Role of Government in Microeconomics II

Indirect tax = tax on a transaction (goods/services), collected by the seller and passed to the government.

Two forms:

• Specific tax: fixed $/unit (e.g.$0.50/litre on petrol). Supply curve shifts LEFT (or upward) by a CONSTANT amount.
• Ad valorem tax: percentage of price (e.g. 20% VAT). Supply shifts LEFT by a PROPORTIONAL amount — the shift fans out (larger absolute shift at high prices).

Effect on equilibrium:

• Equilibrium PRICE rises (consumers pay more).
• Equilibrium QUANTITY falls.
• Government collects revenue = tax × new Q*.

Tax incidence. Who bears the tax burden?

Condition	Burden
Demand more inelastic than supply	Consumers bear MORE
Supply more inelastic than demand	Producers bear MORE
Both equally elastic	Burden split roughly evenly

Worked example. Tobacco has very inelastic demand (addictive, few substitutes). A $1/pack tax: consumers absorb most of the burden — the price rises by close to$1; smokers still buy.

In contrast, a tax on a luxury good with elastic demand: consumers cut back sharply; producers must absorb most of the tax to maintain sales.

Welfare effects of an indirect tax:

• Consumer surplus FALLS.
• Producer surplus FALLS.
• Government gains revenue (= tax × Q after).
• DEADWEIGHT LOSS: some trades that would have happened don't (small triangle of lost CS + PS not captured by gov't).

Rationales for indirect taxes:

• Raise revenue.
• Discourage demerit goods (tobacco, alcohol, sugary drinks).
• Internalise negative externalities (carbon tax).

Subsidy = government payment to producers (or sometimes consumers) to lower price and/or boost output.

Effect. Supply curve shifts RIGHT (or downward by subsidy/unit).

• Equilibrium price FALLS (consumers pay less).
• Equilibrium quantity RISES.
• Producers receive (price paid by consumers) + (subsidy/unit) = original supply-curve price.

Welfare effects:

• Consumer surplus RISES.
• Producer surplus RISES.
• Government bears COST (subsidy × new Q*).
• Net deadweight loss: subsidy cost may exceed combined CS+PS gain (because extra output produced at MC > MB).

Rationales for subsidies:

• Promote MERIT goods (education, healthcare).
• Internalise POSITIVE externalities (renewable energy).
• Support strategic industries.
• Maintain rural / agricultural incomes.
• Lower prices of essentials for the poor.

Subsidy incidence — who benefits most? Mirror image of tax:

• Inelastic demand → consumers gain MORE.
• Inelastic supply → producers gain MORE.

Critiques of subsidies:

• Opportunity cost of government spending.
• May reward inefficient producers.
• Hard to remove once established (political pressure).
• May distort international trade (WTO disputes).
• Sometimes captured by lobby groups, not target beneficiaries.