ChainWhat it assumes · how to break it
Start
The government imposes a specific indirect tax on a product with external costs, for example the UK Soft Drinks Industry Levy, charged on producers of sugary soft drinks since April 2018 at two rates depending on sugar content.
1
As a result, producers' costs of supplying each unit rise, so the supply curve shifts up vertically by the amount of the tax.
specific tax · supply
specific tax · supply
Assumes: The tax is charged on each unit sold.
But: Producers can avoid a tax based on content by changing the product, as many drinks firms did by cutting sugar below the levy threshold before it began.
2
This means the market price rises, but usually by less than the tax, because producers absorb part of it to limit the fall in sales.
tax incidence
tax incidence
Assumes: Producers compete on price.
But: A firm with market power may raise its price by the full tax, or more, if it expects rivals to do the same.
3
Consequently, the price producers receive after paying the tax falls, so revenue per unit falls.
producer incidence
producer incidence
Assumes: Producers cannot pass the whole tax on.
But: If demand is very price inelastic, nearly all the tax is passed on and the price received barely falls.
4
At the same time, the quantity sold falls as consumers move up the demand curve.
PED
PED
Assumes: Demand responds to the higher price.
But: With inelastic demand sales fall only a little.
5
Therefore, producer surplus and profit fall, most of all for firms whose products cannot easily be changed.
producer surplus · profit
producer surplus · profit
Best link to attack
Assumes: Firms keep selling the product in its taxed form.
Assumes: Firms keep selling the product in its taxed form.
But: Firms can reformulate to escape the tax: many soft drinks makers cut sugar below the levy thresholds and paid a lower rate or none at all.
End
Producers receive a lower price per unit, sell fewer units and lose producer surplus and profit.
Evaluation chain
- E1However, the fall in profit depends on whether producers keep selling the product in its taxed form.
- E2Because the soft drinks levy is charged by sugar content, firms could cut sugar to move into the lower band or out of the levy altogether.
- E3As a result, many firms paid much less tax than expected, though reformulating has its own costs and some consumers disliked the new recipes.
- E4So producer profit falls much less than the simple tax diagram suggests, and the levy changed the products sold more than it cut sales.
Another way to attack it: Firms selling untaxed substitutes, such as bottled water or diet drinks, may gain sales, so the effect differs across producers in the industry.
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Questions this answers
- Explain how an indirect tax affects producer surplus.
- Assess the impact of the soft drinks levy on producers.
- Analyse why the incidence of a tax on producers depends on price elasticity of demand.
Diagram
Supply shifts up by the tax. Show the price received falling from P1 to P2 minus the tax and quantity falling from Q1 to Q2; shade the producer incidence and the producer surplus lost, including the producers' part of the deadweight loss triangle.
Reverse and related
Removal of the tax → the price received rises, sales rise and producer surplus recovers.