Source: Image of Tax Graph created by Kate Eskra, Images of Tax Incidence with Inelastic & Elastic Demand / Inelastic & Elastic Supply created by Kate Eskra, Image of Subsidy Graph created by Kate Eskra, Images of Subsidy Incidence on Elastic/Inelastic Demand created by Kate Eskra
Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on Taxes and Subsidies. As always, my key terms are in red, and my examples are in green. So in this tutorial we'll be looking at the effect of taxes and subsidies on both consumers and sellers. And we'll talk about how elasticity of both demand and supply actually affects who bears the burden, or receives either the tax or the subsidy.
So we're certainly all aware that we pay taxes. And we know we pay taxes on our income at three levels-- local, state, and federal. We also pay a lot of taxes on goods and services. What we do in economics is we look at how this alters the market outcomes. So you'll see a graph. And you'll notice how the equilibrium quantity being purchased or being supplied is impacted. And it also definitely impacts the price that we pay.
So as your key term here, tax is defined as an additional cost of supply or purchase, levied to alter consumer behavior and/or to increase government revenue. So the purpose of a tax could be either to change our behavior to get us to buy less of something, or to increase government revenue, or a combination of the two.
So here's your graph of a tax. This is just a basic graph here. And let's just make a specific example. Let's say that we're taxing cigarettes. That's a really common example of a tax. In the case of a tax, what it does since it's an increased cost to the producer, anything that's an increased cost will shift supply. And when we shift supply that is going to increase the price. So the original equilibrium was here at Q1 and P*.
With a decrease in supply that's movement along the demand curve, and the new market price being paid is Pc, as I've indicated there. But the price that producers are going to receive is actually down here. Because the amount of the tax is the distance between the supply curves. And notice we are purchasing a lower quantity, as the price we pay rises. That's the law of demand. As prices go up, we buy a lower quantity.
OK. But who is really impacted? What is the tax incidence? That's the next question. And tax incidence is the economic burden of a tax. So who bears the burden? Is it the consumer? Is it the producer? Is it a combination? Generally, it's going to be a combination. But we can look and see who bears more of the burden.
It depends on the good or service, certainly. And it all has to deal with the concept of elasticity. And we know the elasticity measures the change in either quantity demanded or supplied, showing the sensitivity of one variable to characteristics of another variable, so how responsive is something to something else, basically.
So here we have an inelastic demand curve. Notice how it is pretty straight up and down. And that's a very inelastic demand curve, meaning that consumers are not very responsive to a price change. So what's going on here is as we shift supply to the left, and this is the amount of the tax. Remember the distance between the supply curves is the tax. Producers with this inelastic demand can really raise price a whole lot. You can see from P1 to P2 how much they can raise price. They're not losing a lot in sales. So here consumers bear this amount of the burden in the form of higher prices. And really this little amount is all that the producers will bear in terms of the burden.
Similarly, if we look at something with very elastic supply it's going to have a very similar outcome. Because you can notice here that they can raise price pretty significantly, and the burden that they would bear would just be this tiny little mount here. So consumers are going to bear most of the burden in the form of higher prices when either demand is inelastic or supply is elastic.
An opposite situation is if we have very elastic demand compared to supply. Here notice how the producers really cannot raise price much at all, as the supply shifts up into the left. So this is the amount that consumers bear the burden, which is not as much at all. But the producers here are going to have to bear a lot of the burden in the form of the tax. So they'll have to pay most of the tax. And even with that little increase in price, notice the change in quantity. That's because we, as consumers, are very responsive to the price change with elastic demand.
And now the only other one left is a very inelastic supply. And again, this will have a very similar outcome as with the elastic demand. So with elastic demand and inelastic supply, the price cannot be raised very much at all. So producers will bear the majority of the burden.
OK. So one thing that I just wanted to note here before we move on to subsidies, is that actually some items, a lot of items in fact, have different elasticities along their demand curve. It's not consistent. So some, like cigarettes or alcohol, I'm indicating here have kind of elastic demand at lower prices. So when they raise the tax initially, it can generate a pretty decent response in terms of consumers cutting back on buying cigarettes. Maybe the people who were on the border, wanted to quit anyway, or just are casual smokers, they might cut back now that they have to pay a tax.
But as that tax gets higher and higher and higher, now you've reached the sort of inelastic portion of the demand curve for cigarettes. Because these are people who, they haven't responded to the price change. They're probably not going to respond to the price change. They are addicted to cigarettes and they are going to continue smoking, pretty much regardless of price. So the impact of the tax can really be different as it gets higher and higher, because of that characteristic of some of these items.
OK. Let's talk about subsidies now. A subsidy is this sum paid, typically by the government, to either suppliers or consumers to assist in the production or purchase of a good or service. The point of a subsidy is to get supply increased. So here really we're just reversing the process. You're going to notice that supply will be obviously increasing whenever there is a subsidy, not decreasing as with the tax. So when we shift the supply curve to the right that's now taking the initial price and quantity, as you can see here. The price that consumers are paying is now lower. And the price that producers are receiving, because the amount of the subsidy is the distance between the two supply curves, is up here at Pp.
Now keep in mind that to fund this subsidy we would have to take tax revenue from some other source in order to fund this. OK. And again, we can go through the exact same exercise. But really it's a little different here, because it's not about anymore who is bearing the burden, but instead it's who collects the subsidies. So it's the opposite mentality that we're using here.
I'm starting with an elastic demand. And with elastic demand you can see that producers are actually going to receive more of it. Because the price doesn't go up very much, people buy a lot more. They're much more responsive. But the price does not fall by very much. With subsidies prices fall with an increase in supply. But the producers actually receive more of it, because people are buying a greater quantity.
With inelastic demand consumers are actually going to receive more of it. Whereas with a tax, this was different. Here you can see that's the portion that consumers are receiving. And that little portion there would be how much the producers would receive.
So in this tutorial we looked at the effects that taxes and subsidies have on the prices paid by consumers and producers. And we talked a lot about how depending on the elasticity of the supply and demand, one really might bear the burden more than the other. Thank you so much for listening. Have a great day.
An additional cost of supply or purchase levied to alter consumer behavior and/or increase government revenue.
Sum paid (typically by a government entity) to either suppliers or consumers to assist in the production or purchase of a good or service.
The economic "burden" of a tax.
Measurement of change in quantity demanded (supplied) which indicates the sensitivity of one variable to characteristics of another variable or income.