25 Indirect taxes, subsidies, and price controls

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1 5 Indirect taxes, subsidies, and price contros By the end of this chapter, you shoud be abe to: define and give exampes of an indirect tax expain the difference between a specific tax and a percentage tax expain the importance of easticity in understanding the effect of a specific tax on the demand for, and suppy of, a product expain how the imposition of an indirect tax may affect consumers, producers, and the government HL expain the significance of the easticity of demand and suppy in assessing the incidence of an indirect tax HL using equations of inear functions, show and expain the effects of indirect (specific) taxes on a market HL iustrate and cacuate how the incidence of tax differs for consumers, producers and the government HL using equations of inear functions, show and expain the effects of subsidies on a market HL cacuate the effects of minimum and maximum prices from diagrams define a subsidy expain how the granting of a subsidy may affect consumers, producers, and the government expain, distinguish between, iustrate and give exampes of maximum and minimum price contros discuss the consequences of price contros on the stakehoders in a market. hen governments impose taxes on products, or give subsidies to firms, there are bound to be effects upon demand and suppy and we now need to consider those possibe effects and how they are infuenced by the reative price easticities for the product. The effect of an indirect tax on the demand for, and suppy of, a product An indirect tax is one imposed upon expenditure. It is paced upon the seing price of a product, so it raises the firm s costs and shifts the suppy curve for the product verticay upwards by the amount of the tax. Because of this shift, ess product wi be suppied at every price. There are two types of indirect taxes to consider: A specific tax: This is a specific, or fixed, amount of tax that is imposed upon a product, for exampe, a tax of $ per unit. It thus has the effect of shifting the suppy curve verticay upwards by the amount of the tax, in this case, by $. This is shown in Figure 5.(a). is the origina suppy curve and tax is the curve after the tax is imposed. (a) A specific tax $ $ +tax (b) A percentage tax $ +tax $ Figure 5. The effect on a suppy curve of different types of indirect taxes 63

2 5 Indirect taxes, subsidies, and price contros 5 Indirect taxes, subsidies, and price contros 64 A percentage tax (aso known as an ad vaorem tax): This is where the tax is a percentage of the seing price and so the suppy curve wi shift as shown in Figure 5.(b). It is cear from this that the gap between and tax wi get bigger as the price of the product rises. If the percentage tax is %, then at a price of $5, the tax on the product wi be $. If the price of the product is $, then the tax becomes $. The gap between the suppy curves widens because it is a percentage tax. hen an indirect tax is imposed on a product, we need to consider what the effect wi be on consumers, producers, the government, and the market as a whoe. In order to do that, add the demand curve to the graph and consider the foowing questions. hat wi happen to the price that the consumers pay? hat wi happen to the amount received by the producer? How much tax wi the government receive? hat wi happen to the size of the market, and so empoyment? If we take a norma demand and suppy curve and then assume that the government imposes a specific tax on a product, we get the diagrams shown in Figure 5.(a), (b), and (c). The market is in equiibrium, with Q e being suppied and demanded at a price of P e. After the tax of per unit is imposed, the suppy curve shifts verticay upwards from to tax. The producers woud ike to raise the price to P and so pass on a of the cost of the tax to the consumers. However, as we can see in Figure 5.(a), at that price, there is an excess suppy and so price has to fa unti a new equiibrium is reached, which is at a price of P, where Q is both demanded and suppied. e can now address the questions that we asked previousy. From Figure 5.(a), we can see that the price of the product for the consumers rises from P e to P, which is their share of the tax, and is about haf of the whoe tax of. Producers now receive per unit, after paying the tax of to the government. Thus they contribute the rest of the tax, P e per unit. The revenue for producers fas from P e Q e to Q. This is shown in the bue striped section in the diagram. From Figure 5.(b), we can see that the government wi receive tax revenue equa to P and that the market fas in size from one producing Q e units to one producing Q units. This may we have impications for the eve of empoyment in the market, as firms might empoy fewer peope. Figure 5.(c) shows us that, in this case, the burden of the indirect tax is shared fairy eveny between the consumers and the producers. (a) Producer revenue +tax (b) Government tax revenue (c) The tax burden +tax +tax + Producer revenue before tax is imposed Producer revenue after tax is imposed Tax revenue for government Figure 5. The imposition of a specific tax on a product consumers producers tudent workpoint 5. Be an enquirer Research cigarette taxes in a country or region of your choice. onsider the foowing: How much is the tax on a package of cigarettes? Has the tax changed over recent years? If so, why? However, the share of the tax burden for consumers and producers wi vary with the reative vaues of price easticity of demand and suppy for the product, as wi government revenue, and the effect on the size of the market. Let us ook at two different situations. In the first case, consider a market where the price easticity of demand is reativey eastic and the price easticity of suppy is reativey ineastic, i.e. where the vaue of PE is greater than the vaue of PE. This is shown in Figure 5.3. The market is in equiibrium with Q e being suppied and demanded at a price of P e. After the tax of per unit is imposed, the suppy curve shifts verticay upwards from to tax. The producers woud ike to raise the price to P and so pass on a of the cost of the tax to the consumers. However, at that price, there is an excess suppy and so price has to fa unti a new equiibrium is reached, which is at a price of P, where Q is both demanded and suppied. However, in this case, the producers cannot pass on a ot of the burden of the tax, because demand is very eastic and too many of the consumers woud stop buying the product. Thus the producers have to bear most of the burden of the tax themseves. The price of the product for the consumers rises just a itte from P e to P. Producers now receive per unit, after paying the tax of to the government. Thus they contribute the majority of the tax, P e per unit. The income of producers fas a great dea, from P e Q e to Q. The consumers share of the tax is P e P. The government wi receive high tax revenue equa to P and the market fas in size from one producing Q e units to one producing Q units. This wi once again have impications for the eve of empoyment in the market. In this case, the burden of the indirect tax is much heavier on the producers than on the consumers. This is because of the difference in the vaues of the easticities. In the second case, consider a market where the price easticity of demand is reativey ineastic and the price easticity of suppy is reativey eastic, i.e. where the vaue of PE is ess than the vaue of PE. This is shown in Figure 5.4. The market is in equiibrium with Q e being suppied and demanded at a price of P e. After the tax of per unit is imposed, the suppy curve shifts verticay upwards from to tax. The producers woud ike to raise the price to P and so pass on a of the cost of the tax to the consumers. However, at that price, there is an excess Is there an increase or decrease in the tax? ho benefits and who suffers from the tax? Figure 5.3 The imposition of a specific tax on a product where PE is greater than PE +tax Figure 5.4 The imposition of a specific tax on a product where PE is ess than PE +tax consumers producers consumers producers 65

3 5 Indirect taxes, subsidies, and price contros 5 Indirect taxes, subsidies, and price contros suppy and so price has to fa unti a new equiibrium is reached, which is at a price of P, where Q is both demanded and suppied. In this case, the producers can pass on a ot of the burden of the tax, because demand is fairy ineastic and few of the consumers woud stop buying the product. Thus the consumers have most of the burden of the tax passed on to them. The price of the product for the consumers rises substantiay from P e to P. Thus they contribute the majority of the tax, P P e per unit. Producers now receive per unit, after paying the tax of to the government. The income of producers fas a sma amount, from P e Q e to Q. The government wi receive high tax revenue equa to P and the market fas in size from one producing Q e units to one producing Q units. This wi once again have impications for the eve of empoyment in the market. In this case, the burden of the indirect tax is much heavier on the consumers than on the producers. e can use the exampes above to derive a set of rues reating to the incidence of indirect taxes on producers and consumers: here the vaue of PE is equa to the vaue of PE for a product, then the burden of any tax imposed wi be shared equay between the consumers and producers of the product. here the vaue of PE is greater than the vaue of PE for a product, then the burden of any tax imposed wi be greater on the producers of the product than on the consumers. 3 here the vaue of PE is ess than the vaue of PE for a product, then the burden of any tax imposed wi be greater on the consumers of the product than on the producers. This is why governments tend to pace indirect taxes on products that have reativey ineastic demand, such as acoho and cigarettes. By doing this, demand changes by a proportionatey smaer amount than the change in price and so the government wi gain high revenue and yet not cause a arge fa in empoyment. ou shoud be abe to think of some other good reasons why governments put taxes on such goods. These wi be addressed further when we study macroeconomics. Assessment Advice In HL paper 3 you may be asked to pot demand and suppy curves from inear functions and then iustrate and cacuate the effects of the imposition of an indirect tax on the market in terms of price, quantity, consumer expenditure, producer revenue, government revenue, consumer surpus, or producer surpus. ou may aso be asked to expain any of the above changes or cacuations. Here is an exampe of the kinds of questions that you may face and suggested responses. Let us assume that a product has the demand function and suppy function shown beow: Q 5, P Q 5 4 4P Graph and abe the demand and suppy curves when prices are $, $, $, $3, $4, $5, and $6. Identify: a the equiibrium price b the equiibrium quantity bought and sod (Q =, P) 4 8, A specific tax of $.5 is paced upon the product. 3 raw and abe a new curve to show the effect of the imposition of the specific tax. 4 Identify: a the new equiibrium price b the new equiibrium quantity bought and sod 5 acuate the government revenue from the tax. 6 acuate the amount of tax paid by: a consumers b producers 7 Iustrate the area showing the oss of consumer and producer surpus. 8 Expain why the consumers bear more of the burden of tax than the producers. The required diagram is shown beow:, + $.5 indirect tax (Q = 4 + 4P),6 Loss of consumer and producer surpus, tudent workpoint 5. Be a thinker iustrate and expain A product has reativey ineastic demand and aso reativey ineastic suppy. raw a diagram to show this and then show the effect of the imposition of a percentage tax on the product. Labe the diagram carefuy and state the areas corresponding to: a the origina revenue of the producer b the revenue of the producer after the tax is imposed c the tax revenue received by the government d the amount of the tax paid by the consumers e the amount of the tax paid by the producers. A product has reativey eastic demand and aso reativey eastic suppy. raw a diagram to show this and then show the effect of the imposition of a specific tax on the product. Labe the diagram carefuy and state the areas corresponding to: a the origina revenue of the producer. b the revenue of the producer after the tax is imposed c the tax revenue received by the government d the amount of the tax paid by the consumers e the amount of the tax paid by the producers. The equiibrium price and quantity bought and sod are shown as $4 and, units. The new suppy curve, showing the effect of the indirect tax of $.5, is drawn and abeed. The new equiibrium price and quantity bought and sod are shown as $5 and, units. (If asked, you coud have expained that tota consumer expenditure increases from $4 3, 5 $4,8 to $5 3, 5 $5,) Government revenue from this tax is $.5 on, units sod 5 $,5. The amount of tax paid by the consumers is $ 3, 5 $,. The amount of tax paid by the producers is $.5 3, 5 $5. The oss of consumer and producer surpus is shown on the diagram by the shaded area. ou coud expain that consumers woud bear more of the burden of tax than producers because the demand for the product is ineastic at that price, which may be seen from the diagram, and so producers are abe to pass on more of the burden of tax to consumers, since their quantity demanded wi fa by reativey ess than the price increases. 66 oud it be sensibe for a government to tax a product with such easticities? Expain your answer. oud it be sensibe for a government to tax a product with such easticities? Expain your answer. 67

4 5 Indirect taxes, subsidies, and price contros 5 Indirect taxes, subsidies, and price contros 68 The effect of a subsidy on the demand for, and suppy of, a product A subsidy is an amount of money paid by the government to a firm, per unit of output. There are a number of reasons why a government may give a subsidy for a product and the main ones are: To ower the price of essentia goods, such as mik, to consumers. In this way, the government hopes that the consumption of the product wi be increased, encouraged by the ower price. To guarantee the suppy of products that the government thinks are necessary for the economy. This may be because the goods are essentia for the economy, such as a basic food suppy or a power source ike coa. It may aso be that the industry creates a ot of empoyment that woud be ost, thus causing economic and socia probems. 3 To enabe producers to compete with overseas trade, thus protecting the home industry. (This is deat with in more detai in hapter.) If a subsidy is granted to a firm on a certain product, then the suppy curve for the product wi shift verticay downwards by the amount of the subsidy, because it reduces the costs of production for the firm, and more wi be suppied at every price. As with indirect taxes, the amount of the subsidy that is passed on to the consumers in the form of ower prices, and the amount that is retained by the producers, wi depend upon the reative easticities of demand and suppy. Athough percentage subsidies are sometimes granted, they are rare and so we wi concentrate on specific subsidies. A specific subsidy is a specific amount of money that is given for each unit of the product, for exampe, a subsidy of $ per unit. It thus has the effect of shifting the suppy curve verticay downwards by the amount of the subsidy, in this case by $, at every price. This is shown in Figure 5.5. is the origina suppy curve and subsidy is the curve after the subsidy is granted. If we take a norma demand and suppy curve and then assume that the government grants a specific subsidy on a product, we get the diagrams shown in Figure 5.6(a), (b), and (c). The market is in equiibrium with Q e being suppied and demanded at a price of P e. After the subsidy of per unit is granted, the suppy curve shifts verticay downwards from to subsidy. As we can see in Figure 5.6(a), the producers ower their prices and increase output unti a new equiibrium is reached, which is at a price of P, where Q is both demanded and suppied. From Figure 5.6(a), we can see that the price to consumers fas from P e to P, not the whoe amount of the subsidy, which woud need a fa to P. The income of the producers rises from the origina amount of P e Q e to Q. The consumers pay P Q for their purchases and P is paid to the producers by the government as the subsidy on the Q units. From Figure 5.6(b), we can see that the consumers get to buy the origina Q e units at a ower price, P, thus saving the expenditure P P e. However, they do purchase more units, Q e Q, because the price is ower, $ $ subsidy Figure 5.5 The effect on a suppy curve of a specific subsidy suppied (a) Increase in producer revenue (b) hange in consumer expenditure Figure 5.6 The granting of a specific subsidy on a product subsidy suppied (c) Amount of government subsidy subsidy suppied subsidy suppied spending Q e Q extra. Tota consumer expenditure may increase or fa, depending upon the reative savings and extra expenditure. Figure 5.6(c) shows us that the tota cost of the subsidy to the government is P. This money has to be found from somewhere and so there is an opportunity cost here. Once again, the government must either take money away from other areas of expenditure, such as buiding infrastructure or providing pubic amenities, or it must raise taxes. There are a number of things that need to be evauated when a government is considering the granting of a subsidy: tudent workpoint 5.3 Be a thinker iustrate and expain The demand and suppy functions for a product are given beow: Q 5 6 P Q 5 P Make a tabe to show the demand schedue and suppy schedue for the product when prices are $, $, $, $3, $4, $5 and $6. raw a diagram to show the demand curve and suppy curve that represent the demand and suppy schedues that you have made. 3 Iustrate the equiibrium price and quantity bought and sod. 4 Using simutaneous equations cacuate the equiibrium price and quantity. The opportunity cost of government spending on the subsidy in terms of other aternative government spending projects. hether the subsidy wi aow firms to be inefficient, if they do not have to compete with foreign producers in a free market. Athough a subsidy aows consumers to buy products at a ower price, they may aso be the taxpayers who are funding the subsidy. ho is paying the taxes? hat damage wi it do to the saes of foreign producers who are not receiving subsidies from their governments? There is a great dea of internationa debate concerning the biions of doars of subsidies that high-income countries give to their farmers. These subsidies ead to over-production and it is argued that this is highy damaging to sma-scae farmers in deveoping countries who do not receive subsidies themseves and then have to compete with the ow prices charged by the farmers who do receive subsidies. High-income country farmers are accused of dumping their products in deveoping countries. That is, they are accused of seing such products at prices beneath their costs of production. This is a major issue of contention at the ord Trade Organization (TO). Now et us assume that the government gives the producers a subsidy of $ per unit. 5 Add the new suppy curve to the graph. 6 Iustrate the new equiibrium price and quantity. 7 acuate the increase in producer revenue when the subsidy is given. 8 acuate the tota expenditure by the government. 9 Expain why both consumers and producers benefit from the granting of the subsidy. Identify possibe osers from the granting of the subsidy and expain why they may ose. 69

5 5 Indirect taxes, subsidies, and price contros 5 Indirect taxes, subsidies, and price contros 7 Price contros Athough it may seem to be an optimum situation, the free market does not aways ead to the best outcomes for a producers and consumers, or for society in genera, and so governments often choose to intervene in the market in order to achieve a different outcome. There are two key situations where this occurs: tudent workpoint 5.4 Be enquiring Read the foowing text and answer the questions which foow otton producers hope to benefit from Brazi's subsidy batte with us African cotton-producing countries are happy with Brazi's success in its case with the ord Trade Organisation against the United tates' continued use of subsidies in cotton production. True, we don't benefit directy from the TO ruing, said Prosper Vokouma, representative of Burkina Faso to the United Nations in Geneva and coordinator of the 4. The 4 is the grouping of four cotton-exporting African countries of which Benin, Burkina Faso, Mai, and had are the members. But it has heped put the issue of the 'white god' on the TO agenda. The TO ruing gives egitimacy to the 4's demands, Vokouma says. It is a strong criticism of the massive and distorting subsidies. The TO dispute settement body has confirmed that U subsidies damage other countries' producers because of their impact on word market prices. e know that the U has a bad conscience regarding this issue. ome,5 arge farmers share more than $3 biion between them every year, whereas to 3 miion African cotton producers ive in misery because the product of their hard work is not even enough to feed them, says Vokouma. tudies by internationa organisations show that the tota aboition of U subsidies woud increase the word cotton price by 4%. maximum prices minimum prices e now ook at each of these situations in turn. Maximum (ow) price contros This is a situation where the government sets a maximum price, beow the equiibrium price, which then prevents producers from raising the price above it. These are sometimes known as ceiing prices, since the price is not abe to go above the ceiing. Maximum prices are usuay set to protect consumers and they are normay imposed in markets where the product in question is a orkers at Rupa otton Miers in Athi River export processing zones spin cotton bas into int, most of which is shipped to the U market. Photo/ANTHON KAMAU According to the charity Oxfam, this woud transate into additiona revenue that coud feed one miion more chidren per year, or pay the schoo fees of two miion chidren in est Africa. Adapted from: /53955/8868/-/6d5iy/-/ Using an appropriate diagram, expain why U subsidies damage other countries' producers because of their impact on word market prices and how the aboition of U subsidies" coud "increase the word cotton price by 4%. omment on the advantages and the disadvantages of the aboition of U cotton subsidies. 3 The artice was written in March. Research the current situation with regard to U cotton subsidies. Have the 4 countries in Africa experienced a positive change in their circumstances? necessity and/or a merit good (a good that woud be underprovided if the market were aowed to operate freey). For exampe, governments may set maximum prices in agricutura and food markets during times of food shortages to ensure ow-cost food for the poor, or they may set maximum prices on rented accommodation in an attempt to ensure affordabe accommodation for those on ow incomes. Figure 5.7 shows the situation that may exist if the government were to impement a maximum price in the market for bread. ithout government interference, the equiibrium quantity demanded and suppied woud be Q e, at a price of P e. The government imposes a maximum price of P Max in order to hep the consumers of bread. However, a probem now arises. At the price P Max, Q wi be demanded because the price has faen, but ony Q wi be suppied. Thus we have a situation of excess demand. If the government does not intervene further, they wi find that consumption of bread actuay fas from Q e to Q, even though it is at a ower price. The excess demand creates probems. The shortages may ead to the emergence of a back market (an iega market), where the product is sod at a higher price, somewhere between the maximum price and the equiibrium price. There may aso be queues deveoping in the shops and producers may start to decide who is going to be aowed to buy. ince these probems are not reay fair for the consumers, the government may now need to make attempts to eiminate, or at east reduce, the shortage. There are a number of ways in which the government may try to do this. Essentiay, it woud have two options. First, it coud attempt to shift the demand curve to the eft, unti equiibrium is reached at the maximum price, but this woud imit the consumption of the product, which goes against the point of imposing the maximum price. econd, the government can attempt to shift the suppy curve to the right, unti equiibrium is reached at the maximum price, with more being suppied and demanded. There are a number of ways of doing this. The government coud offer subsidies to the firms in the industry to encourage them to produce more. The government coud start to produce the product themseves, thus increasing the suppy. 3 If the government had previousy stored some of the product, then they coud reease some of the stocks (stored goods) onto the market. However, if the product were perishabe, ike bread, this woud not be possibe. As we can see in Figure 5.8, if the government is abe to shift the suppy curve to the right, by subsidising, direct provision, or using stored bread, then equiibrium wi be reached at P Max, with Q oaves of bread being demanded and suppied. However, it is fair to say that this may we mean that the government incurs a cost, especiay in the case of a subsidy, and that this wi have an opportunity cost. If the government spends money supporting the bread industry, it may have to reduce expenditure in some other area, such as education or heath care. Price of bread ($) Price of bread ($) PMax Q of bread (s of oaves) PMax Excess demand Figure 5.7 The market for bread Excess demand Q of bread (s of oaves) Figure 5.8 Government action to sove the probem of excess demand Maximum price Maximum price 7

6 5 Indirect taxes, subsidies, and price contros 5 Indirect taxes, subsidies, and price contros 7 tudent workpoint 5.5 Be a thinker iustrate, expain, and suggest soutions A government wishes to keep the cost of cheap rented accommodation ow in a city, by imposing ega maximum rents on properties of a certain size. In doing this, they aim to: provide ow-cost rented accommodation for peope on ow incomes provide more rented accommodation for peope on ow incomes. raw a diagram to show the effect of the maximum rent egisation on the market for rented accommodation. Expain the situation facing those peope who rent out their properties. 3 Expain the situation facing those peope who wish to rent properties. 4 uggest measures that the government might take to ensure that they achieve both of their stated aims above. Assessment Advice In HL paper 3 you may be asked to cacuate possibe effects from the price ceiing diagram incuding the possibe shortage, changes in expenditure and tota expenditure. Here is an exampe of the kinds of questions that you may face and suggested responses. Beow is the market for cooking oi in a country. Price of cooking oi per itre ($) of cooking oi (miions of itres) The government of the country decides to impose a ega price ceiing of $ per itre. Indicate the equiibrium price and quantity on the graph. how the price ceiing on the diagram. 3 Expain how much cooking oi wi be demanded and suppied foowing the imposition of the price ceiing. 4 acuate the change in consumer expenditure on cooking oi foowing the imposition of the price ceiing. 5 Expain two measures that the government may take to achieve their aim of giving ess expensive cooking oi to more peope. The required diagram is shown beow: Price of cooking oi per itre ($).5.5 Price ceiing.5 of cooking oi (miions of itres) The equiibrium price and quantity are shown as $.5 and miion itres of cooking oi. The ceiing price is indicated at $. ou coud expain that at the maximum price of $,.5 miion itres of cooking oi wi be demanded but ony.5 miion itres wi be suppied. This means that there wi be an excess demand for cooking oi of miion itres. onsumer expenditure before the maximum price was miion 3 $.5 5 $.5 miion. onsumer expenditure after the maximum price was.5 miion 3 $. 5 $.5 miion. Therefore, consumer expenditure on cooking oi has faen by $ miion. ou coud expain that if the government wants to achieve its aim then they need to eiminate the excess demand. This might be done by: a irect provision of cooking oi by the government, i.e. the setting up of government owned cooking oi manufacturers. b Granting subsidies to cooking oi producers in order to encourage greater suppy. Minimum (high) price contros This is a situation where the government sets a minimum price, above the equiibrium price, which then prevents producers from reducing the price beow it. These are sometimes known as foor prices, since the price is not abe to go beow the foor. Minimum prices are mosty set for one of two reasons. To attempt to raise incomes for producers of goods and services that the government thinks are important, such as agricutura products. They may be heped because their prices are subject to arge fuctuations, or because there is a ot of foreign competition. To protect workers by setting a minimum wage, to ensure that workers earn enough to ead a reasonabe existence. Figure 5.9 shows the situation that might exist if the government were to impement a minimum price in the market for wheat. ithout government interference, the equiibrium quantity demanded and suppied woud be Q e, at a price of P e. The government imposes a minimum price of P Min in order to increase the revenue of the producers of wheat. However, a probem now arises. At the price P Min, ony Q wi be demanded because the price has risen, but Q wi now be suppied. Thus we have a situation of excess suppy. If the government does not intervene further, they wi find that consumption of wheat actuay fas from Q e to Q, abeit at a higher price. The excess suppy creates probems. Producers wi find that they have surpuses and wi be tempted to try to get around the price contros and se their excess suppy for a ower price, somewhere between P Min and P e. In order to maintain the minimum price, it is ikey that the government wi have to intervene. This is shown in Figure 5.. The government woud normay eiminate the excess suppy by buying up the surpus products, at the minimum price, thus shifting the demand curve to the right and creating a new equiibrium at P Min, with Q being demanded and suppied. The new demand curve woud be government buying. The government coud then store the surpus, destroy it, or attempt to se it abroad. However, storage tends to be rather expensive and destroying products is considered to be wastefu. eing abroad is aways an option, but it often causes angry reactions from the foreign governments invoved, who caim that products are being dumped on their markets and wi harm their domestic industries. In some cases, such as the European Union agricutura poicy, farmers are guaranteed a minimum price and are then paid to set aside and that they woud have used to produce the product in question. They are then paid the price for an estimated harvest and nothing is actuay grown. This costs the same for the government, but avoids storage costs or destroying produce. Price of wheat ($) PMin Excess suppy Q of wheat (s of tonnes) Figure 5.9 A minimum price in the market for wheat Price of wheat ($) PMin Excess suppy Minimum price Minimum price + government Q buying of wheat (s of tonnes) Figure 5. Government action to sove the probem of excess suppy 73

7 5 Indirect taxes, subsidies, and price contros 5 Indirect taxes, subsidies, and price contros There is bound to be an opportunity cost whenever governments spend money in any given area. In this case, the cost of buying up and storing surpuses must be paid and so the government may we have to cut back on expenditure in some other area, such as funding for teacher training, or raise taxes. There are two other ways that the minimum price can be maintained. First, producers coud be imited by quotas, restricting suppy so that it does not exceed Q. This is shown in Figure 5.. This woud keep price at P Min, but woud mean that ony a imited number of producers woud receive it. econd, the government coud attempt to increase demand for the product by advertising or, if appropriate, by restricting suppies of the product that are being imported, through protectionist poicies, thus increasing demand for domestic products. Price of wheat ($) PMin Quota Q of wheat (s of tonnes) Figure 5. A quota to maintain a minimum price Minimum price Examination questions Paper, essay questions a Expain the possibe effect on consumers and producers when a specific tax is imposed on cigarettes. [ marks] b Evauate the possibe outcomes of imposing such a tax. [5 marks] a Expain why a government might grant a subsidy to the producer of wheat. [ marks] b iscuss the consequences of such a subsidy. [5 marks] 3 a Expain the roe of prices in aocating resources in an economy. [ marks] b iscuss the consequences of the setting of a maximum price in a market of your choice. [5 marks] If governments do protect firms by guaranteeing minimum prices, probems are ikey to occur. Firms may think that they do not have to be as cost-conscious as they shoud be and this may ead to inefficiency and a waste of resources. It may aso ead to firms producing more of the protected product than they shoud and ess of other products that they coud produce more efficienty. tudent workpoint 5.6 Be a thinker iustrate and expain A government wishes to increase earnings for those workers who are on ow wages, by introducing minimum wage egisation in order to raise wage eves above the equiibrium wage. In doing this, they aim to: ensure higher wages for ow-paid workers increase the number of workers empoyed. raw a diagram to show the effect of the minimum wage egisation on the market for ow-paid workers. Expain the consequences of the minimum wage for the workers. 3 Expain the situation facing the empoyers. 4 uggest measures that the government might take to ensure that they achieve both of their stated aims above. Assessment advice: If the market is given to you, as in the market for cigarettes in question, you shoud state any assumptions that you might make in answering the question. In this case, since the incidence of an indirect tax varies according to the price easticity of demand, you woud need to state your assumption about the nature of the price easticity of demand for cigarettes. If the market is not given to you, as in question 3, then you shoud choose an appropriate market as the basis for your expanation. This highights the need to earn a good range of exampes for each of the topics that you study. ase note that in essay question 3 the two parts of the question come from different chapters. ou must be aware that question setters try to cover different areas of the syabus within questions and therefore you must be abe to make inks between the different topics. ince one of the core concepts in economics is the aocation of scarce resources this is a topic that you shoud try to incude in a different topics/chapters. ou be the journaist tudent workpoint 5.7 Beow is the market for carrots in a country. Price of carrots per bushe ($) of carrots (miions of bushes) The government of the country decides to impose a ega price foor of $.6 per bushe of carrots. Indicate the origina equiibrium price and quantity on the graph. how the price ceiing on the diagram. 3 Expain how many carrots wi be demanded and suppied foowing the imposition of the price foor. 4 acuate the change in producer revenue from carrots foowing the imposition of the price foor. 5 Expain two measures that the government may take to achieve their aim of giving more revenue to the carrot farmers. Headine: rivers and petro station owners protest angriy against a recent increase in petro taxes Economics concept: The effect of an indirect tax, easticity of demand. iagram: The effect of an indirect tax. Hints: ork out whether you think the demand for petro is reativey eastic or ineastic. The diagram shoud show a tax and then show the consequences of an increase in the tax. As before, set up a hypothetica community and consider the stakehoders

8 5 Indirect taxes, subsidies, and price contros ata response exercise igarette tax hike woud benefit Tennessee residents Though southern states ike Tennessee traditionay suffer from the highest incidence of youth and adut smoking in the nation, the indirect taxes the state and its neighbours impose on cigarettes are among the owest. It is fet that increasing Tennessee s indirect tax on cigarettes woud hep immensey in the fight to keep teenagers from beginning the habit. That s one of the advantageous aims of identica pieces of egisation in the House and enate that propose to increase state taxes on cigarettes in this session, whie decreasing the tax on groceries by the same amount. hie a tax increase of any kind tends to be highy unpopuar, this proposa deserves serious consideration. It has been cacuated that the state has the country s highest average food tax at 8.4%, but one of the owest cigarette taxes. The specific tax is set at cents per pack, or one cent a cigarette. The nationa average for cigarette taxes is 9 cents per pack. The egisation seeks to decrease the state saes tax rate on food, whie increasing the tax on cigarettes to 3.5 cents per cigarette on Juy 6, with further increases each year of.5 cents or the amount needed to baance the oss in revenue created by the decrease in the saes tax on food. The increase in the per-pack tax on cigarettes proposed in this egisation is admittedy a huge increase. But the decrease in saes tax on grocery items woud obviousy benefit the majority of Tennesseans. And no one seriousy disputes the disastrous heath consequences of cigarette smoking. The evidence is a around us. In Tennessee, studies show 4,5 youths become reguar smokers every year. et, according to recent data from the epartment of Heath and Human ervices, Tennessee ony spends about $.5 miion on smoking prevention and treatment programs annuay. That s the owest amount budgeted among a states except for nnsyvania. Tennessee has one of the highest percentages of smokers in the nation. That obviousy needs to change. This is egisation that wi reduce the effective price of food, save ives and decrease the ong-term heath care costs associated with tobacco use. This sounds ike a winning proposition for everyone. ource: Kingsport Times-News Monday, March 6 Assessment advice: data response h enever you are drawing diagrams in a data response answer, aways try to use actua numbers on the diagram, if they are given in the text. Aso, make sure that you abe the axes fuy. 76

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