These two policies are opposites doing the same job: both work by moving the supply curve. Get the three price points right on the diagram and every calculation in this sub-topic falls out of it.
📘 What you need to know
An indirect tax is paid on goods when they are bought. It is collected from producers, which is why the supply curve shifts left.
A specific tax is a fixed amount per unit, so the new supply curve is parallel to the old one. An ad valorem tax is a percentage, so the two curves diverge.
After a tax: consumers pay more (P2), producers keep less (P3), and quantity falls.
Tax revenue = (P2 − P3) × Q2. It splits into consumer incidence and producer incidence.
PED decides the split. The more inelastic demand is, the more of the tax consumers end up paying.
A subsidy is a payment per unit to producers, so supply shifts right: lower price for consumers, higher price for producers, higher quantity.
Subsidy cost = (P3 − P2) × Q2, paid by the government — so it has an opportunity cost.
Indirect taxes on a diagram
The tax adds to the cost of supplying every unit, so producers need a higher price to supply the same amount. Draw the new supply curve above the old one by the size of the tax, and read off three prices: what buyers pay, what the market used to be, and what sellers actually keep.
The trick students find hardest: P3 is where the new quantity meets the original supply curve. Drop a line from Q2 and see where it crosses S1.
Reading the diagram
The market started at P1Q1.
The tax shifts supply from S1 to S2, so the new equilibrium is P2Q2: higher price, lower quantity.
Producers hand the tax over, so they keep only P3 per unit.
The gap from P2 down to P3 is the tax per unit. Multiply it by Q2 for total tax revenue.
Box A (P2 − P1) × Q2 is what consumers pay. Box B (P1 − P3) × Q2 is what producers absorb.
A specific tax gives you a parallel shift; an ad valorem tax is a percentage, so the gap between the curves widens as the price rises and the two curves fan apart. Everything else about the diagram is identical.
WORKED EXAMPLE
A $6 per unit tax is placed on a good. Before the tax, price was $14 and 50,000 units were sold. After the tax, consumers pay $18, producers keep $12, and 38,000 units are sold. Calculate the tax revenue, the two incidences, and the welfare loss. [6]
Step 1: tax revenue6 × 38,000 = $228,000Step 2: consumer incidence (price rise × new quantity)(18 − 14) × 38,000 = $152,000Step 3: producer incidence (price fall × new quantity)(14 − 12) × 38,000 = $76,000Step 4: check they add up152,000 + 76,000 = 228,000 ✓Step 5: welfare loss is the triangle between the two quantities0.5 × (50,000 − 38,000) × 6 = $36,000Revenue $228,000; consumers $152,000, producers $76,000; welfare loss $36,000Consumers carry twice as much as producers, so demand here is relatively inelastic.
Who actually pays? PED decides
The government collects the tax from the seller, but that is not the same as the seller bearing the cost. If buyers have nowhere else to go, the firm can pass most of the tax on in a higher price. If buyers walk away easily, it cannot.
This is why taxes land on tobacco and fuel. Inelastic demand means the revenue is large and the burden falls mostly on the buyer.
Subsidies
A subsidy is the mirror image: a payment per unit to producers, so supply shifts right. Consumers pay less, producers receive more, and more is traded. The government picks up the bill.
The producer share is on top here because producers now receive more than the old price, while consumers pay less. It is the one diagram where the boxes swap round.
WORKED EXAMPLE
A government subsidises electric scooters by $8 per unit. Before: price $30, quantity 20,000. After: consumers pay $24, producers receive $32, quantity 26,000. Calculate the total cost to the government and each side’s share. [5]
Step 1: total cost (subsidy × new quantity)8 × 26,000 = $208,000Step 2: consumer share (price fall × new quantity)(30 − 24) × 26,000 = $156,000Step 3: producer share (price rise × new quantity)(32 − 30) × 26,000 = $52,000Step 4: check156,000 + 52,000 = 208,000 ✓Cost $208,000: $156,000 to consumers, $52,000 to producersConsumers gain most here because demand is relatively inelastic, exactly as with a tax.
🧩 Drawing either diagram without getting lost
Draw the original market and label P1Q1.
Shift supply: left and up for a tax, right and down for a subsidy.
Mark the new equilibrium P2Q2 where the new supply curve meets demand.
Drop a line down from Q2 to find where it crosses the original supply curve. That price is P3.
Draw the boxes from the vertical axis across to Q2, split at P1.
Label everything and state which box belongs to whom.
Evaluating the two policies
Policy
Arguments for
Arguments against
Indirect tax
Raises revenue; discourages harmful consumption; makes producers cover some of the damage they cause.
Barely reduces consumption when demand is inelastic; regressive, hitting poorer households hardest; can push trade into illegal markets; job losses if output falls a lot.
Subsidy
Lowers prices and raises consumption of goods society wants more of; supports domestic industries; can change habits over time.
Expensive, with a large opportunity cost; can prop up inefficient firms; often kept alive by lobbying long after the original reason has gone; may create excess supply.
The tax paradox worth memorising. A tax works best for revenue when demand is inelastic, and best for cutting consumption when demand is elastic. It can never do both jobs brilliantly at once, and saying so is a strong evaluation line.
💡 Exam tip
Always shift supply, never demand. The tax or subsidy changes what it costs to supply, not what buyers want.
Build both incidence boxes from Q2, the new quantity. Using Q1 is the single most common diagram error here.
Label all three price points. Answers that show only P1 and P2 cannot earn the incidence marks.
Bring PED into every evaluation: it decides who pays, how much revenue there is, and whether behaviour changes.
Check your incidences add up to the total. It is a free accuracy check.
For subsidies, always mention opportunity cost. The money had to come from somewhere.
⚠ Common mix-up
Shifting the demand curve when a tax is imposed. Demand has not changed at all.
Thinking producers pay the whole tax because they hand it over. They only bear the part they cannot pass on.
Measuring tax revenue with the old quantity. Fewer units are traded now, and the tax is only collected on those.
Putting the consumer box on top for a subsidy. The boxes swap round for subsidies.
Drawing an ad valorem tax as a parallel shift. Percentage taxes make the curves diverge.
Calling a subsidy free. It is government spending, so something else gets less.
Forgetting the welfare loss triangle when a question asks about efficiency.
Up next: Price Ceilings and Price Floors — what happens when a government stops moving the curves and simply outlaws certain prices.
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