IBDP Economics 2.6 Elasticity of supply HL Paper 1 - New Syllabus

(a) Answer:

Price elasticity of supply (PES) measures the responsiveness of the quantity supplied of a good to a change in its price, ceteris paribus. Primary commodities generally have a relatively inelastic supply, whereas manufactured products tend to have a relatively more elastic supply.

1. The time period required to increase production is generally longer for primary commodities.

Many primary commodities, particularly agricultural products, depend on natural production cycles. Farmers cannot immediately increase the supply of crops following an increase in price because additional production may require several months or even years. Therefore, in the short run, the quantity supplied responds relatively little to a price increase, giving primary commodities a relatively low PES.

Manufactured products can often be produced more quickly by increasing working hours, using additional machinery or reallocating resources between production lines. Therefore, manufacturers may respond more rapidly to higher prices by increasing output, making the supply of manufactured products relatively more elastic.

2. Factors of production are generally less mobile and storage is more difficult for many primary commodities.

Production of primary commodities is often dependent on specific land, climate and natural resources. These factors cannot easily be moved or increased when prices rise. This limits the ability of producers to respond to changes in price and contributes to relatively inelastic supply.

In addition, some primary commodities are perishable and cannot be stored easily for long periods. For example, fresh agricultural products cannot simply be held in storage and released when prices rise. This reduces producers’ ability to adjust the quantity supplied in response to price changes.

Manufactured products are generally easier to store and producers may have unused capacity. If factories are operating below full capacity, firms can increase production relatively quickly when prices rise without immediately requiring large amounts of additional capital. This makes their supply relatively more elastic.

3. Costs of increasing production can also affect PES.

For primary commodities, expanding production may require substantial increases in land, labour and other inputs. As production expands, costs may rise significantly, limiting the response of quantity supplied to a higher price.

Manufacturing firms may be able to expand production using existing machinery and facilities, particularly when there is spare capacity. This allows quantity supplied to respond more strongly to price changes.

A relatively steep supply curve can represent the inelastic supply of a primary commodity, while a relatively flatter supply curve can represent the more elastic supply of a manufactured product. The flatter supply curve shows that a given change in price results in a larger percentage change in quantity supplied.

Therefore, the PES of primary commodities is generally lower because production often requires longer time periods, factors of production are less mobile, storage may be difficult and production capacity cannot be increased quickly. Manufactured products generally have more flexible production processes, greater storage possibilities and greater unused capacity, allowing supply to respond more strongly to price changes.

(b) Answer:

An indirect tax is a tax imposed on spending on goods and services, such as a specific tax per unit or an ad valorem tax. An increase in an indirect tax increases firms’ costs of supplying the product and therefore affects the price, quantity traded, government revenue and the welfare of different stakeholders.

Effect on the market

An increase in an indirect tax shifts the supply curve to the left/upward because the cost of supplying each unit increases. The new market equilibrium results in a higher price paid by consumers and a lower quantity traded.

The extent to which consumers and producers bear the tax depends on the relative PED and PES. If demand is relatively inelastic, consumers are less responsive to the higher price and are likely to bear a larger proportion of the tax. If demand is relatively elastic, producers may bear a greater proportion because a large increase in price would cause a substantial fall in quantity demanded.

Similarly, if supply is relatively inelastic, producers have less ability to reduce quantity supplied and may bear a greater proportion of the tax. Therefore, the incidence of the tax depends on the relative responsiveness of both consumers and producers.

Effect on consumers

Consumers generally lose from an increase in indirect tax because the price they pay increases and the quantity available for consumption decreases. This reduces consumer surplus.

For example, when governments increase taxes on cigarettes, the retail price increases. Consumers who continue purchasing cigarettes have less disposable income available for other goods and services, while some consumers may reduce their consumption.

The impact on consumers may be particularly significant when the tax is imposed on a necessity or a product for which demand is relatively inelastic.

Effect on producers

Producers may experience a reduction in revenue and profit because the tax increases their costs and reduces the quantity sold. Firms may absorb part of the tax rather than passing the entire amount on to consumers, particularly when demand is price elastic.

For example, an increase in taxation on fuel can increase the costs of petrol stations and other firms in the fuel supply chain. If firms cannot fully pass the tax on to consumers, their profit margins may fall.

Effect on workers

Workers may be affected if firms respond to lower sales and higher costs by reducing production. Firms may reduce working hours, slow recruitment or make workers redundant. The effect is likely to be stronger in industries where demand is highly responsive to price and the tax causes a substantial fall in output.

Effect on government

The government gains tax revenue from the indirect tax. The amount of revenue depends on the tax rate and the quantity of the good sold after the tax.

If demand is relatively inelastic, quantity demanded falls by a relatively small percentage following the increase in price. Therefore, the government may collect substantial revenue. If demand is highly elastic, the quantity demanded may fall considerably, limiting the increase in tax revenue.

Effect on resource allocation and allocative efficiency

An indirect tax can improve resource allocation when the taxed good creates a negative externality. For example, taxes on petrol and cigarettes can attempt to reflect some of the external costs associated with pollution or healthcare costs.

If the tax is correctly set to reflect the marginal external cost, it can move the market closer to the socially optimal level of output and improve allocative efficiency. However, accurately measuring the external cost is difficult, so the tax may be set too high or too low.

Real-world example: tobacco taxation

Governments have increased taxes on tobacco products to reduce smoking and generate government revenue. Because demand for cigarettes is relatively inelastic, the higher tax can raise significant revenue while reducing consumption to some extent. However, the relatively inelastic demand means that the fall in consumption may be smaller than the government would desire.

Real-world example: fuel taxation

Higher fuel taxes can increase the price of petrol and diesel, reducing demand and encouraging more efficient use of fuel. This can help address negative externalities such as congestion and pollution. However, higher fuel prices also increase transportation and production costs for businesses and can contribute to higher prices throughout the economy.

Regressive effects

Indirect taxes can be regressive because lower-income households may spend a larger proportion of their income on taxed necessities. An increase in the tax can therefore place a relatively greater financial burden on poorer households.

For example, a higher tax on fuel can disproportionately affect low-income households that rely on cars for commuting and have limited ability to switch to alternative forms of transport.

Macroeconomic consequences

A significant increase in indirect taxes can contribute to cost-push inflation because firms face higher production costs and may increase prices. If the tax applies to widely used inputs such as energy or fuel, the effects can spread throughout the economy.

However, if the tax reduces consumption and aggregate demand sufficiently, it could also reduce demand-pull inflation. The overall macroeconomic effect therefore depends on the size and nature of the tax and the state of the economy.

The type and size of the tax also matter. A specific tax imposes a fixed amount per unit, whereas an ad valorem tax is a percentage of the price. A large increase in either type can create a much larger effect on prices, output and stakeholder welfare than a small increase.

Overall evaluation: An increase in indirect tax generally raises the consumer price, lowers quantity traded and creates government revenue. Consumers and producers are likely to lose some surplus, while the government gains revenue. Workers may also be affected if firms reduce production and employment.

However, the consequences depend heavily on PED and PES, the size and type of the tax, the nature of the good and whether the tax is designed to correct a market failure. Where a negative externality exists, taxation can improve allocative efficiency by reducing overconsumption. However, the tax may be regressive and can create inflationary pressure if it significantly raises production costs.

Therefore, an increase in indirect tax can improve social welfare when it is targeted at goods generating significant external costs, but its overall consequences for stakeholders depend on the responsiveness of demand and supply and the government’s objectives.