(a) Using diagrams, explain how the incidence(burden) of an indirect tax may be affected by the price elasticity of demand. [10 marks]
– Define tax: indirect tax is a tax levied on goods and services, it is levied on producers who then pass on to consumers in terms of higher prices
– Define PED: PED refers to the degree of responsiveness of quantity demanded to a given change in price of the product
Ability of market forces of demand and supply to achieve allocative inefficiency, ie welfare not maximised (DWL exists) and there is requirement of government intervention. Welfare is maximised or market is efficient only if MSB=MSC at socially optimal output.
– Define negative externalities
Costs incurred to third parties who are not directly involved in production and consumption of goods and services. It negatively influences third bystander who is not involved in transaction. Without government regulation, the price mechanism does not internalise the external cost generated (for example, if a person smokes and creates 2nd hand smoke or health problems to the person beside him, he does not pay for it).
– Production *not required here
When MSC > MPC (because MSC=MPC+MEC), for example, in the production of factories, society incurs the private costs of production + water/air pollution generated, which is not internalised to private costs (the costs of running the factories.
From diagram, social welfare is maximised when MSC=MSB, at Qopt. But in the absence of government regulation, external costs are not internalised by price mechanism, society consumes at MPB=MPC, or output Qm.
This results in over-consumption and welfare loss (or dwl), which it the shaded region in the diagram.
When MPB > MSB (because MPB=MSB+MEC), for example, in the consumption of cigarettes, private individuals enjoy greater benefits from smoking as opposed to society, who incurs external costs of air pollution and health problems to non-smokers, as a result, MSB<MPB.
From diagram, social welfare is maximised when MSC=MSB, at Qopt. But in the absence of government regulation, external costs are not internalised by price mechanism, society consumes at MPB=MPC, or output Qm, this means they do not pay for the external costs generated, such as a smoker does not pay the costs required to clear up the second smoke and air pollution.
This results in over-consumption and welfare loss (or dwl), which is the shaded region in the diagram.
From Diagram, Social welfare is maximised when MSB = MSC, at Qe, but in the absence of government intervention, private market consumes at Q1, where MPB=MPC, resulting in over-consumption and welfare loss in the shaded region.
Market failure exists because the price mechanism fails to internalise the external costs to producers and consumers, resulting in over-allocation and welfare loss of such items.
Governments can use a variety of measures, amongst which, indirect taxation.
Indirect taxation is a form of tax that levied on producers, who then pass on the tax to consumers in terms of higher prices. An example would be excise tax on cigarettes, alcohol, fuel.
This solves market failure as it internalises the external costs of production and consumption, forcing private individuals to pay for externalities(external costs) generated. The allocation of such resources will then be reduced, and if all of the external costs are indeed internalised, then MEC=0. With reference to diagram, allocation now is reduced to Q1, where MPB=new MPC(tax). As a result, allocative efficiency is achieved, there is no deadweight loss, and welfare is maximised.
For consumption, with a tax, MPC or supply shifts leftward due to rise in costs, output drops to Q1, where MPB=MSc, allocative efficiency achieved, welfare loss eliminated.
Taxation has its limitations because it is not possible for governments to quantify the external costs, it is at best an approximate and markets might not actually be consuming at Qopt if calculation of external costs was inaccurate.
A tax might also be ineffective in eliminating the external costs directly. For instance, taxing consumers for the use of motor vehicles does not eliminate the air pollution created. It is only effective if governments use the revenue to subsidise clean energy or green vehicles.
If demand is inelastic, taxation would be ineffective, because qty dd is unresponsive to price change. A huge amount of tax would have to be levied (which might lead to inequity distribution since only high income earners can consume such products), and possible growth of black markets.