SUBSIDIES

As with taxes the total subsidy per unit is the vertical distance between the
supply curves, but since it has the effect of lowering costs of production the
subsidy will shift supply to the right to S  + subsidy.  This has the effect of
increasing output to Q2 and lowering the price to Pc.  The cost taxpayers (paid
by the government) is equal to the total subsidy per unit (ab) multiplied by the
quantity of the good consumed (Q2) this gives the shaded area PcPfab.

INDIRECT TAXES

An indirect tax is a tax on the expenditure on goods.  These are taxes paid by
the seller of the good, who usually asks the consumer to pay some or all of it.


Specific taxes are indirect taxes where a fixed sum is paid per unit sold.
Examples of such taxes in the UK are excise duties on tobacco, alcoholic
drinks and petrol.


Ad valorem taxes are indirect taxes where a certain percentage is added on to
the price of each unit sold.  A UK example is Value Added Tax (VAT) currently
standing at 17.5%.


A subsidy is a grant given by the government which is usually a fixed sum
granted per unit sold.

EFFECT ON SUPPLY CURVES OF THE DIFFERENT INDIRECT
TAXES

As seen in the section on supply, taxes have the effect of raising costs of 

production a thereby shifting the supply curve to the left.  For a specific tax 

this will mean that the shift will be a parallel one because the amount of tax is 

the same at all prices, the vertical distance between the supply curves will 

give the amount of specific tax.  For an ad valorem tax the curve will swing to 

the left, because the amount of tax per unit increases as prices get higher, 

thereby widening the gap between the pre tax supply curve and the post tax

supply curve.  This situation is shown on the diagrams below:

THE INCIDENCE OF TAXATION

The incidence of taxation is the burden of tax shared between buyers and 

sellers.

The following diagram shows how this is worked out:

The specific tax per unit is shown as the vertical distance (t) between the two 

supply curves.  The price to the consumer has risen to P2 and output of the 

good has fallen to Q2.  The incidence or burden for the consumer can be 

calculated as the change in price multiplied by the quantity of the good 

consumed, this gives the area P1P2ab.  The total government revenue from 

the tax can be found by multiplying the specific tax per unit (t) by the quantity 

bought/sold Q2 this gives the area P2-tP2ac.  That part of the government 

revenue not paid by the consumer must therefore have been paid by the 

producer and producer contribution is P2-tP1bc. 

The total government’s tax revenue is equal to the specific tax per unit 

multiplied by the equilibrium output after tax. 

The consumer’s tax burden or incidence is equal to the change in price 

multiplied by the equilibrium output after tax.  It is the top portion of the 

government’s revenue. 

The producer’s tax burden is equal to the area of the government’s tax 

revenue which is not paid by the consumer.  This is the bottom portion of the 

government’s tax revenue. 

TAX INCIDENCE AND ELASTICITY

When demand is inelastic the consumer’s tax burden is greater than the 

producer’s.

When demand is elastic the producer’s tax burden is greater than the 

consumer’s.

When supply is elastic the consumer’s tax burden is greater than the 

producer’s. 

When supply is inelastic the producer’s tax burden is greater than the 

consumer’s.

The relationship between elasticity and tax incidence is exactly when an ad 

valorem tax is levied on goods.

FURTHER OBSERVATIONS

Government’s tend to impose specific taxes on alcohol, petrol and cigarettes 

the reasons for this are: 

Demand will be relatively unaffected and so firm’s will lose little in the way of 

revenue.

Government’s revenue is highest when taxing goods with inelastic demand. 

Recent governments have tried to persuade consumers to use less of these 

goods for health/environmental reasons.

AGRICULTURAL PRODUCTS

It is in these markets where prices are set most often by the forces of supply
and demand.  However it also in these markets where there is the most
government intervention.  The reasons for this include:


•  Agricultural prices are subject to considerable fluctuations – this can
cause low incomes for farmers, or high prices for consumers and/or
uncertainty which discourages investment.
•  Low incomes of farmers
•  Protection of traditional rural ways.

•  Competition from abroad – farm may go out of business if the
government doesn’t intervene due to cheap imports.

The reasons for large price fluctuations are:


•  Inelastic supply – it is difficult to expand production of foodstuffs in the
short run.

•  Supply fluctuations – harvest are unpredictable affected as they are by
weather, disease and pests. Therefore some years can se bumper
harvests other can see poor harvests.
•  Inelastic demand – foodstuffs tend to be inelastic in demand because:
       •  Many are considered basic necessities;
       •  There are no close substitutes;
       •  They account for a relatively small proportion of people’s incomes.

The effects of this are shown on the following diagram:

In the short term supply of foodstuffs is virtually perfectly inelastic as all
harvest crops are always brought to market.  Since demand is relatively
inelastic the price in a good year is significantly lower than price in a bad year.
This huge potential for fluctuation in price means the potential for high
consumer prices one year and low farmer’s incomes the next year.  The
government can intervene to help the situation in the following ways:

(A) BUFFER STOCKS

This is a way of stabilising prices by fixing at a price where long run demand 

and supply meet.  A suitable price will be P3 in the following diagram:

When there is a good harvest (Sgood) the government buys the surplus (Qg –
Q3) and stores it to use if there is a bad harvest (Sbad) releasing Q3 – Qb.
Such solutions are only useful for non-perishable s like grain, wine, milk
powder or food which can be frozen.

(B) SUBSIDIES

This solution has been highlighted earlier.  The advantages of subsidies are a 

guaranteed income to the farmer and lower prices to the consumer.  The 

disadvantage of subsidies is the cost to the taxpayer/government.

(C) MINIMUM PRICES 

This solution has again been highlighted earlier.  In the European Union (EU) 

the Common Agricultural Policy (CAP) is an example of minimum prices the 

reasons for its existence include: 

•  Assured food supplies.

•  Guaranteed incomes for farmers.

•  Growth in agricultural productivity

•  Stable prices.

•  Reasonable prices for consumers

Problems with the policy include: 

•  Surpluses leading to large wine lakes, butter mountains etc.  Although 

for some agricultural products the introduction of quotas has reduced 

surpluses e.g. sugar and milk.

•  Costs to the taxpayer of purchasing these surpluses.

•  Tend to result in high prices to the consumer rather than reasonable 

prices. The McSharry reforms of 1992 went a little way towards 

achieving this.

•  Harms the environment because farmers are over-producing.

•  Surpluses are often ‘dumped’ on third world markets, this can damage 

the domestic agricultural industry in these places.

(D) COBWEB THEORY

These markets are also often dynamic in nature.  In the sense that supply 

decisions are often the result of prices in the previous periods. 

The diagram shows the long run equilibrium of Pe and Qe.  Assume that in 

year 1 a bad crop results in supply only being at Q1.  This shortage will put up 

prices to P1 (position a).  Since farmers knew they could get P1 for the crop in 

year 1 they will therefore plant Q2 of the crop for year 2 (this will get them P1

on their supply curve).  However in year 2 there is a surplus and they realise 

that to sell all of Q2 they will have to drop the price to P2.  Based on this they 

will plant Q3 of the crop for year 3.  However in year 3 there is now a shortage 

putting up prices to P3.  This time they will pant Q4 of the crop.  However this 

time there is a surplus pushing down prices to P4. This situation will continue

until eventually the farmers get it right and reach the long run equilibrium of 

Pe. 

GOVERNMENT PRICE CONTROLS

MINIMUM PRICES

A minimum price is a price floor set by the government where the price is not 

allowed to fall below this set level (although it is allowed to rise above it).

Reasons for setting a price floor:

•  To protect the earnings of producers – in certain industries prices are 

subject to great fluctuations.  Minimum prices will guarantee producers 

income in periods when prices would otherwise have been very low.  

Examples include certain agricultural products. 

•  To create a surplus – in periods of glut surpluses can be stored in 

preparation for possible future shortages.

•  To guarantee a certain level of earnings – workers can be given a 

minimum wage so that their earnings don’t fall below a certain 

(unacceptable) level.

The diagram below shows the effects of a minimum price: 

The minimum price has created a surplus (excess supply) of Qs – Qd.  There 

are three ways in which the government can deal with this surplus: 

The government purchases all the surplus to store it, destroy it or sell it in 

other markets.  If the government seeks to do this then it has to buy up the 

excess (Qs – Qd) at the current minimum price.  This means the cost to the 

government and therefore taxpayer is the shaded area QdabQs.

The government could artificially lower supply to Qd by issuing quotas which 

limit production. 

Demand could be raised by advertising, finding alternative uses or by taxing 

substitutes.

MAXIMUM PRICES

A maximum price is a price ceiling set by the government where the price is 

not allowed to rise above this set level (although it is allowed to fall below).

The reason for setting a maximum price is so that the prices of necessities 

don’t rise too much in times of shortage.  Such a situation is common in times 

of war and/or famine.

The maximum price has caused a shortage (excess demand) equal to Qd – 

Qs.  The government can deal with this in two ways:

•  First come first serve – this is the situation in a lot of eastern European 

countries and means that huge queues are common. 

•  Rationing – Purchases are limited by the number of coupons or 

vouchers issued.  Such as was seen during WWII.

•  Encouraging more homegrown production – as seen in WWII.

•  Drawing on stores from previous surpluses. 

Problems with maximum prices include:

•  Black markets – Selling of rationed goods illegally at very high prices to 

consumers who feel that they are not able to purchase enough legally. 

•  Reduces the supply of already scarce products. 

EXCHANGE RATES

An exchange rate is the rate at which one currency exchanges for another on
the foreign exchange market.  An example is £1:$1.50.

THE DEMAND FOR STERLING (£S)

Sterling is demanded for several reasons: 

•  To purchase UK exports – foreigners need sterling in order to buy our 

exports (although this is usually done through a third party such as the 

original importer).  As exchange rates rise so does the price of UK 

exports and therefore there should be a fall in exports meaning a fall in 

the demand for sterling.

•  Foreign investment in the UK – Nissan may want to build a new factory 

in the UK they need to spend pounds to do this.  Foreign investors may 

wish to put money in UK banks, perhaps attracted by high rates of 

interest. 

•  Speculation – Traders on the foreign exchange markets buy and sell 

sterling for profit.  A high exchange rate usually means demand for 

sterling is low as traders realise that the next movement is likely to be a 

fall in the exchange value.  This is the most important cause of short 

term exchange rate changes. 

As the exchange rate rises the demand for sterling falls and vice versa.

THE SUPPLY OF STERLING (£S)

Sterling is supplied for similar reasons: 

•  To purchase foreign imports – UK importers need to supply sterling in 

order to buy foreign currency so that they can buy their imported 

goods.  As the exchange rate rises, the price of imports falls, there 

should be an associated increase in imports, which leads to an 

increase in the supply of sterling to pay for them. 

•  UK investment abroad 

•  Speculation. 

As the exchange rate rises the supply of sterling will also rise and vice versa.

EQUILIBRIUM

The equilibrium exchange rate is shown below: 

The equilibrium is set where D = S at £1:$1.40.

CHANGES IN THE EXCHANGE RATE

A fall in the exchange rate is known as a depreciation.  A rise in the exchange 

rate is known as an appreciation.

Causes of depreciation include:

•  High UK inflation – UK will sell less exports because they are now too 

expensive (causing a fall in the demand for sterling).  The UK will buy 

more imports because they are now cheaper than UK goods (causing 

an increase in the supply of sterling).

•  A fall in UK interest rates – The UK will attract less foreign investment 

(causing a fall in the demand for sterling).  UK residents will now invest 

money in foreign banks which now have more attractive rates than 

domestic banks (causing an increase in the supply of sterling).

•  Speculation – Traders lose confidence in the pound expecting it to fall 

in value, this w  ill mean they will sell sterling (causing an increase in 

the supply of sterling) and they will not wish to buy sterling (causing a 

fall in the demand for sterling).

•  UK goods become less competitive – If foreigners no longer wish to but 

UK products due to quality issues, changes in tastes etc.  then the 

demand for sterling will fall.

THE HOUSING MARKET

THE DEMAND FOR HOUSES

An increase in the demand for houses can be caused by:

•  Income – rapidly increasing incomes tend to cause significant 

increases in the demand for houses.

•  Desire for home ownership – there is a certain status associated with 

home ownership.

•  Cost of mortgages – if the cost of mortgages are low then demand for 

houses will increase.  This can be caused by low interest rates, good 

fixed rates, discounted interest rates etc.

•  Availability of mortgages – at certain times financial institutions may 

make it easier to obtain a mortgage.  Examples include allowing people 

to borrow more, cash back schemes and 100% mortgages. 

•  Price expectations – a big influence on demand is if people believe that 

houses prices will continue to rise.  People thus believe that if the buy 

now they can sell at a profit later. 

THE SUPPLY OF HOUSES

In the short term the supply of houses is relatively inelastic since it is very 

difficult to bring new houses on to the market.  In the longer term supply can 

be influenced by: 

•  Costs of production – building costs such as price of land a wages can 

shift supply to the left. 

•  Government regulation – new government regulations can severely 

restrict the number of house being constructed.

•  Council house sales – in the 1980’s the government encouraged 

people to purchase their council houses. 

EFFECTS ON EQUILIBRIUM

The diagram below shows the effect of an increase in demand on the price of 

houses with an inelastic supply curve: 

Any increase in demand means only a small short term increase in supply but 

a relatively large increase in price.

RENT CONTROLS

The reason for the government to have rent controls is to provide cheap 

rented accommodation for the very poor.  The effect can be seen on the 

following diagram:

The rent control is an example of a maximum price, which brings down the 

cost of renting a house (R2).  There are however a few problems as a result: 

The quantity of rented accommodation available falls to Qs. 

There is now a shortage of rental accommodation equal to Qd – Qs. 

In the longer term landlords may opt not to rent out their accommodation and 

sell it instead, because their profits have fallen due to the lower rents now 

available.  This will bring about a further fall in the availability of rented 

accommodation and therefore an even bigger shortage. 

LABOUR MARKETS

THE DEMAND FOR LABOUR

The demand for labour is the firm’s willingness to employ labour at each given 

wage rate.  As the wage rate rises the demand for labour will fall and vice 

versa.

The reasons for this are:

•  As wages increase firms will look to substitute labour for something 

cheaper i.e. capital (machinery). 

•  As wages increase, this puts up costs of production, which will in turn 

put up the price of the product, as prices rise demand falls, therefore 

with less of the product demand there will be less need for labour. 

THE SUPPLY OF LABOUR

The supply of labour is the employees willingness to work at each given wage 

rate.  As the wage rate rises more labour will be supplied and vice versa.

The reasons for this are:

•  Higher wages attract worker from other industries.

•  Higher wages attract people who are currently unemployed.

•  In the long term higher wages encourage people to train to work in that 

occupation.

EQUILIBRIUM

This is established where demand for labour equals supply of labour.  As 

shown in the following diagram: 

SHIFTS IN DEMAND AND SUPPLY

The demand for labour can shift to the right because:

•  Demand for the product has increased.

•  Labour productiveness has increased (through better training, 

education and technology). 

•  Price of capital increases making it relatively cheaper to employ labour.

The diagram below shows the effects:

An increase in the demand for labour also increases both wages and the 

quantity of labour employed.

The supply of labour can shift to the right because:

•  Increase in population.

•  Working conditions have improved (or deteriorated in an alternative 

industry).

•  Increase in training and education (long term).

The effects are shown below:

An increase in the supply of labour causes wages to fall and a rise in the 

quantity of labour employed.

EFFECTS OF A MINIMUM WAGE

A minimum wage is very similar to a minimum price.  The idea of a minimum 

wage is to guarantee a reasonable wage to workers in low paid industries.  

The diagram below shows the effects of a minimum wage: 

The minimum wage is set at Wm above the equilibrium wage W1.  The workers 

in the industry have indeed benefited from higher wages, but there are a few 

negative effects:

The minimum wage has cause a surplus (excess supply of workers), as far as 

the labour market is concerned this has created unemployment in the industry 

equal to Qs – Qd.

Q1 – Qd have now lost their jobs (these people were originally working before 

the minimum wage was introduced).