Http:// Copyright 2006 – Biz/ed Correcting Market Failure Subsidies and Taxation

http://www.bized.co.uk

Copyright 2006 – Biz/ed

Correcting Market Failure

Subsidies and Taxation




• Subsidies:– Aim to change relative prices– Given to the producer– Used to help re-distribute income– Used to help firms compete– Numerous examples – state benefits, free

school meals, working tax credits, agriculture, transport, regional development, housing, employment, education




• Effects of Subsidies:– Shifts supply curve to right– Reduces price to consumer– Increases output – market failure is perceived as a

lack of output– Long term effects on market – distorts price signals– Who benefits – depends who gets the subsidy and

how it is used!– Welfare effects: cost of the subsidy to the taxpayer

minus the value of the benefits received– Impact on relative consumer and producer surplus



Subsidies and TaxationPrice

Quantity Bought and Sold

D

S

£10

500

S + Subsidy

Amount of subsidy per unit (£4)

£14

£7

700

Totalcost of the subsidy

First we look at the market before the subsidy

The subsidy will encourage suppliers to offer more for sale at every price

The amount of the subsidy is the vertical distance between the two supply curves

The effect of the subsidy is to reduce prices and increase the amount available – but at what cost?




• Taxation:– Specific or flat rate – amount per unit – Ad Valorem – percentage of the price– Levied on the producer – indirect tax– Examples: VAT, excise duties, tariffs, levies,

duties (e.g. stamp duty) National Insurance Contributions (NICs) – a tax on employment?

• Incidence – who pays?– Producer/consumer – price elasticity of

demand




• Effects of a tax:• Increases price• Reduces consumption/output• Welfare effects:

– Burden of tax on producer and consumer – changes in producer and consumer surplus

– Tax yield minus the cost of the tax




• Effects of Taxation:– Distortion of the market– Influence on behaviour– Extent of the effect dependent on the degree of

elasticity – number of substitutes, addictiveness of the product, proportion of income devoted, time scale

– Creation of underground markets – smuggling, booze cruises, etc.

– Increases business costs – competitiveness?– Raises revenue to help pay for government services



Incidence of a tax on petrolPrice p per litre

Quantity Bought and Sold (000s litres per day)

D

S

74

50

S + tax

Amount of tax = 3p per litre

76.8

Tax RevenueTax burden of

consumer

Tax burden of producer

49.5

Petrol has an inelastic demand curve

The tax effectively increases the cost of production, shifting supply to the left

The amount of the tax is the vertical distance between the two supply curves

Some of the tax is passed on to the consumer in the form of higher prices – this is the burden of tax

The producer has to carry the rest of the burden. With an inelastic demand this may not be very much!



Incidence of an ad valorem tax on a product with a greater degree of price elasticity

Price

Quantity Bought and Sold

D

S

£7

900

S + Tax

500

£9

Amount of the tax (£6)

£3

Total Tax Paid

Burden onConsumer

Burden on Producer

Documents

Http:// Copyright 2006 – Biz/ed Correcting Market Failure Subsidies and Taxation