Section 1.3 Government Intervention 8

1.
3 GOVERNMENT INTERVENTION (INDIRECT TAXES & SUBSIDIES)

3.1 INTERNATIONAL TRADE (RESTRICTIONS ON FREE TRADE: TRADE
PROTECTION)
2.3 MACROECONOMIC OBJECTIVES (EQUITY IN THE DISTRIBUTION
OF INCOME)
1.3 Government intervention
Why Governments Intervene In Markets:

The government tries to combat market inequities through
regulation, taxation, and subsidies.
Governments may also intervene in markets to promote
general economic fairness.
Maximizing social welfare is one of the most common and
best understood reasons for government intervention.
Examples of this include breaking up monopolies and
regulating negative externalities like pollution.
Governments may sometimes intervene in markets to promote
other goals, such as national unity and advancement.
1.3 Government intervention
(Indirect taxes & Subsides)
Indirect taxes
An indirect tax is a tax collected by an intermediary i.e.
seller, from the person who bears the ultimate economic
burden of the tax i.e. consumer.
It is imposed on expenditure. In simple terms, it is a tax
which is imposed on goods and services sold. It is usually
added to the cost of the good or service and charged
from the ultimate consumer. The seller will then file a
return to the government on all the taxes he has
collected from the consumer.
Examples are sales tax and excise duty
1. Explain why governments impose
indirect (excise) taxes.
The main reasons for government imposing taxes can be:
To generate Government revenues: excise duties on beers, wines
and spirits are price inelastic in demand, so tax price increases by
levying specific alcohol and tobacco taxes raise consumer
expenditures as a whole on these categories and therefore
taxation revenues;
To discourage consumption: Government might use taxes to
discourage consumption of certain demerit goods such as
cigarettes.
To alter the pattern of consumption: Government might use
direct taxes a mean to alter the consumption pattern of its
population. Certain goods can be made more price attractive
through lower taxes while goods which have high marginal social
cost can be made expensive through taxation.
2. Distinguish between specific and ad valorem taxes.
Specific tax is a flat rate of tax whereas ad valorem tax is

a percentage tax.
Ad valorem literally the term means “according to value.” It
is imposed on the basis of the monetary value of the taxed
item.
A specific tax is when specific amount is imposed upon a
good, for example $10 on each mobile phone sold;
whereas ad valorem tax is expressed as a percentage of
the selling price e.g. 12% of the sales.
The amount of specific tax changes in the same proportion
as the quantity sold increase, whereas, in ad valorem the
tax collected is more at higher prices then at lower prices.
3. Draw diagrams to show specific and ad valorem taxes,
and analyses their impacts on market outcomes.
4. Discuss the consequences of imposing an indirect tax on the
stakeholders in a market, including consumers, producers and the
government.
Imposition of tax results in three economic

observations.
Incidence: Incidence of tax means the party who
actually pays the tax.
Government revenue: the amount of tax government
will receive as revenue
Resource allocation: the amount of fall in quantity
demanded and produced created by the tax.
A Tax on Sellers Effects of a $1.50 per
unit tax on sellers
A tax on
sellers shifts
P
the S curve up S2
by the amount S1
PB = $11.00
of the tax. Tax
$10.00
PS = $9.50
The price
buyers pay D1
rises, the
price sellers Q
430 500
receive falls,
eq’m Q falls.
A Tax on Buyers Effects of a $1.50 per
unit tax on buyers
A tax on
buyers shifts P
the D curve
down by the S1
PB = $11.00
Tax
amount of the
tax. $10.00
PS = $9.50
The price
buyers pay D1
rises, the D2
price sellers Q
430 500
receive falls,
eq’m Q falls.
The Incidence of a Tax: how the burden of a tax is shared among
market participants
P
Because S1
PB = $11.00
of the tax, Tax
buyers pay $10.00
$1.00 more, PS = $9.50
sellers get
D1
$0.50 less.
D2
Q
430 500
The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
P
What matters S1
is this: PB = $11.00
Tax
A tax drives $10.00
a wedge PS = $9.50
between the
price buyers D1
pay and the
price sellers Q
receive. 430 500
government.
Incidence or tax burden

When a tax imposed on a good
or service increases the price by
the amount of the tax, the burden
of the tax falls on consumers.
If instead it lowers wages or
lowers prices for some of the other
factors of production used in the
production of the good or service
taxed, the burden of the tax falls
on owners of these factors.
government.
If the tax does not change the product’s price or factor

prices, the burden falls on the owner of the firm—the owner
of capital.
If prices adjust by a fraction of the tax, the burden is
shared. The incidence of tax will be shared between the
consumers and producers, depending on the price elasticity
of demand (PED) and the price elasticity of supply (PES)
for that product (which we will discuss later).
If we assume that the burden is equally shared by both the
consumers and the producers then the size of incident is
equal. This means the incidence of tax is equally distributed
by both the consumer and producer.
government.
Government revenue
Putting taxes on goods and
services generates revenue
for the government.
Figure shows the shaded
region as tax revenue for
government i.e. CYXP1. The
implication will be a fall in
output from Qe to Q1 and
thus the consumption and
production of the commodity
will fall.
Total Revenue & Burden of Taxation
The Effects of a Tax
P
Without a tax,
CS = A + B + C A
S
PS = D + E + F B C
Tax revenue = 0 PE
D E
Total surplus D
= CS + PS F
=A+B+C
+D+E+F
Q
QT QE
P
With the tax,

CS = A
A
PS = F PB S
Tax revenue B C
=B+D D E
Total surplus PS D
=A+B F
+D+F
The tax causes
Q
total surplus to QT QE
fall by C + E
P
C + E is called the
deadweight loss A
(DWL) of the tax, PB S
the fall in total B C
surplus that D E
results from a PS D
market distortion, F
such as a tax.
DWL is the loss of Q
efficiency. QT QE
About the Deadweight Loss
P
Because of the tax, the

units between
QT and QE are not sold. PB S
The value of these units
to buyers is greater than
the cost of producing PS D
them,
so the tax has prevented
some mutually beneficial
trades. Q
QT QE
5. Explain, using diagrams, how the incidence of indirect taxes on consumers and
firms differs, depending on the price elasticity of demand and on the price
elasticity of supply.
When PED is greater than PES

Where PED is greater than PES,
it implies that consumers are
more sensitive to price changes
as compared to suppliers.
Thus the incidence of tax will be
more on the suppliers because if
too much burden of tax is
passed on to the consumers then
the demand will fall drastically.
Therefore, this time the price
paid by buyers barely rises;
sellers bear most of the burden
of the tax.
When PES is greater than PED

When the supply curve is
relatively elastic, the bulk of the
tax burden is borne by buyers.
This is because PED as
compared to PES is elastic,
which means; consumers are not
that price sensitive and will not
reduce their consumption even if
the prices rise.
Because the PES is elastic,
suppliers will stop the supply if
the cost of production goes up.
Therefore, buyers end up
getting higher burden of tax.
PED is equal to PES

In this case both the producer and consumer will share
equal burden of tax.
Videos:
Examining the effect of an excise tax on an inelastic
good – Cigarettes
Examining the Effect of an Excise Tax on an Elastic

Good – Candy bars
CASE 1: Demand is more
Elasticity and Tax Incidence inelastic than Supply
P In this case,
buyers bear
Buyers’ share PB S most of the
of tax burden burden of
Tax
Price if no tax the tax.
Sellers’ share PS
of tax burden
D
Q
CASE 2: Supply is more
Elasticity and Tax Incidence inelastic than Demand
P In this case,
S
sellers bear
Buyers’ share most of the
of tax burden PB
burden of
Price if no tax the tax.
Tax
Sellers’ share
of tax burden PS
D
Q
Elasticity and Tax Incidence
 If buyers’ price elasticity > sellers’ price elasticity,

buyers can more easily leave the market when the tax
is imposed, so buyers will bear a smaller share of the
burden of the tax than sellers.
 If sellers’ price elasticity > buyers’ price elasticity,
the reverse is true.
 The more Inelastic the more the burden of taxation
is shifted to that party.
 When the curve is perfectly inelastic that party pays
all the tax and when the curve is perfectly elastic
the other party pays all the tax.
Elasticity and Tax Incidence
When the curve is perfectly inelastic that
party pays all the tax
When the curve is perfectly elastic the
other party pays all the tax.
6. Plot demand and supply curves for a product from linear functions and then illustrate
and/or calculate the effects of the imposition of a specific tax on the market (on price, quantity,
consumer expenditure, producer revenue, government revenue, consumer surplus and producer
surplus).
Step 1
Use the linear functions
given to draw the relevant
demand and supply curves
and to identify the
equilibrium price and
quantity.
E.g. If the demand and
supply functions for a
product are QD = 2000 –
200P and QS = -400 +
400P.
6. Plot demand and supply curves for a product from linear functions and then illustrate and/or
calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer
expenditure, producer revenue, government revenue, consumer surplus and producer surplus).
Step 2
Change the supply function by taking the amount of the specific tax
away from P, simplify the equation, and then draw the new supply
curve.
 E.g. If the government imposes a specific tax of $0.75, then the supply
function is changed, because the producers will have to pay the tax and
so the price they receive falls by $0.75. Thus, the price in the equation is
(P – 0.75) at each level.
If we put this in the equation, we get QS = - 400 + 400(P - 0.75).
Then, we can simplify the supply function and draw the new supply curve.
 QS = - 400 + 400(P - 0.75)
 QS = - 400 + (400xP) – (400 x 0.75)
 QS = - 400 + 400P – 300
 QS = -700 + 400P
6. Plot demand and supply curves for a product from linear functions and then illustrate and/or calculate
the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer
revenue, government revenue, consumer surplus and producer surplus).
Step 3
Identify the effects that are requested by the question in terms
of price, quantity, consumer expenditure, producer revenue,
government revenue, consumer surplus or producer surplus.
 E.g. In the diagram above, the new equilibrium price is $4.50
and the new quantity demanded is 1100 units.
 Consumer expenditure goes from 1200 units at $4 = $4,800,
to 1100 units at $4.50 = $4,950 – an increase of $150.
 Producer revenue, after paying the tax of $0.75 per unit,
goes from 1200 units at $4 = $4,800 to 1100 units at $3.75
= $4,125 – a fall of $675.
 Government revenue is 1100 units at a tax per unit of $0.75
= $825.
Using Linear Equations to Calculate the Effect of an Indirect Tax (for HL students)
Step 1
Calculate the original equilibrium price and quantity from the demand
and supply functions.
 E.g. If the demand and supply functions for a product are
QD = 2000 – 200P and QS = -400 + 400P. Then equilibrium can be
calculated by setting the equations against each other, so that:
 QD = QS,
 2000 – 200P = -400 + 400P
 2400 = 600P
 P = $4
Substitute $4 as P in either equation to get the equilibrium quantity, which

is 1,200 units.
Step 2
Rearrange the supply function to take account of the specific
tax that is set and then find the new equilibrium.
 E.g. If the government imposes a specific tax of $0.75, then the
supply function is changed, because the producers will have to
pay the tax and so the price they receive falls by $0.75. Thus,
the price in the equation is (P - 0.75) at each level.
If we put this in the equation, we get
QS = - 400 + 400(P - 0.75).
Then, we can simplify the supply function.
 QS = - 400 + 400(P - 0.75)
 QS = - 400 + (400xP) – (400 x 0.75)
 QS = - 400 + 400P – 300
 QS = -700 + 400P
Now, equilibrium is where the old demand equation

meets the new supply equation:
 2000 – 200P = -700 + 400P
 2700 = 600P
 P = $4.50
Substitute $4.50 as P in either equation to get the new

equilibrium quantity, which is 1,100 units.
Step 3
Calculate the further effects that are requested by the
question in terms of consumer expenditure, producer
revenue, government revenue, consumer surplus or
producer surplus.
 E.g. Consumer expenditure goes from 1200 units at $4 =
$4,800, to 1100 units at $4.50 = $4,950 – an increase of
$150.
Producer revenue, after paying the tax of $0.75 per unit,
goes from 1200 units at $4 = $4,800 to 1100 units at
$3.751 = $4,125 – a fall of $675.
Government revenue is 1100 units at a tax per unit of
$0.75 = $825.
7. Explain why governments provide subsidies,
and describe examples of subsidies.
A subsidy is a form of financial assistance paid by the
government to a business or economic sector.
Why subsidies are given?
Subsidies might be given to:
Lower the cost of necessary goods which might affects a
major part of population. Example, subsidies given to
essential food items and oil (in India).
Guarantee the supply of merit goods, which the
government thinks consumers should consume.
Help domestic firms become more competitive in the
international market, also known as protectionism.
8. Draw a diagram to show a subsidy, and analyze the
impacts of a subsidy on market outcomes.
Subsidy reduces the cost

of production. Thus the
supply curve for the
product shifts vertically
downwards by the
amount of subsidy
provided.
9. Discuss the consequences of providing a subsidy on the
government.
Impact of subsidies on Producers:

Subsidies are monetary benefits provided to the
producer by the Government on account of production
of certain commodity.
Subsidies lead to increase in producer revenue. Due to
subsidy the supply curve (S-subsidy) will shift vertically
downwards by the amount of subsidy.
This reduces the cost of production and more is now
being supplied at every price.
9. Discuss the consequences of providing a subsidy on the stakeholders in a
market, including consumers, producers and the government.
Through the diagram, we can see,

initially the market was at
equilibrium with Qe being supplied &
demanded at Price (Pe).
Government provides subsidy WZ
per unit.
Producers lower their prices to P1
Increase output till a new equilibrium
is reached at Q1
The producer will however not pass
all the subsidy benefit to the
consumer.
Initial producer revenue was
OPeXQe which now increases to
ODWQ1.
government.
Impact of subsidies on
Consumers
Consumers will now consume
more of the product due to
lower prices. Consumers pay
less as the prices fall from Pe to
P1, however, they end up
consuming more from Qe to Q1.
It is difficult to say by how much
the consumer expenditure will
increase or fall as it will
depend on their relative saving
and extra expenditure.
government.
Impact of subsidies on
Government
Government will end up
paying a subsidy of P1DWZ.
Obviously, this will involve an
opportunity cost.
Government will have to
forego investments in other
sectors of the economy in
order to provide subsidy.
At the end of the day, the
burden usually lies on the
taxpayer.
government.
When PED is elastic

relative to PES
The consumers do not
benefit from a great fall
but, because their demand
is relative elastic, they
increase their consumption
by a significant amount.
government.
When PED is inelastic

relative to PES
Consumption of the product
is increased and so is the
revenue of the producer.
The consumer benefit from a
relatively large price fall,
but their demand is relative
inelastic, their consumption
does not increase by a
great amount.
9. Discuss the consequences of providing a subsidy on the stakeholders in
a market, including consumers, producers and the government.
The more inelastic the curve, the more the benefit

from the subsidy is kept by that party.
government.
Because total surplus in a market is lower under a

subsidy than in a free market, we can conclude that
subsidies create economic inefficiency, known as
deadweight loss.
The deadweight loss in the diagram above is given by
area H, which is the shaded triangle to the right of the
free market quantity.
Economic inefficiency is created by a subsidy because
it costs a government more to enact a subsidy than the
subsidy creates in additional benefits to consumers and
producers.
calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer
expenditure, producer revenue, government expenditure, consumer surplus and producer surplus).
Step 1
Use the linear functions given
to draw the relevant demand
and supply curves and to
identify the equilibrium price
and quantity.
 E.g. If the demand and

200P and QS = -400 +
400P.
Step 2
Change the supply function by adding the amount of the subsidy to P,
simplify the equation, and then draw the new supply curve.
 E.g. If the government grants a subsidy of $0.75 per unit, then the supply
function is changed, because the producers receive the subsidy and so the
price they receive rises by $0.75. Thus, the price in the equation is (P +
0.75) at each level.
 If we put this in the equation, we get QS = - 400 + 400(P + 0.75).
Then, we can simplify the supply function and draw the new supply curve.
 QS = - 400 + 400(P + 0.75)
 QS = - 400 + (400xP) + (400 x 0.75)
 QS = - 400 + 400P + 300
 QS = -100 + 400P
Step 3
Identify the effects that are requested by the question in terms of
price, quantity, consumer expenditure, producer revenue, government
revenue, consumer surplus or producer surplus.
 E.g. In the diagram above, the new equilibrium price is $3.50 and the
new quantity demanded is 1300 units.
Consumer expenditure goes from 1200 units at $4 = $4,800, to 1300
units at $3.50 = $4,550 – a decrease of $250.
Producer revenue, after receiving the subsidy of $0.75 per unit, goes
from 1200 units at $4 = $4,800 to 1300 units at $4.25 = $5,525 – an
increase of $725.
Government cost of the subsidy is 1300 units at a subsidy per unit of
$0.75 = $975.
The gains of consumer surplus and producer

surplus can be identified from the diagram and then
calculated.
The original consumer surplus was the triangle
4,10,Y. So it is the area of that, which is ½ x $6 x
1200 = $3,600.
The new consumer surplus is the triangle 3.50,10,Z.
So it is the area of that, which is ½ x $6.50 x 1300 =
$4,225.
The increase in consumer surplus is $4,225 - $3,600
= $625.
The original producer surplus was the triangle 4,1,Y. So it is the area of
that, which is ½ x $3 x 1200 = $1,800.
The new producer surplus is the triangle 4.25,1,X. So it is the area of that,
which is ½ x $3.25 x 1300 = $2,112.5.
The increase in producer surplus is $2,112.5 - $1,800 = $312.5.
 [Out of interest, community surplus, which is consumer surplus + producer
surplus, goes from $5,400 to $6,337.50. This is an increase of $937.50.
The cost of the subsidy to the government is $975 (see above). So, it
follows that the subsidy created a dead-weight loss of $975 - $937.50 =
$37.50. This occurs because the extra hundred units produced because of
the subsidy would not have been produced in a free market.
 The dead-weight loss is indicated by the triangle XYZ, and so it can also
be calculated by finding the area of that triangle, which is ½ x $.75 x
100 = $37.5.]
Step 1
Calculate the original equilibrium price and quantity from the
demand and supply functions.
 E.g. If the demand and supply functions for a product are
QD = 2000 – 200P and QS = -400 + 400P. Then equilibrium
can be calculated by setting the equations against each other,
so that:
 QD = QS,
 2000 – 200P = -400 + 400P
 2400 = 600P
 P = $4
Substitute $4 as P in either equation to get the equilibrium
quantity, which is 1,200 units.
Step 2
Rearrange the supply function to take account of the subsidy
that is given and then find the new equilibrium.
 E.g. If the government grants a subsidy of $0.75 per unit, then
the supply function is changed, because the producers will get
the subsidy and so the price they receive rises by $0.75 per
unit. Thus, the price in the equation is (P + 0.75) at each level.
If we put this in the equation, we get QS = - 400 + 400(P +
0.75).
Then, we can simplify the supply function.
 QS = - 400 + 400(P + 0.75)
 QS = - 400 + (400xP) + (400 x 0.75)
 QS = - 400 + 400P + 300
 QS = -100 + 400P
Now, equilibrium is where the old demand equation

meets the new supply equation:
 2000 – 200P = -100 + 400P
 2100 = 600P
 P = $3.50
Substitute $3.50 as P in either equation to get the new

equilibrium quantity, which is 1,300 units.
Step 3
Calculate the further effects that are requested by the
question in terms of consumer expenditure, producer
revenue, government revenue, consumer surplus or
producer surplus.
 E.g. Consumer expenditure goes from 1200 units at $4 =
$4,800, to 1300 units at $3.50 = $4,550 – a decrease
of $250.
Producer revenue, after receiving the subsidy of $0.75 per
unit, goes from 1200 units at $4 = $4,800 to 1300 units at
$4.252 = $5,525 – a rise of $725.
Government cost of the subsidy is 1300 units at a subsidy
per unit of $0.75 = $975.
10. Plot demand and supply curves for a product from linear functions and then
illustrate and/or calculate the effects of the provision of a subsidy on the market (on price,
quantity, consumer expenditure, producer revenue, government expenditure, consumer
surplus and producer surplus).
Videos:
Calculating the Effects of a Subsidy using Linear
Equations (HL Only)
The Effects of a Subsidy on Market Equilibrium

3.1 International trade (Restrictions on free trade: Trade
protection)
World price and comparative advantage
World price: The price of a good that prevails in the world

market for that good.
The effects of free international trade can be shown by
comparing the domestic price of a good without trade and
the world price of the good.
 If a country has a comparative advantage, the
domestic price will be below the world price, and
the country will be an exporter of the good.
 If the country has a comparative disadvantage,
the domestic price will be higher than the world
price, and the country will be an importer of the
good.
International Trade in an Exporting Country
World price of good Z > domestic price of good Z.

 Domestic producers increase production as the price
moves up to the world price.
 Domestic consumers decrease consumption as the price
moves up to the world price.
 The excess supply (surplus) will be exported to willing
buyers in another country.
The analysis of an exporting country yields two
conclusions:
 Domestic producers of the good are better off, and
domestic consumers of the good are worse off.
 Trade raises the economic well-being of the nation as a
whole because the gains of producers exceed the losses
of consumers.
Figure 3 How Free Trade Affects Welfare in an Exporting Country
Price
of Steel
Consumer surplus
before trade Domestic
Price supply
after A Exports
trade World
B D price
Price
before
C
trade
Producer surplus
before trade Domestic
demand
0 Quantity
of Steel
Copyright © 2004 South-Western
A Country That Exports Soybeans
P Soybeans
Without trade,
CS = A + B S
exports
PS = C A
$6
Total surplus B D
=A+B+C $4 gains
With trade, C from trade
CS = A D
PS = B + C + D Q
Total surplus
=A+B+C+D
International Trade in an Importing Country
World price of good T < domestic price of good T.

 Domestic producers decrease production as the price moves
down to the world price.
 Domestic consumers increase consumption as the price moves
down to the world price.
 The excess demand (shortage) will be satisfied by imports
from willing sellers in another country.
The analysis of an importing country yields two
conclusions
 Domestic producers of the good are worse off, and
domestic consumers of the good are better off.
 Trade raises the economic well-being of the nation as a whole
because the gains of consumers exceed the losses of
producers.
Figure 5 How Free Trade Affects Welfare in an Importing Country
Price
of Steel
Consumer surplus
after trade Domestic
supply
A
Price
before trade B D
Price World
after trade C price
Imports
Producer surplus Domestic
after trade demand
0 Quantity
of Steel
Copyright © 2004 South-Western
World price and comparative advantage
Summary: The Welfare Effects of Trade
PD < PW PD > PW
direction of trade exports imports
consumer surplus falls rises
producer surplus rises falls
total surplus rises rises
Whether a good is imported or exported,

trade creates winners and losers.
But the gains exceed the losses.
The Welfare Effects of Trade
11. Explain, using a tariff diagram, the effects of imposing a tariff on
imported goods on different stakeholders, including domestic producers,
foreign producers, consumers and the government.
Tariffs, or customs duties, are taxes on imported products,

usually in an ad valorem form, levied as a percentage
increase on the price of the imported product
The imposition of tariffs leads to the following:
 Higher prices
 Domestic consumers face higher prices, which also

means that there is a loss of consumer surplus. However,
there is a gain in domestic producer surplus as
producers are protected from cheap imports, and
receive a higher price than they would have without the
tariff. However, it is likely that there is an overall net
welfare loss.
11. Explain, using a tariff diagram, the effects of imposing a tariff on imported goods
on different stakeholders, including domestic producers, foreign producers, consumers
and the government.
The imposition of a tariff shifts up the world supply curve

to World Supply + Tariff. The result is that domestic
producers have been protected from cheaper imports
from the rest of the World.
Given that domestic consumers face higher prices, they
also suffer a loss of consumer surplus. In contrast,
domestic producers increase their producer surplus as
they receive a higher price than they would have without
the tariff.
Increased market share also means that jobs will be
protected in the domestic economy.
and the government.
and the government.
Welfare loss
However, the reduction in
consumer surplus is
greater than the increase
in producer surplus. Even
when adding the tariff
revenue (area K,L,M,N)
there is still a net loss. The
net welfare loss is
represented by the
triangles X and Y.
and the government.
Distortion
 There is a potential distortion of the principle of
comparative advantage, whereby a tariff alters the cost
advantage that countries may have built up through
specialization.
Retaliation
 There is the likelihood of retaliation from exporting
countries, which could trigger a costly trade war.
 However, in the short run tariffs may protect jobs, infant
and declining industries, and strategic goods. Tariffs
may also help conserve a non-renewable scarce
resource. Selective tariffs may also help reduce a trade
deficit, and reduce consumption.
Analysis of a Tariff
P
Cotton shirts
deadweight
free trade loss = D + F
CS = A + B + C
+D+E+F S
PS = G
Total surplus = A + B
+C+D+E+F+G A
tariff B
CS = A + B
$30
C D E F
PS = C + G $20
Revenue = E G
D
Total surplus = A + B Q
+C+E+G 25 40 70 80
Analysis of a Tariff
P
Cotton shirts
deadweight
D = deadweight loss loss = D + F
from the
overproduction S
of shirts
F = deadweight loss A
from the under- B
consumption $30
C D E F
of shirts $20
G
D
Q
25 40 70 80
12. Calculate from diagrams the effects of imposing a tariff on imported goods
on different stakeholders, including domestic producers, foreign producers,
consumers and the government.
12. Calculate from diagrams the effects of imposing a tariff on imported goods on
different stakeholders, including domestic producers, foreign producers, consumers and
the government.
Domestic producers previously sold 10 units at the world price

of $8. After the tariff, they are paid $10 and sell 15.
Domestic producers revenue before tariff:
P world X Q domestic = $8 X 10 = $80.
Domestic producer revenue after tariff:
P tariff X Q new domestic = $10 X 15 = $150.
Foreign producers receive the world price of $8, but their
imports are reduced from 20 units to 10.
Foreign produce revenue before tariff:
P world X Q imports = $8 X (30 – 10) = $160
Foreign produce revenue after tariff:
P world X Q new imports = $10 X (25 – 15) = $100
12. Calculate from diagrams the effects of imposing a tariff on imported goods on
different stakeholders, including domestic producers, foreign producers, consumers and
the government.
Consumer surplus is calculated as the area of the surplus triangle, ½ (base X height).
Consumer surplus before tariff:
½ ( highest price – P world ) X Q world = 0.5(20 – 8) X 30 = $180
Consumer surplus after tariff:
½ ( highest price – P tariff ) X Q world = 0.5(20 – 10) X 25 = $125
Government revenue is calculated as the amount of the tariff multiplied
by the number of imports.
Government revenue before tariff:
$ 0 = no tax collected
Government revenue after tariff:
(P tariff – P world) X Q new imports = ($10 - $8) X (25 – 15) = $20
Deadweight loss of tariff = 2(0.5(30-25)X($10-$8)) = $10
2.3 Macroeconomic Objectives (Equity in the distribution of
income) The role of taxation in promoting equity
13. Distinguish between direct and indirect taxes, providing
examples of each, and explain that direct taxes may be used as a
mechanism to redistribute income.
An indirect tax is a tax collected by an intermediary i.e. seller, from

the person who bears the ultimate economic burden of the tax i.e.
consumer.
 It is imposed on expenditure. In simple terms, it is a tax which
is imposed on goods and services sold. It is usually added to
the cost of the good or service and charged from the ultimate
consumer. The seller will then file a return to the government on
all the taxes he has collected from the consumer.
Examples
 GST (Goods and service tax)
 VAT (Value added tax)
 Consumers are charged a percentage of tax while purchasing

a good/service and then the seller pays the tax collected to
the Government.
13. Distinguish between direct and indirect taxes, providing examples of
each, and explain that direct taxes may be used as a mechanism to
redistribute income.
Direct Taxes
It is a tax paid directly to the government by the
persons on whom it is imposed.
Examples
 Tax imposed on peoples’ income-Income tax
 Tax on wealth – wealth Tax
 Tax on firm’s profits.- corporate tax

14. Distinguish between progressive, regressive and
proportional taxation, providing examples of each.
 Progressive Tax A tax in which people with

more income pay a larger percentage in taxes.
Example: Income tax (Direct Tax)
 Regressive Tax A tax in which people with
more income pay a smaller percentage in taxes.
Example: Sales Tax (Indirect Tax)
 Proportional Tax A tax in which people pay the
same percentage of income in taxes regardless of
their incomes.
Example: Flat Tax (Direct Tax)
Examples of the Three Tax Systems
regressive proportional progressive

% of % of % of
income tax tax tax
income income income
$50,000 $15,000 30% $12,500 25% $10,000 20%
100,000 25,000 25 25,000 25 25,000 25
200,000 40,000 20 50,000 25 60,000 30

15. Calculate the marginal rate of tax and the
average rate of tax from a set of data.
An average tax rate is the ratio of the total amount of

taxes paid to the total tax base (taxable income or
spending), expressed as a percentage.
 Let T be the total tax liability.
 Let B be the total tax base.
Average tax rate = T / B

15. Calculate the marginal rate of tax and the
average rate of tax from a set of data.
A marginal tax rate is sometimes defined as the tax rate that applies to
the last (or next) unit of the tax base (taxable income or spending).
In plain English, the marginal tax rate is the tax percentage on the highest
dollar earned. For example, in the United States, the top marginal tax
rate is 39.6%, but that rate applies only to earnings over $400,000 per
year; earnings under $400,000 have a lower tax rate of 33% or less.
That formal definition only holds true to the equation following when the
denominator equals one unit of the tax base. In practice most decisions
require the denominator to be a larger amount. The marginal tax rate
equals the change in taxes divided by the change in tax base, expressed
as a percentage.
 Let T be the total tax liability.
 Let B be the total tax base.
Marginal tax rate = T/ B

16. Explain that governments undertake expenditures to provide directly, or to subsidize, a
variety of socially desirable goods and services (including health care services, education,
and infrastructure that includes sanitation and clean water supplies), thereby making them
available to those on low incomes.
 Higher government spending on merit goods should yield

a positive social rate of return which leads to an
improvement in total economic welfare.
 There is a case for some form of government intervention
to encourage increased consumption of merit goods. This
might take the form of an explicit government subsidy to
reduce the private marginal costs of consumption and
cause an expansion of demand.
 The government often provides merit goods "free at the
point of use" and then finances them through general
taxation.
 Examples of merit goods that are largely state provided
include primary health care and public schooling.
17. Explain the term transfer payments, and provide examples,
including old age pensions, unemployment benefits and child
allowances.
A transfer payment is a payment from the government to

an individual for which no good or service is exchanged. In
order to be eligible to receive them, an individual has to
fall below a certain income threshold or to be experiencing
economic hardship.
Transfer payments existing in most developed countries
include:
 Unemployment benefits
 Social security benefits
 Nutritional subsidies
 Higher education grants and tuition subsidies
 Welfare benefits
18. Evaluate government policies to promote equity (taxation, government
expenditure and transfer payments) in terms of their potential positive or negative
effects on efficiency in the allocation of resources.
A tax system that punishes innovation, productivity and

hard work is clearly undesirable and should therefore
be avoided. However, a tax system including
progressive marginal income taxes combined with
regressive indirect taxes ensures that both the rich and
the poor share a portion of the nation’s tax burden. Yet
it also ensures that those with the greatest ability to pay
bear the largest burden while those whose ability to
pay the lowest benefit from the public and transfer
payments that the government provides. This reduces
the inequality of income distribution and corrects for the
market failures that results in a free market system.
 Progressive Tax A tax in which people

with more income pay a larger percentage in taxes.
 Regressive Tax A tax in which people with
more income pay a smaller percentage in taxes.
 Proportional Tax A tax in which people pay the
same percentage of income in taxes regardless of
their incomes.
 in-kind transfers transfers to the poor given in
the form of goods and services rather than cash
Section 1.3: Government intervention
Price controls
19. Explain why governments impose price ceilings, and describe
examples of price ceilings, including food price controls and rent controls.
Price ceiling:
A legal maximum on the price at which a good or service
can be sold.
A price ceiling may be set to prevent price from rising
beyond a pre-determined level.
A price ceiling will only have an effect on the market if it is
set below the prevailing market clearing price.
A price ceiling is also called a maximum price, and may be
used if it is felt that the resource or commodity should be
more widely available, as in the case of food or medicines,
or where there are specific historical, political or cultural
reasons why allowing price to rise to its natural level.
19. Explain why governments impose price ceilings, and describe
examples of price ceilings, including food price controls and rent controls.
The purpose of a price

ceiling is to protect
consumers of a certain
good or service.
By establishing a
maximum price, a
government wants to
ensure the good is
affordable for as many
consumers as possible.
Rent control is an
example of a price ceiling.
20. Draw a diagram to show a price ceiling, and analyze the
impacts of a price ceiling on market outcomes.
A price ceiling has an economic impact only if it is less than the

free-market equilibrium price.
An effective price ceiling will lower the price of a good, which
decreases the producer surplus.
The effective price ceiling will also decrease the price for
consumers, but any benefit gained from that will be minimized by
the decreased sales due to the drop in supply caused by the
lower price.
If a ceiling is to be imposed for a long period of time, a
government may need to ration the good to ensure availability
for the greatest number of consumers.
Prolonged shortages caused by price ceilings can create black
markets for that good.
EXAMPLE 1: The Market for Apartments
Rental P S
price of
apts
$800
Eq’m w/o
price controls
D
Q
300
Quantity of
apartments
How Price Ceilings Affect Market Outcomes
P S
Price
A price ceiling $1000
ceiling
above the
equilibrium price $800
is
not binding –
it has no effect on
the market D
outcome. Q
300
P S
The equilibrium
price ($800) is
above the ceiling
and therefore $800
illegal.
Price
The ceiling $500
is a binding ceiling
constraint shortage
on the price, and D
Q
causes 250 400
a shortage.
P S
In the long run,
supply and
demand $800
are more
Price
price-elastic. $500
ceiling
So, the shortage shortage
is larger. D
Q
150 450
21. Examine the possible consequences of a price ceiling, including shortages,
inefficient resource allocation, welfare impacts, underground parallel markets and
non-price rationing mechanisms.
With a shortage, sellers must ration the goods among

buyers.
Some rationing mechanisms: (1) long lines
(2) discrimination according to sellers’ biases
These mechanisms are often unfair, and inefficient:
the goods don’t necessarily go to the buyers who value
them most highly.
In contrast, when prices are not controlled,
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal.
22. Discuss the consequences of imposing a price ceiling on the
government.
Who benefits and who loses from this

policy?
Depends. There are 200,000 fewer
apartments supplied in the market at
this lower price, so both consumers and
producers lose out by not renting out
apartments.
This is the dead-weight loss triangle
(DWL) in the graph. Those consumers
who manage to find an apartment at
this lower price gain because they now
pay a price $200 lower than before, so
their consumer surplus goes up (CS).
Suppliers are the clear losers. They rent
out fewer apartments and the producer
surplus in the economy goes down (PS).
22. Discuss the consequences of imposing a price ceiling on the
government.
What Can the Government do about the
shortage created by the Binding Ceiling?
Without Govt. interference, the market will be left with a

shortage or excess demand.
This could lead to illegal markets, long lines, bribery, etc…
The Govt. could try to shift the demand curve to the left by
providing subsidies for alternatives.
The Govt. could try to shift the supply curve to the right by
(i) subsidies to the producers to produce more,
(ii) the Govt. could provide the good or service themselves,
(iii) if the Govt. had stored some of the product they could
release it to the market (buffer stocks).
23. Calculate possible effects from the price ceiling diagram, including the
resulting shortage and the change in consumer expenditure (which is
equal to the change in firm revenue).
Step 1
and to identify the
quantity.
E.g. If the demand and supply
functions for a product are
QD = 2000 – 200P and QS
= -400 + 400P.
Step 2
Draw the ceiling price onto the
diagram, below the equilibrium
price.
Then indicate the quantity
demanded and the quantity
supplied at the ceiling price.
Then calculate the shortage
(excess demand) that is created by
imposing the ceiling price.
E.g. The government decided to
impose a maximum price of $3.
The quantity demanded is now
1,400 units and the quantity
supplied is 800 units, so the excess
demand (shortage) is 600 units.
Step 3
Calculate from the diagram total
expenditure and changes in
expenditure.
E.g. The total expenditure on the
product before the ceiling price was
$4 x 1200 units = $4,800.
The total expenditure on the product
after the ceiling price was $3 x 800
units = $2,400.
Expenditure has fallen by $2,400 or
50%.
[Remember that the expenditure of
the consumers is the same as the
revenue of the producers.]
resulting shortage and the change in consumer expenditure (which is equal to
the change in firm revenue).
Step 4
Calculate any further effects that are requested by the
question, in terms of the subsidy that might be necessary to
eliminate the excess demand created by the minimum price
and the total government expenditure on the subsidy.
E.g. If there is an excess demand of 600 units, then the
government, if they wish to rectify this, will need to shift the
supply curve to the right by 600 units at every price.
This would add 600 units to the supply function:
Originally: QS = -400 + 400 P
Now, it would need to be:
QS1 = -400 + 600 + 400P = 200 + 400P.
resulting shortage and the change in consumer expenditure (which is equal to
the change in firm revenue).
As we can see from the diagram,

producers will now produce at the
equilibrium, where 1,400 units are
demanded and supplied at a price
of $3.
We can see from the original
supply curve, without the subsidy,
that in order to supply 1400 units,
the producers need to receive
$4.50.
Thus, the subsidy per unit is $1.50.
The total subsidy payment by the
government will be 1,400 x $1.50
= $2,100.
24. Explain why governments impose price floors, and describe examples of
price floors, including price support for agricultural products and minimum wages.
Price floor:
A legal minimum on the price or service at which a good can be
sold.
A price floor, which is also referred to as a minimum price, sets the
lowest level possible for a price.
Price floors, and minimum prices, only have an effect if they are
set above the actual market clearing price.
There are many instances of governments in the real world setting
price floors, such as setting a national minimum wage for labor
to ensure that individuals are able to earn a ‘living wage’.
In addition, given the instability of agricultural prices and the
need to ensure food security, farm prices may be set which
guarantee a minimum price to farmers.
25. Draw a diagram of a price floor, and analyze the
impacts of a price floor on market outcomes.
EXAMPLE 2: The Market for Unskilled Labor
Wage W S
paid to
unskilled
workers
$4
Eq’m w/o
price controls
D
L
500
Quantity of
unskilled workers
How Price Floors Affect Market Outcomes
W S
A price floor
below the
equilibrium price $4
is
Price
not binding – $3
floor
it has no effect on
the market D
outcome. L
500
How Price Floors Affect Market Outcomes
labor
W surplus S
Price
The equilibrium wage $5 floor
($4) is below the floor
and therefore $4
illegal.
The floor
is a binding constraint
on the wage,
and causes D
L
a surplus 400 550
(i.e., unemployment).
The Minimum Wage
Min wage laws unemp-
do not affect W loyment S
highly skilled Min.
$5
workers. wage
They do affect $4
teen workers.
Studies:
A 10% increase
in the min wage D
raises teen L
400 550
unemployment
by 1-3%.
26. Examine the possible consequences of a price floor, including surpluses and
government measures to dispose of the surpluses, inefficient resource allocation
and welfare impacts.
A price floor is economically consequential if it is

greater than the free-market equilibrium price.
Price floors lead to a surplus of the product.
Supply surpluses created by price floors are generally
added to producer's inventory or are purchased by
governments.
Consumer surplus is the gain obtained by consumers
because they can obtain a product for a lower price
than they would be willing to pay.
Producer surplus is the benefit producers get by
selling at a price higher than the lowest price they
would sell for.
27. Discuss the consequences of imposing a price floor on the
government.
Who wins and who loses with this

policy?
Clearly consumers lose because they
now pay higher prices (CS in the graph
on the right is smaller) and there are
some consumer that are not going to
buy, so there is dead-weight loss (DWL)
on the consumer side.
On the producer side, there are some
producers who will not trade, so there is
also some dead-weight loss (DWL) on
the producer side.
But, for those producers who do sell
their product at a higher price, they
gain more producer surplus (PS).
Note how producer surplus has
increased for those who sell.
27. Discuss the consequences of imposing a price floor on the
government.
27. Discuss the consequences of imposing a price floor on the stakeholders
in a market, including consumers, producers and the government.
What Can the Government do about the
surplus created by the Binding floor?
Without Govt. interference, the market will be left with a

surplus.
This will lead to overall less demand and or sellers trying to
get around the high prices by selling below the floor price
which will be illegal.
The Govt. could buy up the surplus from the producers.
The surplus could then either be stored, destroyed or sold
abroad all of which create their own set of problems.
The Govt. could subsidies the purchase of the good or
service to increase the demand for it.
They could also advertise to increase demand or they could
use a Quota.
28. Calculate possible effects from the price floor diagram, including the resulting
surplus, the change in consumer expenditure, the change in producer revenue,
and government expenditure to purchase the surplus.
Step 1
and to identify the
quantity.
E.g. If the demand and
200P and QS = -400 +
400P.
Step 2
Draw the floor price onto the
diagram, above the equilibrium
price.
Then indicate the quantity
demanded and the quantity
supplied at the floor price.
Then calculate the surplus (excess
supply) that is created by
imposing the floor price.
E.g. The government decided to
impose a minimum price of $5.
The quantity demanded is now
1,000 units and the quantity
supplied is 1,600 units, so the excess
supply (surplus) is 600 units.
Step 3
Calculate from the diagram the total amount that the
government would have to pay to buy up the surplus.
This would be the excess supply times the minimum price.
 E.g. The government would need to buy 600 units at $5 per
unit = $3,000.
Step 4
Calculate the total income of the producers. This will come
from sales to the consumers and sales to the government.
 E.g. The consumers will sell 1,600 units at a price of $5 =
$8,000. They will receive $5,000 from the consumers (1000
units x $5) and $3,000 from the government (600 units x $5).
Buffer stock scheme
The prices of agricultural products such as wheat, cotton,
cocoa, tea and coffee tend to fluctuate more than prices of
manufactured products and services.
This is largely due to the volatility in the market supply of
agricultural products coupled with the fact that demand and
supply are price inelastic.
One way to smooth out the fluctuations in prices is to
operate price support schemes through the use of buffer
stocks. But many of them have had a chequered history.
Buffer stock schemes seek to stabilize the market price of
agricultural products by buying up supplies of the product
when harvests are plentiful and selling stocks of the
product onto the market when supplies are low.
Buffer stock scheme
A target price can be

achieved through
intervention buying and
selling.
The buffer stock
managers are likely to
establish a price ceiling,
above which
intervention selling will
occur, and a price floor,
below which
intervention buying will
take place.
Commodity agreement
Commodity agreements are arrangements between
producing and consuming countries to stabilize markets and
raise average prices.
Such agreements are common in many markets, including the
market for coffee, tea, and sugar.
The market for commodities is particularly susceptible to
sudden changes in conditions of supply conditions, called
supply shocks.
Shocks such as bad weather, disease, and natural disasters
are largely unpredictable, and cause commodity markets to
become highly volatile.
In comparison, markets for the final products derived from
these commodities are much more stable.
Commodity agreement
Commodity agreements often involve intervention
schemes, such as buffer stocks, and usually only last for
a few years, whereupon they are re-negotiated.
They differ from cartels such as OPEC, largely because
discussions and negotiations involve both producer and
consumer countries, unlike cartels, which are established
to protect the interest of producers only.
Example - The International Cocoa Agreement

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1.

3 GOVERNMENT INTERVENTION (INDIRECT TAXES & SUBSIDIES)

Why Governments Intervene In Markets:

Specific tax is a flat rate of tax whereas ad valorem tax is

Imposition of tax results in three economic

Incidence or tax burden

If the tax does not change the product’s price or factor

With the tax,

Because of the tax, the

When PED is greater than PES

When PES is greater than PED

PED is equal to PES

Examining the Effect of an Excise Tax on an Elastic

 If buyers’ price elasticity > sellers’ price elasticity,

 2000 – 200P = -400 + 400P

Substitute $4 as P in either equation to get the equilibrium quantity, which

Now, equilibrium is where the old demand equation

Substitute $4.50 as P in either equation to get the new

Subsidy reduces the cost

Impact of subsidies on Producers:

Through the diagram, we can see,

When PED is elastic

When PED is inelastic

The more inelastic the curve, the more the benefit

Because total surplus in a market is lower under a

supply functions for a

 QS = - 400 + (400xP) + (400 x 0.75)

 QS = - 400 + 400P + 300

The gains of consumer surplus and producer

Now, equilibrium is where the old demand equation

Substitute $3.50 as P in either equation to get the new

The Effects of a Subsidy on Market Equilibrium

World price: The price of a good that prevails in the world

World price of good Z > domestic price of good Z.

World price of good T < domestic price of good T.

direction of trade exports imports

consumer surplus falls rises

producer surplus rises falls

total surplus rises rises

Whether a good is imported or exported,

Tariffs, or customs duties, are taxes on imported products,

 Domestic consumers face higher prices, which also

The imposition of a tariff shifts up the world supply curve

Domestic producers previously sold 10 units at the world price

An indirect tax is a tax collected by an intermediary i.e. seller, from

 VAT (Value added tax)

 Consumers are charged a percentage of tax while purchasing

 Tax on wealth – wealth Tax

 Tax on firm’s profits.- corporate tax

 Progressive Tax A tax in which people with

regressive proportional progressive

$50,000 $15,000 30% $12,500 25% $10,000 20%

100,000 25,000 25 25,000 25 25,000 25

200,000 40,000 20 50,000 25 60,000 30

An average tax rate is the ratio of the total amount of

 Let B be the total tax base.

Average tax rate = T / B

 Let B be the total tax base.

Marginal tax rate = T/ B

 Higher government spending on merit goods should yield

A transfer payment is a payment from the government to

 Social security benefits

 Higher education grants and tuition subsidies