Evaluate the likely microeconomic effects of an indirect tax

Question 1

KAA1

Answer 1

An indirect tax raises the price of goods with negative externalities (e.g., cigarettes, alcohol, sugary drinks) → Higher prices cause quantity demanded to fall (especially if demand is price elastic) → Reduces overconsumption → Corrects market failure → Moves output closer to the socially optimal level, improving allocative efficiency.

Chain of reasoning (→ arrows):
Indirect tax ↑ → Prices ↑ → Quantity demanded ↓ → Negative externalities ↓ → Allocative efficiency ↑ → Market failure corrected.

✅ Stakeholder Focus:

Consumers: Face higher prices, but benefit from reduced external harms (e.g., health issues, environmental damage).

✅ Real-life Application:

The UK Soft Drinks Industry Levy (2018) helped cut sugary drink sales by 10% while increasing sales of low-sugar alternatives (British Medical Journal, 2019).

📈 Diagram Suggestion:

Negative externality diagram:

Show MSC (marginal social cost) above MPC (marginal private cost).

Indirect tax shifts supply left → Price rises → Output falls towards socially efficient quantity (Qoptimum).

Question 2

Eval1

Answer 2

If the good has price inelastic demand (e.g., cigarettes, addictive goods) → Quantity demanded falls only slightly → Tax mostly raises government revenue without significantly reducing harmful consumption → Market failure persists.

✅ Real-life Application:

Cigarette taxes are very high in the UK, yet smoking rates fell only gradually because demand is highly inelastic.

✅ Other Stakeholders Affected:

Government: Gains extra tax revenue (positive for public services).

Producers: See revenue fall if sales decline sharply (especially for smaller brands).

Question 3

KAA2

Answer 3

Indirect taxes increase firms’ marginal costs → Shifts the supply curve left → Firms pass some costs onto consumers → But small firms with fewer resources may struggle to absorb the tax → Leads to lower investment, higher production costs, and possible firm closures → This reduces productive efficiency in the market.

Chain of reasoning (→ arrows):
Indirect tax ↑ → Production costs ↑ → Supply curve shifts left → Small firm profitability ↓ → Investment ↓ → Productive inefficiency ↑.

✅ Stakeholder Focus:

Small Producers: Most vulnerable to indirect taxes; risk being pushed out of the market.

✅ Real-life Application:

After the sugar tax, smaller drink companies (e.g., boutique sodas) struggled more than multinational brands like Coca-Cola, which could afford reformulation and marketing changes.

📈 Diagram Suggestion:

Supply and demand diagram:

Supply shifts left → Price rises → Quantity falls.

Highlight how costs are divided between producers and consumers depending on elasticity.

Question 4

Eval2

Answer 4

Larger firms with strong brand loyalty or economies of scale (e.g., Coca-Cola, Nestlé) can absorb the tax better → They can spread higher costs over more units → Remain profitable and maintain productive efficiency → Only weaker firms exit.

✅ Real-life Application:

Coca-Cola continued strong sales despite the UK Sugar Tax, partly because loyal consumers accepted higher prices.

✅ Other Stakeholders Affected:

Consumers: May lose product variety if smaller brands exit.

Government: Benefits from industry reformulation (healthier products).