initial price was $4
The final price is $5
The tax burden for consumers is $1
For producers if the tax is $1.5 and the consumers paid
$1 the producers pay $0.5
Step 9: Loss of consumer surplus
Red triangle = (H.b)/2 = (1*200)/2= $100
Step 10: Loss of producer surplus
Blue triangle = (h.b)/2 = (0.5*200)/2 = $50
Step 11: Loss of community surplus = 100+50= $150
GRAPH