What this lesson teaches
I can describe taxes, subsidies, price controls and quotas as ways a government intervenes in a market.
Syllabus 9570, 2.1.3(a). Government Intervention in Markets: Governments may intervene in markets in the form of taxes, subsidies, price controls (maximum and minimum prices) and quantity controls (quotas)
Make a guess
The government puts a $2 tax on every bottle of a sugary drink. How much does the price shoppers pay usually rise?
- By less than $2, because sellers absorb part of the tax.
- By exactly $2, because sellers pass the tax on in full.
- By more than $2, because sellers add extra profit.
Show the answer
By less than $2, because sellers absorb part of the tax.
The higher price cuts the quantity bought, so sellers cannot pass on the whole tax. Buyers and sellers usually share it.
A tax shifts supply up by the tax, so buyers pay more, sellers keep less and less is sold.
An indirect tax, such as excise duty on cigarettes, is charged on each unit sold. For the seller, it works like a higher cost.
So the supply curve shifts up by the amount of the tax, from S to S+tax. At the old price there is now a shortage, and the price rises.
At the new equilibrium, buyers pay a higher price (P1) and fewer units are sold (Q1). Sellers keep the price minus the tax (P2). The government collects the tax on every unit sold.
The price rises by less than the tax because buyers cut back. How much less depends on price elasticity of demand, which is covered in a later lesson.
Put these in order
A tax is placed on each bottle of a sugary drink. Put the chain in order.
- Buyers pay more, sellers keep less, and the government collects the tax.
- A shortage at the old price pushes the price up.
- The supply curve shifts up by the amount of the tax.
- The government charges a tax on each bottle sold.
- Fewer bottles are sold at a higher price.
Show the answer
- The government charges a tax on each bottle sold. For sellers, the tax works like a higher cost on every unit.
- The supply curve shifts up by the amount of the tax. At the old price, sellers now offer fewer bottles than buyers want.
- A shortage at the old price pushes the price up. As the price rises, some buyers switch to other drinks and buy fewer bottles.
- Fewer bottles are sold at a higher price. On each bottle, buyers pay part of the tax through the higher price and sellers pay the rest out of what they keep.
- Buyers pay more, sellers keep less, and the government collects the tax.
- Buyers
- Pay more (P1).
- Sellers
- Keep less (P2 = P1 - tax).
- Government
- Collects tax x Q1.
Worked example: A $2 tax on bottled drinks
Before the tax, 80 bottles a day sell at $6. After a $2 tax, 60 bottles sell at $7.
- Buyers now pay $7, only $1 more, because some switch to other drinks.
- Sellers keep $7 - $2 = $5 a bottle, $1 less than before.
- The government collects $2 x 60 = $120 a day.
- Buyers spend $7 x 60 = $420. Sellers keep $5 x 60 = $300. Check: $300 + $120 = $420.
Watch out for this
A $2 tax raises the price buyers pay by exactly $2.
Usually buyers pay part of the tax and sellers absorb the rest, because the higher price cuts the quantity bought. Here buyers pay $1 more and sellers keep $1 less.
Check your understanding
After a $1 tax per unit, the price buyers pay rises from $10 to $10.60. What do sellers keep per unit?
- $9.60.
- $11.00.
- $10.60.
Show the answer
$9.60.
Right. Sellers keep the price paid minus the tax: $10.60 - $1 = $9.60.