Solutions to market failure- Taxation

A summary page on taxation for the OCR unit 1 18 mark question

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Taxes- Taxation on products is indirect tax, these can be of two types: Flat rate (Excise duties) or
percentage taxes (Ad Valorem ) e.g. Vat at 20%. Some examples of products that are taxed:
Petrol- excises and ad valorem to reduce consumption to stop the externality of harmful
emissions but is a necessity and so inelastic bringing in government revenue.
Cigarettes- Excises due to negative externalities (Demerit good) For medical reasons and
creates a large income due to inelastic nature.
Alcohol- Also negative externalities and inelastic nature
Analysis of taxation- Assuming an excise duty is imposed, costs would become increased and supply
would shift to the left. Ideally the tax will reflect the negative externality on the third party and the
reduced supply will cause the equilibrium price to increase from P1 to P2 and the equilibrium quantity
falling from Q1 to Q2. For price elastic products producers pay the most of the tax and for inelastic
products the consumer pays most of the tax. Whomever pays the majority of the tax pays the tax
Tax and external cost diagram
To correct the market failure a tax is imposed to internalise the negative externality. This increases
cost to the producer who therefore supply less. The reduced supply causes equilibrium price rising
from P1 to P2 and equilibrium quantity falling from Q1 to Q2. Market failure is corrected here
because as the product is no longer under priced and over produced, therefore this has resolved the
Allocative inefficiency as the product is now produced at the socially desirable level of output.
Advantages and disadvantages of taxation
+ Internalises the external cost so that private costs equal the social costs (Raises price for the
consumer so causes consumption to fall correcting the market failure)
+ Polluter pays- The first party is being forced to account for the negative externality which
they have caused. This can be an incentive not to consume.
+ Fairer solution- equitable- Third party isn't being penalised
+ Tax revenue is made especially is it is price inelastic of demand which can therefore be spent
on providing merit goods or ring fenced to help stop the negative externalities
+ Can't be avoided because it is the law so it must be paid. They are incentivised to pay the tax
through legal action
+ Can be changed on a regular basis
- Taxes may causes British companies to become uncompetitive on the international market as
their costs rise
- Taxes maybe regressive (more spent from lower income groups than higher income
- If the product is very inelastic the negative externality may not fall and so not significantly
having an effect( Therefore the effectiveness of tax depends on the elasticity and the
government objectives of whether to cut consumption or make producer pay.)
- It is hard to work out the negative externality and therefore the size of the tax needed, this
means taxes may be too effective or not effective at all. the process of working out the

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These methods are very subjective as
they rely on value judgements. This leads to government failure if the value of the negative
externality is misjudged
- Taxes increase the price and therefore decreases consumer surplus.
- The size of the tax may also be a problem as politics may dictate the polices, governments
concerned about taxing too heavily and losing votes.…read more


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