IBonomicsIndirect Tax and Market OutcomesSL
MicroeconomicsA diagram showing the effects of an indirect tax on a market, resulting in a leftward shift of the supply curve, higher price for consumers, lower quantity traded, and a reduction in market efficiency.
Curves and elements
- demand
- Demand Curve: Downward-sloping, showing the inverse relationship between price and quantity demanded.
- original supply
- Supply Curve: Upward-sloping, representing the pre-tax quantity producers are willing to supply at each price.
- new supply
- Supply + Indirect Tax: The new supply curve after a per-unit tax increases production costs.
- price effect
- Price Effect: Consumers face a higher price (P+t), depending on the tax incidence.
- quantity effect
- Quantity Effect: Quantity falls from Qe to Q+t, reducing market efficiency.
Key explanations
- 1
An indirect tax is a tax imposed on goods or services, typically paid by producers but passed on to consumers through higher prices.
- 2
The tax shifts the supply curve upward (or to the left), from 'Supply' to 'Supply + Indirect Tax'.
- 3
At the new equilibrium, the price consumers pay rises from Pe to P+t, while the quantity exchanged falls from Qe to Q+t.
- 4
The vertical distance between the original and new supply curves represents the tax per unit.
- 5
While indirect taxes raise government revenue and can help internalize externalities (e.g. cigarette or carbon taxes), they may also reduce consumer and producer surplus and cause welfare loss.
Example exam question
Using a diagram, explain how an indirect tax affects market outcomes, and evaluate the use of indirect taxes as a form of government intervention.
Show example answer
An indirect tax increases production costs, shifting the supply curve leftward. This raises the market price from Pe to P+t and reduces quantity from Qe to Q+t. The tax burden is shared between consumers (who pay more) and producers (who receive less revenue per unit). Governments often use indirect taxes to correct negative externalities — for example, taxing sugary drinks or fossil fuels. However, the effectiveness depends on the elasticity of demand. If demand is inelastic, tax revenue is high but welfare loss may be large. Regressive impacts on low-income groups may also occur.
