1.

3: Government Intervention
Definitions
1. Indirect tax is a tax on expenditure that is ‘hidden’. It raises the firm’s costs and shifts the
supply curve for the product vertically upwards by the amount of tax.
2. Specific tax is an indirect tax where a specific amount is added to the selling price of
each unit. It is represented as a vertically upward, parallel shift of the supply curve.
3. Ad valorem tax is an indirect tax where a percentage is added to the selling price of each
unit. It is represented as a vertically upward, divergent shift of the supply curve.
4. Subsidy is the amount of money paid by the government, per unit of output, aiming at
lowering costs and increasing the production and consumption of the product. It is
represented by a downward shift of the supply curve by the amount of subsidy.
5. Maximum price (price ceiling) is a price usually set by an authority below the
equilibrium determined price. Prices are not allowed to rise above this price, and it is
aimed at protecting consumers from higher prices. Maximum price may be imposed in
markets where the product is a necessity or a merit good. Examples include agricultural
and food markets and housing rentals.
6. Minimum price (price floor) is a price usually set by an authority above the market
equilibrium price. The market price cannot go below this price, as they are usually
implemented to protect producers, particularly those producing essential products.
Examples include agricultural products in the EU.

Indirect tax
● Taxes imposed upon expenditure.
● Raises the firm’s cost and shifts the supply curve upwards.
● Two types of indirect tax:
❖ Specific tax
➢ Specific, fixed amount of tax that is imposed upon a product.
➢ Shifts the supply curve upwards by the amount of tax.
❖ Ad valorem tax
➢ Tax is a % of the selling price.
➢ Supply curve will shift upwards, and the gap between the supply curve and the
supply curve with tax gets bigger as the price of the product rises.

● Evaluation:
❖ Only means of reaching the poor. - contributing to the economy.
❖ Reduce the consumption of demerit goods.
 ❖ Indirect taxes on necessities and merit goods = increase in revenue.
❖ Discourage industries when raw materials are taxed.
❖ Shops charge more for products so that there’s more revenue, regardless of
indirect tax imposed on those products.
❖ Rich and poor people pay the same amount of money, which is seen unfair
by the society.
● Incidence of indirect tax
○ When PED is elastic and PES is inelastic, i.e. PED > PES, there’s more tax
burden for producers than for consumers as producers can’t pass the burden to
consumers because if they did, consumers would stop buying the product.
○ When PED is inelastic and PES is elastic, i.e. PED < PES, there’s more tax
burden for consumers than for producers as only few customers would stop
buying the products as the product is a need, not a want.
○ When PED and PES are equal, the tax burden is equal to both consumers and
producers.

Market for Market for

Alcohol (PED = PES) Alcohol (PED > PES)

S+tax S S+tax S

P1
Price P1 Price
Of Pe Of Pe
Alcohol ($) C Alcohol ($) C
Market for DMarket for
Alcohol (PED < PES) Alcohol (Ad valorem tax)
D
S+tax S S+tax S
Q1
Qe Q1
Price P1 Quantity of Qe
Price P1
Alcohol
Of (units)
Pe Of Pe Quantity of
Alcohol ($) Alcohol ($)
Alcohol (units)
Purple box = Consumer surplus, Yellow box = Producer surplus
D
Subsidy C
● Amount of money paid by the government to a firm per unit of output.
D
● Shifts the supply curve downwards by the amount of subsidy.
● Same incidence effect as indirect taxes in terms of PED and PES.
Q1 Qe
Q1
Qe Quantity of
Quantity of Alcohol (units)
Alcohol (units)
 Market for health care
S

W
S+subsidy
Price D
Of Pe X
Health care ($)
P1 Z
P2 Y D

Qe Q1
● Producer revenue: 0 + Pe + X + Qe → 0 + P1 + Z + Q1.
Quantity of health care (units)
● Consumer expenditure → P1 + Pe + X + 0.5Y → Qe + Y + Z + Q1.
● Government spending → 0 → P1 + D + W + Z.
● Evaluation:
○ There’s an opportunity cost involved with spending on the subsidy in terms of
spending on other government-related projects.
○ Firms might become inefficient if they don’t have to compete with foreign
producers in a free market.
○ Part of the subsidy also goes to taxpayers → Raises the question on who pays
the taxes to the government.
○ Subsidy → Overproduction of products → Damaging for farmers, especially
the ones in developing countries.
○ High-income farmers are occasionally blamed for dumping their products in
developing countries for lower production costs.

Maximum price controls/Price ceiling

● Situation where the government sets a price below the equilibrium price.
● PRevents producers from raising the price above the equilibrium.
● Usually set to protect consumers.
● Normally imposed in markets for necessity or a merit good.
● Leads to excess demand → Shortage of the product.
 Market for Wheat
D

Price
Of Pe
Wheat ($)
Pmax
S

Q1 Qe Q2
● Evaluation:
Quantity of Wheat (tons)
○ Excess demand → Emergence of a black market, where the product is sold at
high price between maximum price and equilibrium price.
○ Long line of queues → Producers decide who they are allowed to buy the
products they are selling.
○ Governments could decrease demand of the product until it reaches equilibrium.
■ Reduces consumption → Goes against the purpose of maximum price.
○ Governments could also increase supply of the product until it reaches
equilibrium.
■ This can be done through providing subsidies, governments producing the
product themselves or releasing some of the stored goods into the market.
■ This could lead to an opportunity cost as firms could use the money for the
above options for other use in the economy.

Minimum price/Price floor

● Situation where the government sets a minimum price above the equilibrium price.
● Prevents producers from reducing the price below it.
● Usually set to raise incomes for producers for products for merit goods and to protect
workers by setting minimum wage.
● Lead to excess supply → Surplus for the product.
 Market for Wheat
D

Pmin
Price
Of Pe
Wheat ($)

Q1 Qe Q2
● Evaluation:
Quantity of Wheat (tons)
○ Excess supply → High levels of stock for firms → Higher production costs.
○ Governments could eliminate excess supply by buying up the surplus products
at the minimum price → Shifts the demand curve to the right.
○ Governments could then store the surplus, destroy it or sell it abroad.
○ Destroying the products would be wasteful since it can be used for future use
when the firms run out of shortage of the product.
○ Selling surplus abroad → Angry reactions from foreign governments as they
feel that the products are being dumped and will harm domestic industries.
○ Opportunity cost in spending on the surplus and on funding for other merit goods.
○ Minimum price can be maintained by limited quotas or advertising/restricting
the supplies of the imported products through protectionist policies →
Increases demand for the domestic products.
○ Firms might think they don’t have to be cost-conscious → Inefficiency and
wastage of resources.
○ Firms might produce more of the protected product than they should and less of
other products that they could produce more efficiently.
Paper 3 Questions

Indirect tax

A country has a competitive demand for cigarettes. Demand for cigarettes is given by Qd = 30 -
2P and supply for cigarettes by Qs = 10 + 3P, where P is price in $ and Qd and Qs are the
quantity of cigarettes demanded and supplied per day.

1. Calculate the equilibrium price and quantity in the cigarette market.

30 - 2P = 10 + 3P Qd = 30 - 2 * $4 = 30 - 8
-10 + 2P -10 + 2P Qd = 22 units
5P = 20
5 5 Qs = 10 + 3 * $4 = 10 + 12
P = $4 Qs = 22 units

Equilibrium price = $4, Equilibrium quantity = 22 units

2. The government imposes an indirect tax of $5 per unit of cigarette packet sold. Draw the new
supply curve in the diagram.

20

19
S + tax
18

17

16
S
15

14

13 2 4 6 8 10 12 14 16 18 20 22 24
26 28 30 32 34 36 38 40
12 Quantity of Cigarettes
Price of (units)
3. State the new11
supply curve. Use the demand function and the new supply curve to calculate
the post-tax equilibrium price and quantity. D
Cigarette
s 10
($)
9
 7

Qs = -5 + 3P 5 Qd = 30 - $7 * 2 = 30 - 14
Qd = 16 units
4
-5 + 3P = 30 - 2P Qs = -5 + $7 * 3 = -5 + 21
+5 +2 P + 5 +2P3 Qs = 16 units
5P = 35
5 5 Equilibrium price = $7
P = $7 2 Equilibrium quantity = 16 units

1
4. Calculate the consumer surplus, producer surplus, government revenue and loss of consumer
and producer surplus.
Consumer surplus = 0.5 * ($15 - $7) * 16 units
Consumer surplus = $64

Producer surplus = 0.5 * ($7 - $1.67) * 16 units

Producer surplus = $42

Government revenue = ($7 - $2) * 16 units

Government revenue = $80

Loss of consumer and producer surplus = 0.5 * (22 - 16 units) * ($7 - $2)
Loss of consumer and producer surplus = $15

5. Calculate the amount of tax paid by consumers and producers.

Amount of tax paid by consumers = ($7 - $4) * 16 units
Amount of tax paid by consumers = $48

Amount of tax paid by producers = ($4 - $2) * 16 units

Amount of tax paid by producers = $32

Subsidy
Demand for textbooks is given by Qd = 80 - 3P and supply for cigarettes by Qs = 40 + 2P, where
P is price in $ and Qd and Qs are the quantity of textbooks demanded and supplied per day.

1. Calculate the equilibrium price and quantity in the textbook market.

80 - 3P = 40 + 2P Qd = 80 - 3 * $8 = 80 - 24
-40 + 3P -40 + 3P Qd = 56 units
5P = 40
5 5 Qs = 40 + 2 * $8 = 40 + 16
P = $8 Qs = 56 units

Equilibrium price = $8, Equilibrium quantity = 56 units

2. The government imposes an subsidy of $10 per unit of textbook sold. Draw the new supply
curve in the diagram.

20
S
19

18

17
S
16
S+subsidy
15

14

13

12 4 8 12 16 20 24 28 32 36 40 44 48 52 56
Price of 60 64 68 72 76 80
11 Quantity of T (units)
Textbooks D
10
($)
3. State the
9 new supply curve. Use the demand function and the new supply curve to calculate
the post-subsidy equilibrium price and quantity.
8

6
 5

3
Qs = 60 + 2P Qd = 80 - $4 * 3 = 80 - 12
2 Qd = 68 units

80 - 3P = 60
1 + 2P Qs = 60 + $4 * 2 = 60 + 8
-60 +3 P -60 +3P Qs = 68 units
5P = 20
5 5 Equilibrium price = $4
P = $4 Equilibrium quantity = 68 units

4. Calculate the change in consumer expenditure and producer revenue.

Change in consumer expenditure = ($4 * (68 - 56 units)) - (($8 - $4) * 56 units)
Change in consumer expenditure = $48 - $224
Change in consumer expenditure = $176 decrease

Change in producer revenue = ($14 * 68 units) - ($8 * 56 units)

Change in producer revenue = $952 - $448
Change in producer revenue = $504 increase

5. Calculate the the total expenditure by the government.

Total expenditure by the govt. = ($14 - $4) * 68 units = $10 * 68 units
Total expenditure by the govt = $680

Minimum price

The government decides to impose a minimum price on cigarettes at $11.

1. Draw the minimum price on the graph below

20

19
S
18

17

16
Min price
15

14

13 2 4 6 8 10 12 14 16 18 20 22 24
26 28 30 32 34 36 38 40
2. Calculate the excess supply (surplus) of cigarettes.
12 Quantity of Cigarettes
Excess supply.Price
= (0.5of
* (16 - 8
(units) units) * ($11 - $7)) + (0.5 * (28 - 16 units) * ($11 - $7))
Excess supply =11$16 + 24
Excess supply = $40
Cigarette
s 10 D
3. Calculate the change
($) in consumer expenditure
9 expenditure. = (28 - 8 units) * $11 - $7 * 16 units
Change in consumer
Change in consumer expenditure = $220 - $112
Change in consumer
8 expenditure = $108 increase