What this lesson teaches
I can explain, draw and evaluate the ways a government corrects market failure, from price controls and taxes to regulation and direct provision.
Syllabus K343, 2.10.3. Government intervention to address market failure: definitions, drawing and interpretation of diagrams, advantages and disadvantages of: maximum and minimum prices in product markets, indirect taxation, subsidies; definitions, advantages and disadvantages of: regulation, privatisation, nationalisation, direct provision of goods and services, quotas, e.g. for the extraction of natural resources
Make a guess
A tax is put on each can of soft drink. Which curve shifts?
- Both curves, because everyone pays more.
- The demand curve, because buyers drink less.
- The supply curve, because sellers' costs rise.
Show the answer
The supply curve, because sellers' costs rise.
The tax is collected from sellers, so it acts like a cost. Supply shifts up, the price rises, and quantity demanded contracts.
A tax on each unit sold raises firms' costs, so supply falls, price rises and quantity falls.
An indirect tax is a tax on spending. It is collected from firms when goods are sold, such as a fixed tax on each pack of cigarettes. It raises firms' costs, so supply decreases. On a diagram, supply shifts up by the amount of the tax.
Price rises and quantity falls. Governments use indirect taxes to cut consumption of demerit goods and goods with external costs, and to raise revenue.
Advantages: the tax discourages harmful consumption and raises money for public services. It also makes buyers pay more of the true cost of what they consume.
Disadvantages: if demand is inelastic, consumption falls only a little. The tax takes a bigger share of poorer people's incomes. Very high taxes can encourage smuggling and illegal sales.
- Indirect tax
- Tax on spending; supply shifts up by the tax.
- Effect
- Price rises, quantity falls, government gains revenue.
- Limit
- With inelastic demand, consumption falls little.
Worked example: A tax on sugary drinks
Suppose a government places a tax of 20 cents on every can of sugary drink.
- Supply shifts up by 20 cents to S + tax, because each can now costs firms more to sell.
- The price buyers pay rises, so quantity demanded contracts and fewer cans are sold.
- The government collects 20 cents x the new quantity as revenue.
- How far consumption falls depends on PED: with many substitutes, demand is elastic and it falls a lot.
Try it step by step
Problem 1
A tax of $2 per unit is placed on a good. Its price rises from $10.00 to $11.50, and 400 units are sold after the tax.
Show the working
- Price rise paid by consumers: $11.50 - $10.00 = $1.50 per unit
- Share of the tax paid by producers: $2.00 - $1.50 = $0.50 per unit
- Total tax revenue: $2 x 400 = $800
Problem 2
A tax of $1 per unit is placed on a good. Its price rises from $4.00 to $4.30, and 1,000 units are sold after the tax.
Show the working
- Price rise paid by consumers: $4.30 - $4.00 = $0.30 per unit
- Share of the tax paid by producers: $1.00 - $0.30 = $0.70 per unit
- Total tax revenue: $1 x 1,000 = $1,000
Problem 3
A tax of $0.50 per unit is placed on a good. Its price rises from $3.00 to $3.40, and 2,000 units are sold after the tax.
Show the working
- Price rise paid by consumers: $3.40 - $3.00 = $0.40 per unit
- Share of the tax paid by producers: $0.50 - $0.40 = $0.10 per unit
- Total tax revenue: $0.50 x 2,000 = $1,000
Watch out for this
An indirect tax shifts the demand curve to the left.
The tax is collected from sellers, so it raises their costs and shifts supply. Quantity demanded falls because of the higher price, which is a movement along demand.
Check your understanding
A government places a tax on each litre of petrol sold. What happens in the market?
- Demand decreases, so the price and the quantity sold both fall.
- Supply decreases, so price rises and quantity sold falls.
- Supply increases, so the price falls as firms pass on the tax.
Show the answer
Supply decreases, so price rises and quantity sold falls.
Right. The tax raises costs, shifting supply up.
Check your understanding
Demand for a good is very price inelastic. The government taxes it to reduce consumption. What is the likely outcome?
- Consumption falls only slightly, but tax revenue is high.
- Consumption rises because the price is higher.
- Consumption falls sharply and revenue is low.
Show the answer
Consumption falls only slightly, but tax revenue is high.
Right. Buyers keep purchasing, so the tax raises money but changes behaviour little.
Check your understanding
A tax of $1 per unit is placed on a good. Its price rises from $5.00 to $5.60. How is the tax shared?
- Consumers pay the whole $1 of the tax
- Consumers pay $0.40 and producers $0.60 of it
- Consumers pay $0.60 and producers $0.40 of it
- Consumers pay $5.60 of tax on each unit
Show the answer
Consumers pay $0.60 and producers $0.40 of it
Right. The price rise is the consumers' share; producers absorb the rest of the $1.
Check your understanding
After a tax of $2 per unit is introduced, 30,000 units are sold. How much tax revenue does the government collect?
- $15,000
- $2
- $30,000
- $60,000
Show the answer
$60,000
Right. Tax revenue = tax per unit x quantity sold after the tax = $2 x 30,000.