Download Indirect Taxes and Subsidies - Producer and Consumer Surplus

Calculating Producer & Consumer Surplus
Hint: Calculate as a triangle!  (base X height)/2
Consumer Surplus Equation
Producer Surplus Equation
((Price intercept of Demand
line – Equilibrium Price) X
Quantity purchased)/2
((Equilibrium Price- Price
intercept of Supply line) X
Quantity purchased)/2
Below example:
(20-8) X 6 = 36
2
Below example:
(8-2) X 6 = 18
2
Practice: Calculate the Consumer & Producer Surplus using the following graph:
Consumer Surplus =
Producer Surplus =
1
Subsidies
Subsidy = An amount of money paid by the government to firms in order to prevent an
industry from failing, to support producers’ incomes, or as a form of protection against
imports. (Definition adapted from Tragakes. Also, subsidies “may also be paid to consumers as
financial assistance or for income redistribution”)

On the above graph…
o Shaded area = the amount the government (EU) spent on the subsidy
o Price per unit = difference between S1 (pre-subsidy) & S2 (after subsidy)
o P1, Q1 = Original equilibrium price and quantity
o Q2 = New equilibrium quantity
o P2 = Price consumers pay after subsidy
(new equilibrium price)
o P3 = Price producers receive after subsidy
(consumer price + price of subsidy)
Welfare Effects of a Subsidy

Because of the subsidy…
o Consumer & producer surpluses INCREASE! because the price for consumers is
lower than the original equilibrium price and the price for producers is higher than
the original equilibrium price.
o However, total social welfare DECREASES! b/c gov’t expenditure is factored in.

New CS + New PS – Gov’t expenditure
< Original CS + Original PS
2
Practice: Calculate the effects of a subsidy on consumer & producer surplus using the
following diagram:

Original CS:

Original PS:

Original Total (Social) Welfare:

New CS (after subsidy):

New PS (after subsidy):

Government expenditure on subsidy:

New Total (Social) Welfare:

Total Welfare Loss:
3
Indirect Taxes
Indirect tax = Tax levied on spending to buy goods and services, that are collected and paid
to the government by the supplier/firm instead of by the individual. (adapted from Tragakes)

On the below graph…
o 2 + 4 = the amount the government (EU) received for the tax
o Tax per unit = difference between S (pre-tax) & S + tax (after tax)
o P1, Q1 = Original equilibrium price and quantity
o Q2 = New equilibrium quantity
o P2 = Price consumers pay after tax
(new equilibrium price)
o P2 – tax = Price producers receive after subsidy (consumer price - price of subsidy)

Explaining the #s on the diagram:
o 1+2+3
= Original Consumer Surplus
o 1
= Consumer Surplus After Tax
o 4+5+6
= Original Producer Surplus
o 6
= Producer Surplus After Tax
o 2+4
= Government Revenue From Tax
o 1+2+3+4+5+6 = Original Total Welfare
o 1+2+4+6
= New Total Welfare
o 3+5
= Deadweight Loss (DWL)

Because of the tax…
o Consumer & producer surpluses DECREASE! because the price for consumers is
lower than the original equilibrium price and the price for producers is higher than
the original equilibrium price. (Also, unemployment may result. Why?)
o Also, total social welfare DECREASES! even w/ gov’t revenues factored in.

New CS + New PS + Gov’t expenditure
< Original CS + Original PS
4
Practice: Calculate the effects of an indirect tax on consumer & producer surplus using the
following diagram:

Original CS:

Original PS:

Original Total (Social) Welfare:

New CS (after tax):

New PS (after tax):

Government revenue from tax:

New Total (Social) Welfare:

Total Welfare Loss
5
Incidences of Taxes
w/Different Elasticities
Practice:
 Draw a diagram that demonstrates
the incidence of an indirect tax with a
unit elastic demand and an elastic supply.
 Draw a diagram that demonstrates
the incidence of a specific tax with an
inelastic demand and a unit elastic supply.
6
Linear Demand and Supply Functions
w/Subsidies and Indirect (Excise) Taxes




REMINDER – Linear demand function equation:
Qd = a – bP
REMINDER – Linear supply function equation:
Qs = c + dP
NEW – Linear supply function w/subsidies
Qs = c + d(P + subsidy)
NEW – Linear supply function w/excise tax
Qs = c + d(P – tax)
Practice: Plot demand and supply curves for a product from linear functions.
Plot both (a)
the original curves and (b) the new diagram with a subsidy.
o Qd = 60 – 2P
Qs = -20 + 2P
The subsidy is $4/kg
 Note: The price is in USD and the quantity is in kgs of stomflies sold per day.
Practice: Using the same information as above, draw a new diagram that shows the effect of
the subsidy. In a brief explanation, explain how the graph demonstrates changes in consumer
surplus, producer surplus, government expenditure, deadweight loss, and total surplus.
7
Practice: Plot demand and supply curves for a product from linear functions. Plot both (a)
the original curves and (b) the new diagram with an excise tax.
o Qd = 60 – 2P
Qs = -20 + 2P
The specific tax is 6.
 Note: The price is in Euros and the quantity is in stimples sold per day.
Practice: Using the same information as above, draw a new diagram that shows the effect of
the specific tax. In a brief explanation, explain how the graph demonstrates changes in
consumer surplus, producer surplus, government revenues, deadweight loss, and total surplus.
8