Indirect Taxes and Subsidies:
Producer & Consumer Surplus
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
1

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
Practice: Without looking at the previous page, draw 2 subsidy diagrams with a subsidy per
unit of wheat set @ $2/bushel. The first diagram should show the total price government
spends on a subsidy and the second should show welfare loss/gain for producers, consumers,
and the government. For the 1st diagram, write at the bottom which price is the price
consumers pay and which one is the price producers receive. Include a key for the 2nd diagram.
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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 (a per unit tax diagram)…
o
o
o
o
o
o

2 + 4 = the amount the government (EU) received for the tax
Tax per unit = difference between S (pre-tax) & S + tax (after tax)
P1, Q1 = Original equilibrium price and quantity
Q2 = New equilibrium quantity
P2 = Price consumers pay after tax
(new equilibrium price)
P2 – tax = Price producers receive after subsidy (consumer price - price of subsidy)
Explaining the #s on the diagram:
o
o
o
o
o
o
o
o
1+2+3
= Original Consumer Surplus
1
= Consumer Surplus After Tax
4+5+6
= Original Producer Surplus
6
= Producer Surplus After Tax
2+4
= Government Revenue From Tax
1+2+3+4+5+6 = Original Total Welfare
1+2+4+6
= New Total Welfare
3+5
= Deadweight Loss (DWL)
Below is an ad valorem tax diagram (20% tax): (C = price producers receive, P2 = price consumers pay)
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
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
Practice: Without looking at the previous page, draw 2 indirect tax diagrams.
The first is a
specific (per-unit) tax of 2 RMB/soda. The second is an ad valorem tax of 10%/soda. Be sure
to include any relevant explanations.
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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.
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