Define specific vs ad valorem taxes and explain how they shift supply
Analyse tax incidence using PED and PES
Explain how subsidies work and their effect on equilibrium price and quantity
Evaluate government intervention via taxes and subsidies using real evidence
Indirect Taxes
What is an Indirect Tax?
Definition
An indirect tax is a tax on expenditure, levied on goods/services rather than income. It raises the cost of production, shifting supply LEFT (upward). Two types:
[Specific] — fixed amount per unit (e.g. £0.57/litre fuel duty)
[Ad valorem] — percentage of price (e.g. 20% VAT)
In both cases, supply shifts left by the amount of the tax.
SPECIFIC TAX
Fixed £ amount per unit sold. Supply shifts up by a constant vertical distance at every quantity. The tax wedge is the same width regardless of price level.
AD VALOREM TAX
Percentage of price. The tax wedge widens at higher prices — so the supply curve rotates, not just shifts. At low prices the wedge is small; at high prices it is large.
Tax Diagram
Effect of an Indirect Tax on Equilibrium
S₁ = Original supply
S₂ = Supply after tax (shifts left/up)
D = Demand
Pc = Consumer price
Pp = Producer price (after remitting tax)
CONSUMER PRICE RISES
The tax raises the price consumers pay from P* to Pc. How much depends on PED — inelastic demand → consumers bear more of the tax burden.
PRODUCER PRICE FALLS
Producers receive Pp < P* after remitting the tax. Inelastic supply → producers bear more of the burden.
QUANTITY FALLS
The tax reduces the quantity traded from Q* to Qt. This creates a deadweight loss triangle — welfare lost that cannot be recovered.
TAX REVENUE
Tax revenue = tax per unit × Qt. On the diagram it's the rectangle between Pc and Pp over the range 0 to Qt — split between consumer and producer contributions.
Tax Incidence
Who Bears the Tax Burden?
INELASTIC DEMAND (PED close to 0)
Consumers bear most of the tax. Supply shifts, but quantity barely changes. Price rises substantially. Examples: petrol, cigarettes, alcohol — deliberately targeted because tax incidence falls on consumers and revenue is predictable. Fiscal drag = most of tax revenue comes from consumers.
ELASTIC DEMAND (PED >> 1)
Producers bear more of the tax. Consumers would switch away, so supply shifts left, quantity falls significantly, and price rises only slightly. Producers must absorb most of the cost to retain customers.
KEY FORMULA
Consumer's share ≈ PES / (PES + |PED|) × tax per unit
Producer's share ≈ |PED| / (PES + |PED|) × tax per unit
Essay Tip: The more inelastic the demand, the more effective the tax is at raising revenue. The more elastic the demand, the more effective it is at changing behaviour (e.g. reducing plastic bag use).
Real-World Application · UK Plastic Bag Charge 2015
Elastic Demand in Action: The 5p Bag Charge
🛍️ THE POLICY
England introduced a 5p charge on single-use plastic bags in October 2015 (raised to 10p in 2021). Prior to this, supermarkets distributed 7.6 billion bags per year. By 2020, usage had fallen by 95% to under 400 million. Revenue (donated to charity) ≈ £800m over 5 years.
📊 THE ECONOMICS
The charge is a specific indirect tax. Supply of bags (from retailer's perspective) shifted left. With elastic consumer demand (easy substitutes: reusable bags), quantity fell dramatically. This is a textbook case of an elastic demand market where a small tax creates large behavioural change.
💡 WHY USE A TAX?
A direct ban would eliminate plastic bags entirely but eliminate consumer choice. A tax allows a price signal that lets consumers decide — those for whom bags are most valuable still buy them. This is the Pigouvian rationale: pricing in the negative externality of plastic pollution.
📝 EXAM LINK
This is also a market failure example (negative externality). The tax internalises the external cost of plastic pollution. Note PED is elastic here — which is unusual for a sin tax. Most sin taxes target inelastic goods (alcohol, tobacco, fuel) to maximise revenue; this tax targets behaviour change instead.
Subsidies
What is a Subsidy?
Definition
A subsidy is a payment by the government to producers to reduce their costs of production. It shifts supply RIGHT (downward), reducing the consumer price and increasing the quantity produced. Subsidies are used to: correct positive externalities, support strategic industries, reduce prices for essential goods, and encourage socially desirable behaviour.
CONSUMER BENEFIT
Consumer price falls. The subsidy is partially passed on to consumers via lower prices. How much depends on PED — more elastic demand = more benefit passed to consumers.
PRODUCER BENEFIT
Producers receive the market price PLUS the subsidy from the government. Effective price = Pmarket + subsidy. This allows high-cost firms to remain viable and expand output.
COST TO GOVERNMENT
Subsidy cost = subsidy per unit × quantity produced. This is a charge on taxpayers and must be weighed against the social benefits generated by increased output.
Subsidy Diagram
Effect of a Subsidy on Equilibrium
S₁ = Original supply
S₂ = Subsidised supply (shifts right/down)
D = Demand
Pc = Lower consumer price
Pp = Higher producer price (incl. subsidy)
PRICE FALLS FOR CONSUMERS
Pc < P*. Consumers benefit from lower price. The proportion passed on depends on relative PED/PES elasticities.
PRODUCERS RECEIVE MORE
Pp > P* — the producer gets the lower market price plus the government transfer. Higher revenue per unit enables expanded production.
MORE OUTPUT
Q rises from Q* to Qs. More of the good is produced and consumed — suitable for goods with positive externalities where private markets under-supply.
SUBSIDY COST
= (Pp − Pc) × Q_new = subsidy per unit × new quantity. Government must fund this from taxation — the fiscal cost must be weighed against social benefits.
Real-World Application · UK Plug-In Car Grant 2011–2022
Subsidising Electric Vehicles
🚗
UK Plug-In Car Grant
2011–2022 Up to £3,500 per vehicle
EV share of new car sales: <0.1% → 15%
THE NUMBERS
The Plug-In Car Grant ran from 2011 to 2022. At its peak it subsidised up to £3,500 off a qualifying EV. By 2022, EVs made up 15% of new UK car registrations, up from under 0.1% in 2011. The subsidy was gradually reduced and then ended entirely in June 2022.
THE ECONOMICS
The subsidy reduced the effective price consumers paid, shifting the supply curve rightward/downward. Because EV demand was relatively elastic (consumers were price-sensitive), much of the subsidy was passed through to consumers as lower prices, driving adoption.
THE DEBATE
Critics: the subsidy mainly benefitted wealthier buyers who could afford EVs without the grant — much of the benefit went as windfall consumer surplus (deadweight subsidy cost). Supporters: the positive externality of lower carbon emissions justified the cost. The policy was ended when EV demand became less elastic and buyers no longer needed the incentive.
Evaluation
Evaluating Taxes and Subsidies
Strengths
Indirect taxes can correct negative externalities by pricing in social costs (Pigouvian approach)
Elastic demand markets respond strongly to taxes, achieving large behavioural change
Subsidies can address positive externalities and market failures where private markets under-produce
Revenue from taxes can fund public goods or be recycled as subsidies (double dividend)
Limitations
Difficult to set the optimal tax rate — requires knowing the exact external cost, which is hard to measure
Regressive taxes (e.g. fuel duty) fall proportionally more on lower-income households
Subsidies distort market signals, may prop up inefficient industries, and create fiscal pressure
Firms/consumers may adapt around taxes (smuggling, tax avoidance, substitution to untaxed goods)
Essay Tip: Evaluate the effectiveness of a tax by asking two questions: (1) Is demand elastic or inelastic — does it change behaviour or just raise revenue? (2) Is the tax correctly calibrated to the external cost? A tax that raises revenue without changing behaviour may be regressive without correcting the market failure.
Glossary
Key Terms
Indirect Tax
Tax on expenditure, not income. Shifts supply left (upward). Can be specific (per unit) or ad valorem (% of price).
Specific Tax
Fixed monetary amount per unit (e.g. £0.57/litre fuel duty). Supply shifts up by a constant vertical amount at every quantity.
Ad Valorem Tax
Tax as a percentage of price (e.g. 20% VAT). The tax wedge grows larger at higher prices — supply curve rotates.
Tax Incidence
The division of the tax burden between consumers and producers, determined by relative PED and PES.
Subsidy
Government payment to producers, reducing costs and shifting supply right (downward). Consumer price falls, quantity rises.
Deadweight Loss
The loss of welfare (CS + PS) from the reduction in quantity below Q* caused by the tax distortion. Represents genuine welfare destruction.
Question 1 of 8 · Indirect Taxes & Subsidies
A specific tax of £1 per unit is imposed on cigarettes. Which effect on the supply diagram is correct?
A
Demand shifts left — consumers buy fewer cigarettes
B
Supply shifts left (upward) by £1 at every quantity
C
Supply shifts right — producers increase output to pay the tax
D
Demand shifts right — the tax raises the price consumers face
Answer · Question 1
A specific tax of £1 per unit is imposed on cigarettes. Which effect on the supply diagram is correct?
A
Demand shifts left — consumers buy fewer cigarettes
B
Supply shifts left (upward) by £1 at every quantity
C
Supply shifts right — producers increase output to pay the tax
D
Demand shifts right — the tax raises the price consumers face
Correct: B. A tax raises the cost of supplying each unit, so producers need a higher price to supply the same quantity — supply shifts left (upward). Demand is unchanged — it only shifts when consumer income, preferences or the price of related goods change. The shift is vertical (upward) by exactly £1 per unit for a specific tax.
Question 2 of 8 · Indirect Taxes & Subsidies
Demand for petrol is very inelastic (PED = −0.1). A fuel duty of 20p per litre is introduced. Who bears most of the tax burden?
A
Producers — they cannot pass costs on to price-sensitive consumers
B
Consumers — they have no good substitutes and cannot easily reduce usage
C
The government — tax revenue falls as consumers switch to alternatives
D
The burden is split equally regardless of elasticity
Answer · Question 2
Demand for petrol is very inelastic (PED = −0.1). A fuel duty of 20p per litre is introduced. Who bears most of the tax burden?
A
Producers — they cannot pass costs on to price-sensitive consumers
B
Consumers — they have no good substitutes and cannot easily reduce usage
C
The government — tax revenue falls as consumers switch to alternatives
D
The burden is split equally regardless of elasticity
Correct: B. With very inelastic demand, consumers cannot easily reduce consumption or switch away. Producers can pass virtually all of the tax through as higher prices, and consumers pay it. The more inelastic demand is, the larger the consumer share of the tax burden — this is why petrol, tobacco, and alcohol are typical targets for excise duties.
Question 3 of 8 · Indirect Taxes & Subsidies
The UK plastic bag charge reduced bag usage by 95%. This suggests the demand for plastic bags is:
A
Perfectly inelastic — consumers will pay any price
B
Inelastic — demand barely responded to the price change
C
Elastic — consumers easily switched to reusable alternatives
D
Unit elastic — demand fell by exactly the same % as the price rose
Answer · Question 3
The UK plastic bag charge reduced bag usage by 95%. This suggests the demand for plastic bags is:
A
Perfectly inelastic — consumers will pay any price
B
Inelastic — demand barely responded to the price change
C
Elastic — consumers easily switched to reusable alternatives
D
Unit elastic — demand fell by exactly the same % as the price rose
Correct: C. A 95% fall in quantity in response to a 5p charge means demand was very elastic. Consumers easily substituted to reusable bags (close substitutes were available). Compare this to cigarettes, where a similar proportional price rise would cause a much smaller reduction — that's inelastic demand. The plastic bag charge was effective as a behaviour-change tool precisely because demand was elastic.
Question 4 of 8 · Indirect Taxes & Subsidies
A subsidy is granted to solar panel manufacturers. Which diagram change correctly represents this?
A
Demand shifts right — consumers want more solar panels
B
Supply shifts left — manufacturers reduce output in response
C
Supply shifts right (downward) — lower production costs enable more supply at each price
D
Supply shifts left and prices rise
Answer · Question 4
A subsidy is granted to solar panel manufacturers. Which diagram change correctly represents this?
A
Demand shifts right — consumers want more solar panels
B
Supply shifts left — manufacturers reduce output in response
C
Supply shifts right (downward) — lower production costs enable more supply at each price
D
Supply shifts left and prices rise
Correct: C. A subsidy reduces manufacturers' costs of production, so they're willing to supply more at every price — supply shifts right (downward). Consumers benefit from a lower price. This is the opposite of a tax. Note: it is the supply curve that shifts, not demand — the subsidy works by reducing production costs, not by changing consumer preferences.
Question 5 of 8 · Indirect Taxes & Subsidies
If PED = −2 and PES = 1, what fraction of a specific tax falls on consumers?
A
2/3
B
1/3
C
2/1
D
1/2
Answer · Question 5
If PED = −2 and PES = 1, what fraction of a specific tax falls on consumers?
A
2/3
B
1/3
C
2/1
D
1/2
Correct: B. Consumer share = PES / (PES + |PED|) = 1 / (1 + 2) = 1/3. Producer share = |PED| / (PES + |PED|) = 2/3. When demand is more elastic than supply, producers absorb more of the tax (they can't pass it on without losing customers). Memorise: elastic demand → producers bear more. Inelastic demand → consumers bear more.
Question 6 of 8 · Indirect Taxes & Subsidies
Which best describes the cost of a subsidy to the government?
A
The reduction in consumer surplus caused by the subsidy
B
Subsidy per unit × original equilibrium quantity Q*
C
Subsidy per unit × new (higher) quantity produced after the subsidy
D
The increase in producer surplus only
Answer · Question 6
Which best describes the cost of a subsidy to the government?
A
The reduction in consumer surplus caused by the subsidy
B
Subsidy per unit × original equilibrium quantity Q*
C
Subsidy per unit × new (higher) quantity produced after the subsidy
D
The increase in producer surplus only
Correct: C. Government subsidy cost = (Pp − Pc) × Q_new, where Q_new is the quantity produced after the subsidy. This is larger than Q* because the subsidy increases output. On the diagram, it's the rectangle between the producer price and consumer price, stretching from 0 to Q_new. A common mistake is to use Q* instead of Q_new — always use the post-subsidy quantity.
Question 7 of 8 · Indirect Taxes & Subsidies
What is the deadweight loss created by an indirect tax?
A
The tax revenue collected by the government
B
The fall in producer surplus from the lower producer price
C
The loss of mutually beneficial transactions that no longer occur between Qt and Q*
D
The increase in consumer surplus from the lower price
Answer · Question 7
What is the deadweight loss created by an indirect tax?
A
The tax revenue collected by the government
B
The fall in producer surplus from the lower producer price
C
The loss of mutually beneficial transactions that no longer occur between Qt and Q*
D
The increase in consumer surplus from the lower price
Correct: C. Deadweight loss is the value of transactions that would have occurred at equilibrium (between Qt and Q*) but are prevented by the tax. At these quantities, WTP > MC — both parties could gain — but the tax wedge makes trading unprofitable. This is the inefficiency cost of the tax. The tax revenue itself is a transfer from consumers/producers to government, not a loss — it's the DWL triangle that represents genuine welfare destruction.
Question 8 of 8 · Indirect Taxes & Subsidies
The UK Plug-In Car Grant subsidised EVs by up to £3,500. Some economists argue part of the subsidy was wasted. This is because:
A
The subsidy shifted demand rather than supply
B
EV buyers are typically high-income consumers who didn't need the incentive
C
Subsidies always create negative externalities
D
The supply of EVs was perfectly inelastic
Answer · Question 8
The UK Plug-In Car Grant subsidised EVs by up to £3,500. Some economists argue part of the subsidy was wasted. This is because:
A
The subsidy shifted demand rather than supply
B
EV buyers are typically high-income consumers who didn't need the incentive
C
Subsidies always create negative externalities
D
The supply of EVs was perfectly inelastic
Correct: B. A 'wasted' subsidy (deadweight subsidy cost) occurs when it is paid for transactions that would have happened anyway — buyers who would have purchased the EV even at the unsubsidised price receive windfall consumer surplus. Economists call this 'infra-marginal' benefit. The subsidy is most efficient at the margin — persuading buyers who wouldn't otherwise switch. Evidence suggests early EV adopters were high-income buyers who would have bought EVs anyway, so a significant portion of the grant went to those who didn't need it.
End of Lesson
Lesson Complete
You've covered indirect taxes, subsidies, tax incidence, and real-world applications.
KEY TAKEAWAYS
• Indirect taxes shift supply left/upward; subsidies shift supply right/downward
• Tax incidence depends on relative elasticities — inelastic demand → consumers bear more
• Consumer share = PES / (PES + |PED|) — memorise this formula
• Deadweight loss = welfare lost from transactions prevented by the tax
• Subsidy cost = subsidy per unit × post-subsidy quantity (not Q*)
Next: review your MCQ answers above — focus on any questions you missed. Strong exam answers link theory to data (e.g. plastic bag charge) and evaluate using elasticity arguments.