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More than likely, you have heard about taxes, and you'd agree that most people don't pay them happily. What about subsidies? Have you heard about them? Subsidies are basically free money or a free pass from paying taxes. I bet you love the idea of those. Well, the government controls all that stuff, both the taxes and the subsidies. And the government implements them depending on the specific effect they want to have on the market. Let's not waste time, let's dive right into it!
First of all, efficiency is good and inefficiency is bad - let's just know this and know peace. So, since the government wants to know peace, it introduces taxes and subsidies when it notices that the market is inefficient. This action is known by economists as government intervention.
Government intervention is the involvement of the government in the market to influence demand and supply and restore efficiency.
So, what are taxes? Taxes are dues or levies established by the government that citizens must pay. There are direct and indirect taxes (or ad valorem), but in the context of the markets we are discussing, indirect tax is the most important so let's focus on that one. Indirect taxes are taxes charged on the consumption of goods and services. The value-added tax (VAT) is a common example of an indirect tax.
Indirect taxes are taxes charged on the consumption of goods and services, levied on either consumers or producers.
Now that you know what taxes are, let's quickly move on to subsidies and find out what they are as well. Subsidies are benefits, usually financial, given to a producer or firm by the government. So, subsidies can be a tax pardon or a cash payment. In the case of a tax pardon, the firm or a group of firms is exempted from paying taxes. On the other hand, a cash payment is what its name says, a payment made to the firm to produce a specific product.
Subsidies are benefits, usually financial, given to a producer or firm by the government.
Great! So you know what taxes and subsidies are. So what do they do? Well, taxes increase the prices of products and subsidies reduce the prices of products. Figure 1 will help you remember. That's it! There are details of course, but what we have here is just an overview.
So, what happens when the government decides to place taxes and subsidies on the market? Let's look at the effects of tax and subsidy on market structure.
Indirect taxes affect how firms behave in the market as production becomes more expensive. As businesses are now paying more for an extra unit of input, marginal cost increases, and this will result in two effects:
Look at the example below.
The government places a 20% of value added tax on timber that costs $100. Since the firm now pays $120 for the timber, it has to ask for a price that covers the $120 production cost instead of the previous $100. Another firm that only has $100 to spend will now have to drop out.
Subsidies make things easier for the firms in the market. Because the government is giving companies free money or exempting them from paying taxes, their production expenses also go down. This means that they will also be able to charge consumers less for their products. There are two main effects here:
Look at the example below.
A government wants to encourage solar energy usage so it subsidizes the production of solar panels. This results in firms paying less to produce solar panels. Other companies, seeing that it costs less to produce solar panels, will start producing solar panels. The lower production cost will make firms sell the solar panels for less, and consumers will now start buying a lot more solar panels.
Now let's look at the effect of taxes and subsidies on market equilibrium.
Subsidies allow producers to spend less making products. This means that they will sell products for less and increase supply. This decrease in price is met with an increase in the quantity of the good demanded. This shifts the market equilibrium to a lower price (P2) and higher quantity (Q2) as shown in Figure 2.
Figure 2. Effect of subsidies on market equilibrium, StudySmarter Originals
Indirect taxes cause producers to spend more on production. This means that they will sell products for a higher price and decrease supply. The increase in price is met with a decrease in the quantity of the good demanded. This shifts the market equilibrium to a higher price (P2) and lower quantity (Q2) as shown in Figure 3.
Figure 3. Effect of indirect tax on market equilibrium, StudySmarter Originals
Taxes and subsidies are an effective way for the government to create efficiency in the market. When used right, there are some key advantages.
First, let's look at the advantages of taxes:
Now, let's look at the advantages of subsidies:
Taxes and subsidies can fail when implemented in the wrong market.
First, let's look at the disadvantages of taxes:
Now, let's look at the disadvantages of subsidies:
An example of the effect of tax on market structure is the taxes on alcohol and cigarettes which then results in higher market prices for these products. On the other hand, the U.S. government subsidizes agriculture to make sure that there are always agricultural producers and enough people are incentivized to farm.
Great! You have reached the end of this article. You should read our article on The Effects of Government Intervention in Different Market Structures to find out the other ways governments intervene in the market.
Indirect taxes are taxes charged on the consumption of goods and services.
Subsidies are benefits, usually financial, given to a producer or firm by the government.
Advantages of taxes:
Advantages of subsidies:
Disadvantages of taxes:
Disadvantages of subsidies:
Tax decreases supply and shifts the market equilibrium to a higher price and lower quantity.
A subsidy increases supply and shifts the market equilibrium to a lower price and higher quantity.
Tax decreases supply and decreases the quantity demanded.
Subsidy increases supply and increases the quantity demanded.
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