Supply and demand exercises with tax

Supply shifts can be to the right or to the left. A shift of the supply curve to the right is due to an increase in supply, while a decrease in supply shifts the curve to the left.

When economists perform these price analyses they use the ceteris paribus assumption, which means “all else being equal”. Shifts in the supply curve reflect change in any one of the factors influencing consumer supply that is consequently distinct from price.

Note that a decrease in the supply of beer shifts the supply curve from O2 to O1. We have that at the initial price of 3 euros the quantity demanded is 3 million liters of beer. An increase in supply shifts the supply curve to O1. The quantity supplied is 2 million liters.

How a tax on a good affects the price paid by buyers.

A tax on sellers of a good will shift the supply curve to the left until the vertical distance between the two supply curves equals the tax per unit; ceteris paribus, this will increase the price paid by consumers, which is equal to the new market price. and decrease the price received by sellers.[1] A subsidy on production will shift the supply curve to the left until the vertical distance between the two supply curves equals the subsidy per unit; ceteris paribus, this will increase the price paid by consumers, which is equal to the new market price.[1

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A subsidy on output will shift the supply curve to the right until the vertical distance between the two supply curves equals the subsidy per unit; ceteris paribus, the price paid by consumers will fall, which is equal to the new market price, and will increase the price received by producers. Similarly, a subsidy on consumption will shift the demand curve to the right; ceteris paribus, the price paid by consumers will fall while the price received by producers will increase by the same amount as if the subsidy had gone to producers. However, in this case, the new market price will be the price received by producers. The end result is that the lower price paid by consumers and the higher price received by producers will be the same, regardless of the administration of the subsidy.[1] In this case, however, the new market price will be the price received by producers.

What effects a tax can have on welfare

Governments can choose between taxes on citizens or taxes on businesses to raise revenue. When considering taxes on businesses, it should be considered that these will increase the price of goods produced and sold, resulting in a welfare loss. However, a distinction must be made between the loss in producer and consumer surplus. The impact on both surpluses depends on the period analyzed.

In the short run, both consumers and producers will suffer from the tax. A new tax increases the price of goods. For example, let’s say this tax is levied on companies that increase prices to cover their losses. In this case, as seen in the adjacent figure, supply will shift to the left decreasing the quantity produced, which increases prices as demand remains unchanged. Therefore, the new equilibrium price will be PD (if the tax is levied on consumers, there will be a shift in demand). A corresponds to the amount of the tax paid by consumers, while B is the amount paid by producers. In reality, only consumers pay more, although producers will sell less. The loss in consumer and producer surplus will depend on the elasticity of the demand curve as seen in the figures below. The lower the elasticity in absolute terms (left figure), the greater the loss in consumer surplus and the lower the loss in producer surplus. Higher elasticity (figure on the right) will have the opposite effect.

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Difference between taxes and subsidies

Given all these elements we can say that the behavior of aggregate demand is very similar to what happens, in microeconomics, with the elasticity of demand, i.e.: at lower prices demand increases and if they rise it decreases.

This is totally logical: if prices are lower, all those who spend on consumer or production goods have more purchasing power because with the money they have they can buy more things and, on the contrary, if everything is more expensive, the purchasing power will be reduced and, probably, the desire to buy will be reduced as well.

This is represented by a graph we call the aggregate demand curve where the horizontal axis represents the total volume of purchases and the vertical axis represents the overall price level.

Although the price level is the variable, there are other factors that influence aggregate demand such as the level of fiscal pressure, expectations of economic growth or recession or the country’s currency exchange rate (inflation, exchange rates, possible devaluations).