Notesale: Turn your study into money

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An indirect tax is imposed on producers by the government, indirect taxes are used to help
correct market failures
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Market failures are caused by
the overproduction of goods with negative externalities these occurs because the price of the
goods to the buyer does not cover all of the costs of producing or consuming the good
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The current free market equilibrium is Q1, P1 this is where marginal private cost (S=MPC)
meets the marginal social benefit (D=MPB=MSB)
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At
the free market equilibrium there is too much production at too low a price this results in
overproduction
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An ad valorem tax increases the cost of production, this means firms are less
willing and able to sell at a given price and time
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This resulted in a contraction along
the D=MPB=MSB curve leading to an increase in price from P to P2 and a decrease in quantity
from Q to Q2, this would decrease consumption and production
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This helps corrects the market
failure of overproduction; this is because a decrease in quantity and an increase in price
makes the free market closer to the social optimum (Q1,P1)
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If the good which is getting overproduced is price inelastic, an indirect tax would
increase price from P to P1 leading to a less than proportional decrease in quantity demanded
from Q to Q1
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If the good was price inelastic an indirect tax would
not be effective in correcting the market failure of overproduction due to a less than
proportional decrease in quantity demanded
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As shown on graph 2
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P

P

Graph 1

S1

S1

Graph 2

S
P1

S

P1
P

D

P

D
Q1 Q

Q

Q1

Q

Q

The effectiveness of the tax would also depend on the size and the type of the tax
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This is because the size of the tax is equal to the external/social costs put on
society, meaning there is no welfare loss, which corrects the market failure
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The size of the
tax can impact the effectiveness of the tax because if a tax is too big it can create a new
market failure, as there are positive externalities in production as shown on the graph below
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C,P,B

MPC+tax
S=MPC

P2
P1

MSC

P
D=MPB=MSB
Q2 Q1 Q

Q

Indirect taxes can be regressive this means they take a proportionally greater amount of
money from those on a lower income
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This creates rising inequality which resulting in a government failure
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P
S1
P1

Payed by consumer

S

Payed by producer

P

D
Q1 Q

Q

An alternative way to correct this market failiure would be by subsidising Green technology
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if a producer to produce green technology it would lower the cost of production
this is because the producer would receive a subsidy per unit cost to the difference between
P3 and P2, as shown on the graph below
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This decreases cost of production shift S=MPC curve
to the right resulting in MSC=MPC with subsidy curve
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Move from the free market equalibrium of Q1,P1
to social opitum of Q2,P2
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Overall I think an indirect tax does help solve the market failure of overproduction
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This is because there are so many
factors that are needed for the tax to be effective
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The main factor that will depend on the effectiveness
of the tax is PED, this because it determines the whether the good is a neccesity and then the
amount of tax they need to put on the good

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