Effect of taxes and subsidies on price

Taxes and subsidies change the price of goods and, as a result, the quantity consumed.

Subsidy impact

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 subsidy is administered.

Effect of elasticity

Depending on the price elasticities of demand and supply, who bears more of the tax or who receives more of the subsidy may differ. Where the supply curve is less elastic than the demand curve, producers bear more of the tax and receive more of the subsidy than consumers as the difference between the price producers receive and the initial market price is greater than the difference borne by consumers. Where the demand curve is more inelastic than the supply curve, the consumers bear more of the tax and receive more of the subsidy as the difference between the price consumers pay and the initial market price is greater than the difference borne by producers.

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.

See also

• Excess burden of taxation
• Tax incidence