Correcting Market Failure

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Correcting Market Failure Subsidies and Taxation

Copyright 2005 – Biz/ed

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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

Copyright 2005 – Biz/ed

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Subsidies and Taxation • 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

Copyright 2005 – Biz/ed

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Price

Subsidies and Taxation S

£14 £10

S + Subsidy Total cost of the subsidy

Amount of subsidy per unit (£4) The The amount subsidy of of the will subsidy encourage subsidy is is to Firsteffect we look atthe the market the reduce suppliers vertical prices offer and more increase between for the before thetodistance subsidy the amount sale two at supply available every price curves – but at what cost?

£7

D 500

700

Quantity Bought and Sold Copyright 2005 – Biz/ed

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Subsidies and Taxation • 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 Copyright 2005 – Biz/ed

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Subsidies and Taxation • 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 Copyright 2005 – Biz/ed

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Subsidies and Taxation • 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

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Incidence of a tax on petrol

Price p per litre

S + tax S Amount of tax = 3p per litre

76.8 Tax burden of Tax Revenue consumer

74

The The Some The producer amount tax of the effectively of tax has the isto passed tax increases carry is the the on rest to the of Petrol has an inelastic the vertical consumer the burden. cost distance ofin With production, the an form between inelastic of shifting higher thedemand two demand curve this supply prices supply may–curves not to this the be isleft the burden very much! of tax

Tax burden of producer

D 50 49.5

Quantity Bought and Sold (000s litres per day) Copyright 2005 – Biz/ed

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

S + Tax

£9 £7

S

Burden on Consumer

Total Tax Paid Burden on Producer

Amount of the tax (£6) D

£3 500

900

Quantity Bought and Sold Copyright 2005 – Biz/ed