Government Intervention: Indirect Taxes, Subsidies and Price Controls
Indirect taxes are taxes on spending, added to the price of a good to correct a negative externality or discourage a demerit good by raising private cost towards social cost.
Before you start
Make sure you're comfortable with these topics first:
Method
- Match the market failure to the instrument: a negative externality or demerit good typically calls for an indirect tax; a positive externality or merit good typically calls for a subsidy; an affordability concern calls for a maximum price; an over-consumption or income-protection concern calls for a minimum price.
- Draw the tax diagram: a specific tax shifts the supply curve vertically upward by the amount of the tax, raising the market price and reducing the equilibrium quantity; the incidence (how much of the tax burden falls on consumers versus producers) depends on the relative price elasticities of demand and supply, with the side of the market that is more price inelastic bearing the larger share of the burden.
- Draw the subsidy diagram: a subsidy shifts the supply curve vertically downward by the amount of the subsidy per unit, lowering the market price and raising the equilibrium quantity.
- Draw the maximum price diagram: setting a price ceiling below the free market equilibrium price creates excess demand (a shortage), since quantity demanded at the lower price exceeds quantity supplied, which can lead to queuing, rationing or a black market.
- Draw the minimum price diagram: setting a price floor above the free market equilibrium price creates excess supply (a surplus), since quantity supplied at the higher price exceeds quantity demanded, which the government or industry may need to store, buy up or otherwise absorb.
- For an evaluation question, use price elasticity of demand and supply to judge how effective each instrument will be at changing quantity, and weigh this against risks such as a black market forming around a price ceiling, a costly surplus forming behind a price floor, or the regressive impact of a tax or minimum price on low-income consumers.
Worked example
A market has demand Qd = 200 - 4P and supply Qs = -40 + 4P, where P is in pounds. Find the free market equilibrium price and quantity. The government then imposes a specific tax of 5 pounds per unit on producers, so the new supply curve is Qs = -40 + 4(P - 5). Find the new equilibrium price paid by consumers and price received by producers.
- Find the free market equilibrium by setting Qd = Qs: 200 - 4P = -40 + 4P, so 240 = 8P, giving P = 30 and Q = 200 - 4(30) = 80.
- Write the new supply curve after the tax: Qs = -40 + 4(P - 5) = -60 + 4P.
- Find the new equilibrium by setting Qd = new Qs: 200 - 4P = -60 + 4P, so 260 = 8P, giving P = 32.50 and Q = 200 - 4(32.50) = 70.
- The price consumers pay rises from 30 to 32.50 pounds, an increase of 2.50 pounds; the price producers receive is the consumer price minus the tax: 32.50 - 5 = 27.50 pounds, a fall of 2.50 pounds from the original 30 pounds.
- Since the tax burden splits evenly (2.50 pounds each) between consumers and producers here, this reflects the equal steepness (elasticity) of demand and supply in this particular example; quantity also falls, from 80 to 70 units.
Practice questions
Try each question, then tap to reveal the answer.
Q1Distinguish a specific tax from an ad valorem tax.Show answer
Answer: A specific tax is a fixed amount of tax per unit sold, regardless of price; an ad valorem tax is a percentage of the price, so the amount of tax rises as the price rises.
Q2Give a real example of a maximum price (price ceiling) policy.Show answer
Answer: Rent controls, which cap the rent a landlord can legally charge below what the free market would set.
Q3Give a real example of a minimum price (price floor) policy.Show answer
Answer: Minimum unit pricing on alcohol.
Q4What determines how the burden of an indirect tax is split between consumers and producers?Show answer
Answer: The relative price elasticity of demand and supply; the side of the market that is relatively more price inelastic bears the larger share of the tax burden.
Q5State the effect of a maximum price set below the free market equilibrium on the quantity supplied and demanded.Show answer
Answer: Quantity demanded rises above the free market level and quantity supplied falls below it, creating a shortage (excess demand).
Q6State the effect of a minimum price set above the free market equilibrium on the quantity supplied and demanded.Show answer
Answer: Quantity supplied rises above the free market level and quantity demanded falls below it, creating a surplus (excess supply).
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain why the incidence of an indirect tax on a good with price inelastic demand falls mostly on consumers.
Show mark scheme
Tick each line you got. Your score builds from the marks on the scheme.
Nothing ticked yet - 4 available
Evaluate the likely effectiveness of imposing a minimum price on alcohol as a way of reducing problem drinking.
Show mark scheme
Tick each line you got. Your score builds from the marks on the scheme.
Nothing ticked yet - 25 available
See real A Level Economics past-paper questions, with official mark schemes →
Free printable worksheet
Want more practice on paper? Download the government intervention: indirect taxes, subsidies and price controls worksheet pack - 6 pages of exam-style questions with a full mark scheme. One email opens every download in this browser for 14 days - no account, no card. Print it for personal and classroom use.
Next topics
Not quite what you needed?
Tell us what is missing on government intervention: indirect taxes, subsidies and price controls, or which topic to write up next. Every request is read, and we reply to every one.
Build a full practice pack.
This topic is one of hundreds in the library - pick the ones a student needs and generate a printable PDF in minutes.