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IB DP Economics — Unit 2: Microeconomics | SL | 2.7 Role of Government in Microeconomics
📋 What You Will Learn
- Define indirect taxes and distinguish between specific (unit) and ad valorem taxes
- Explain how each type of tax shifts the supply curve and affects market equilibrium
- Analyse how the burden of an indirect tax is shared between consumers and producers using diagrams
- Apply the concept of price elasticity of demand (PED) to determine tax incidence
- Evaluate the effectiveness of indirect taxes as a government policy tool, considering equity and efficiency
🔍 Guiding Question When a government taxes a good, who actually pays — the consumer or the producer — and does it matter which one the tax is legally imposed on?
🌍 Why This Matters In 2023, the UK government raised tobacco duty by 15% and introduced a new vaping products tax, while Australia increased its alcohol excise by 3.5%. In both cases, the legal obligation to pay fell on producers — yet consumers saw their prices rise almost immediately. Understanding indirect taxes reveals a fundamental truth: who pays a tax legally and who bears the economic burden are two entirely different questions.
What Is an Indirect Tax?
Governments intervene in markets for many reasons: to raise revenue, to correct market failures, or to discourage consumption of harmful goods. One of the most common tools is the indirect tax — a tax on spending rather than on income.
📖 Definition — Indirect Tax An indirect tax is a tax levied on producers for the production or sale of a good or service. The tax is "indirect" because it is collected from producers but can be partially or fully passed on to consumers through higher prices. Indirect taxes shift the supply curve upward (leftward) by the amount of the tax.
There are two main types of indirect tax in the IB syllabus: specific (unit) taxes and ad valorem taxes. They differ in how the tax amount is calculated and how they affect the supply curve.
Specific (Unit) Taxes
📖 Definition — Specific (Unit) Tax A specific tax (also called a unit tax) is a fixed monetary amount charged per unit of a good, regardless of the price of the good. For example, a tax of $2 per litre of petrol or £5 per pack of cigarettes. The tax amount does not change as the price of the good changes.
Effect on the Supply Curve — Specific Tax
- A specific tax increases the cost of production by a fixed amount per unit.
- This shifts the supply curve vertically upward by the exact amount of the tax at every quantity.
- Because the shift is a constant vertical distance, the new supply curve (S₁) is parallel to the original supply curve (S₀).
- The equilibrium price rises, but by less than the full tax amount (unless demand is perfectly inelastic).
- The equilibrium quantity falls.
💡 Key Insight — The Tax Wedge The tax creates a "wedge" between what consumers pay (p₁) and what producers receive (p₂). The difference p₁ − p₂ always equals the tax per unit (t), regardless of elasticity. What elasticity determines is how this wedge is divided — how much of the tax is borne by consumers versus producers.
Ad Valorem Taxes
📖 Definition — Ad Valorem Tax An ad valorem tax is a tax