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```TAXATION AND SUBSIDY
TAX
• A charge placed on the production of a good and service by the Government.
For example petrol is taxed heavily by the Government
• A tax will increase the cost of production to the producer. It is makes it more
expensive to produce
• Impact :
A marginal tax on the sellers of a good will shift the supply curve to
the left until the vertical distance between the two supply curves is
equal to the per unit tax; when other things remain equal, this will
increase the price paid by the consumers (which is equal to the new
market price), and decrease the price received by the sellers.
An illustration
• The effect of this type of tax can be illustrated on a standard supply and
demand diagram. Without a tax, the equilibrium price will be at Pe and the
equilibrium quantity will be at Qe.
• After a tax is imposed, the price consumers pay will shift to Pc and the price
producers receive will shift to Pp. The consumers' price will be equal to the
producers' price plus the cost of the tax. Since consumers will buy less at the
higher consumer price (Pc) and producers will sell less at a lower producer
price (Pp), the quantity sold will fall from Qe to Qt.
This is a tax based on value or price. So the higher the price the higher the tax.
( b) Specific or unit tax
This tax is based o nthe quantity sold. That is why it is per unit, not based on
the value.
.
Example :
Demand function : P = 15 – Q
Supply function : P = 3 + 0.5 Q
Tax = 3 per unit
What is the P and Q and the equilibrium before and after taxation
Solution :
Pre - tax  - the equilibrium : D=S  Pe = 7 , Qe = 8
- supply function : P = 3 + 0.5 Q
Post - tax  - the price would be higher
- supply function changes anad the curve moves upward
- P’ = 3 + 0.5 Q’ + 3 = 6 + 0.5 Q’  Q’ = 2P’ – 12
The demand is fixed  P = 15 – Q  Q = 15 - P
The market equilibrium  15 – P = 2P – 12  P = 9 ; Q = 6
So post - tax : P’e = 9 ; Q’e = 6
Qs Post- tax
9 ....................... E’
7 ............................ ... E
3
Qs Pre - tax
Qd
Q
Burden of tax on consumer :
tC = 9 – 7 = 2 per unit
= 67%
Burden of tax on the seller/producer :
tP = t – tc
=3– 2=1
= 33% (less than consumers’ burden)
The tax received by the government (the government’s revenue) :
T = # unit sold post-test * tax per unit
= Q’e * t
= 6 * 3 = 18
( that’s why tax is governments’ sumber pendapatan)
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Graphically, there are three ways to determine the tax’s effect:
– Shift the supply curve up by T
– Shift the demand curve down by T
– Use a wedge between the amounts consumers pay and firms receive
PROPORTIONAL TAX / Ad valorem tax
- is a tax based on a certain percentage of the price, not specific
- the same effect , but different analysis
Supply : P = a + bQ

Q = - a/b + 1/b P
Say, proportional tax is 1% of price
P
P – tP
(1-t)P
P
= a + bQ + tP
( t is prop tax in %)
= a + bQ
= a + bQ
= a/(1-t) + b/(1-t) Q  Q = -a/b + (1-t)/b P
Use the same example
Demand function : P = 15 – Q
Supply function : P = 3 + 0.5 Q
The tax from the government is 25% to the selling price
What is the equilibrium price and the amount ( no tax and
with taxation )
Solution :
Pre – tax  Pe = 7 , Qe = 8
The demand is fixed, but the supply is after taxation with t = 25%
P = 3 + 0.5 Q + 0.25 P  0.75 P = 3 + 0.5 Q  P = 4 + 2/3 Q
Q = -6 + 1.5 P
Price equilibrium  Qd
= Qs
15 – P = -6 + 1.5 P  P = 8.4
Q = 6.6
So, after proportional tax, P’e = 8.4 and Q’e = 6.6
The tax received by the government per unit is
t * P’e = 0.25 * 8.4 = 2.1
Burden of the tax on consumer :
tC = P’e – pe = 8.4 – 7 = 1.4 ( 67% )
Burden of the tax on producer :
tP = t – tC = 2.1 – 1.4 = 0.7 ( 33% )
The goverment’ revenue :
T = Q’e * t = 6.6 * 0.25 = 1.6
SUBSIDY
A subsidy is the opposite of a tax used by the government to encourage certain
industries and products. A subsidy has the effect of shifting the supply curve to the
right.
This is a payment of money by the Government to a producer in order to encourage
them to produce or supply a certain good or service.
A subsidy will reduce the cost of production to the producer. It makes it cheaper to
produce.
SUBSIDY
A subsidy is the opposite of a tax used by the government to encourage
certain industries and products. So, a subsidy is a payment to the producer
per unit of production--it works exactly like the excise tax but in reverse
A subsidy has the effect of shifting the supply curve to the right.
This is a payment of money by the Government to a producer in
order to encourage them to produce or supply a certain good or
service.
A subsidy will reduce the cost of production to the producer. It makes it
cheaper to produce.
Price that seller
“sees”
p
p’
Price that
subsidy
S
}
S’
D
• Marginal subsidies on production will shift the supply curve to the right
until the vertical distance between the two supply curves is equal to the
per unit subsidy; when other things remain equal, this will decrease price
paid by the consumers (which is equal to the new market price) and
increase the price received by the producers.
• Similarly, a marginal subsidy on consumption will shift the demand curve
to the right; when other things remain equal, this will decrease the price
paid by consumers and increase the price received by producers by the
same amount as if the subsidy had been granted 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 that consumers pay and the higher
price that producers receive will be the same, regardless of how the
The effect of the subsidy to the equilibrium
- subsidy as a negative tax
- the effect to the product : selling price is decreased
- the market equilibrium ia less than that before / no subsidy
Pre-subsidy  supply function : P = a + bQ
Post-subsidy 
- “ P’ = a + bQ – S
= ( a – s ) + bQ
so the equilibrium point is lower
Why would a government subsidise a product?
• Protect jobs
• Good for the environment
• Improves people‘s health
• Protect a lifestyle (farming, fishing)
Demand function : P = 15 – Q
Supply function : P = 3 + 0.5 Q
The subsidy given by the government is 1.5 to the goods
What is the equilibrium (no subsidy and with subsidy)
Solution :
No subsidy  Pe = 7 , Qe = 8 ( as been done before)
With subsidy  selling price decreased, supply functin is changing
and the curve is downward
Supply no subsidy  P = 3 + 0.5 Q
Supply with subsidy  P = 3 + 0.5 Q – 1.5
= 1.5 + 0.5 Q  Q = -3 + 2 P
The equilibrium after subsidy :
Qd = Qs  15 – P = - 3 + 2P
18 = 3P  P = 6
Q = 15 – P = 15 – 9 = 6
Hence, with a subsidy  P’e = 6 and Q’e = 9
P
Qs (no subsidy)
7 ..................... E
6 ............................... E’
Qs (with subsidy)
0
8
9
15
Q
A subsidy given by the government causes production cost is less than the
real cost
The difference between the real cost and the production cost is the
As a production cost is decreased, the selling price would be decrease as
well and part of it received by the consumer (= SC)
SC = Pe – P’e
Subsidy received by the producer :
SP = S – SC
Subsidy given by the government :
S = Q’e * s