Effects of Taxes and Subsidies on Market Structures

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!

Effects of Taxes and Subsidies on Market Structures Effects of Taxes and Subsidies on Market Structures

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Table of contents

    Overview of Effects of Taxes and Subsidies on Market Structure

    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.

    Effects of Taxes and Subsidies on Market Structure

    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.

    The effects of a tax 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:

    1. Production cost will increase, increasing price along with it.
    2. The number of firms in the market will decline as some of the firms struggle to bear the increased production costs.

    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.

    The effects of a subsidy on market structure

    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:

    1. Production cost will decrease, hence, price will also decrease and consumers will buy more.
    2. The number of firms in the market will increase as more firms realize that it is easier to produce the good that has been subsidized.

    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.

    Effects of Subsidies and Taxes on Market Equilibrium

    Now let's look at the effect of taxes and subsidies on market equilibrium.

    The effects of a subsidy 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.

    Effects of Taxes and Subsidies on Market Structures Effect of subsidies on market equilibrium StudySmarter OriginalsFigure 2. Effect of subsidies on market equilibrium, StudySmarter Originals

    The effects of a tax on market equilibrium

    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.

    Effects of Taxes and Subsidies on Market Structures Effect of indirect tax on market equilibrium StudySmarter OriginalsFigure 3. Effect of indirect tax on market equilibrium, StudySmarter Originals

    Advantages of Taxes and Subsidies on the Market Structure

    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:

    1. Taxes discourage the production and consumption of goods with negative externalities - For instance, since smoking is harmful to the health of smokers, placing high taxes on cigarettes may deter people from buying cigarettes as they become more expensive.
    2. Taxes account for negative externalities which would otherwise be ignored by producers - For example, a product like a car pollutes the air through its emissions. If left alone, auto manufacturing firms would rather not invest in planting trees or adopting more environmentally friendly practices. Therefore, the tax revenue from a tax on greenhouse gas emissions can be used by the government to plant trees or put measures in place to address the pollution.
    3. Governments provide public goods using tax revenue - By collecting tax revenue, governments can spend on public goods such as streetlights and roads.

    Now, let's look at the advantages of subsidies:

    1. Subsidies make goods affordable - There are some goods that contribute to social welfare, and governments like to encourage the production or consumption of such goods. Therefore, subsidies make such goods more affordable. For example, governments would like more companies to produce solar panels and more consumers to use solar panels. Therefore, they may subsidize the production of solar panels.
    2. Subsidies promote positive externalities - If riding bicycles protects the environment, the government may subsidize the production of bicycles, encouraging more people to ride bicycles since firms will sell them at cheaper prices.

    Disadvantages of Tax and Subsidies on the Market Structure

    Taxes and subsidies can fail when implemented in the wrong market.

    First, let's look at the disadvantages of taxes:

    1. Product shortages - High taxes can cause a shortage of products as firms find it too expensive to produce such products.
    2. Smaller firms may struggle compared to bigger firms - Bigger firms may be able to afford the taxes, but smaller firms may eventually drop out of the market, which brings the risk of a monopoly or monopolistic competition.

    Now, let's look at the disadvantages of subsidies:

    1. Overproduction - When a good is subsidized wrongfully, there may be an overproduction of a particular good, which results in more market inefficiency.
    2. Higher taxes - The government must make the free money somewhere else, and this means other firms, or individuals, will be paying higher taxes to fund the subsidized firms.

    Examples of Tax and Subsidies Effects on Market Structure

    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.

    Effects of Taxes and Subsidies on Market Structures - Key takeaways

    • Government intervention is the involvement of the government in the market to influence demand and supply and restore efficiency.
    • Indirect taxes are taxes charged on the consumption of goods and services, levied on either consumers or producers.
    • Subsidies are benefits, usually financial, given to a producer or firm by the government.
    • 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.
    • 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 the products are priced higher.
    Frequently Asked Questions about Effects of Taxes and Subsidies on Market Structures

    What is tax and subsidy?

    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.

    What are the advantages of tax and subsidy on the market structure?

    Advantages of taxes:

    1. Taxes discourage the production and consumption of goods with negative externalities.
    2. Taxes account for negative externalities which would otherwise be ignored by producers.
    3. Governments provide public goods using tax revenue.


    Advantages of subsidies:

    1. Subsidies make goods affordable.
    2. Subsidies promote positive externalities.

    What are the disadvantages of tax on the market structure?

    Disadvantages of taxes:

    1. Product shortages.
    2. Smaller firms may struggle compared to bigger firms.

    Disadvantages of subsidies:

    1. Overproduction
    2. Higher taxes on other firms or individuals

    How does tax and subsidy affects market equilibrium?

    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.

    What is the effects of tax and subsidy on supply and demand?

    Tax decreases supply and decreases the quantity demanded.

    Subsidy increases supply and increases the quantity demanded.

    Test your knowledge with multiple choice flashcards

    Taxes result in higher marginal costs.

    Subsidies result in lower prices.

    Taxes help control negative externalities.

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