Part (a): how a specific tax on an inelastic good affects the market [10]
Defining the terms
An indirect tax is a tax on spending, levied on producers, who then pass some of it on to consumers through the price. A specific (or per-unit) tax is a fixed amount per unit sold, for example a set sum per litre or per packet, as opposed to an ad valorem tax charged as a percentage of price. Price elasticity of demand (PED) measures how responsive the quantity demanded is to a change in price; demand is price inelastic when PED is less than one in absolute value, so a given percentage rise in price causes a smaller percentage fall in quantity. Goods with few close substitutes, that are habit-forming, or that take a small share of income, such as tobacco, petrol or sugary drinks, tend to be inelastic.
How the tax works
A specific tax is a cost of production from the firm's point of view, so it shifts the supply curve vertically upwards by the full amount of the tax per unit. The new supply curve lies above the old one by exactly the tax at every quantity. With the demand curve unchanged, the market moves to a new equilibrium at a higher price and a lower quantity. The price the consumer pays rises, the quantity traded falls, and the government collects revenue equal to the tax per unit multiplied by the new quantity sold.
The crucial point is how the burden splits, and this is governed by PED. Because demand is inelastic, consumers are not very responsive to the higher price: they keep buying almost as much. That lets producers pass most of the tax on as a higher consumer price, because they will not lose many sales by doing so. The price paid by consumers therefore rises by most of the tax, while the price producers keep (the consumer price minus the tax) falls only a little. Quantity falls only modestly. So with inelastic demand the consumer bears most of the tax, the producer bears a smaller share, and government revenue is large because the quantity sold barely falls.
Describing the diagram in prose
Picture price on the vertical axis and quantity on the horizontal axis, with a downward-sloping but steep demand curve (steep because demand is inelastic) and an upward-sloping supply curve S meeting at the original equilibrium price and quantity. The tax shifts supply up to a new curve, S plus tax, parallel to and above the original by the per-unit tax. The new equilibrium sits where S plus tax meets demand: the consumer price rises to a noticeably higher level, while the quantity falls only slightly because the demand curve is steep. The price the producer actually receives is found by going straight down from the new equilibrium by the full tax. Government revenue is the rectangle whose height is the tax per unit and whose width is the new quantity sold. The share of that rectangle above the original price is the consumer's burden; the share below it is the producer's burden, and with inelastic demand the upper, consumer, share is the larger one.
Link back
A specific tax on a good with inelastic demand therefore shifts supply up by the tax, raises the price consumers pay by most of the tax, reduces quantity only a little, and yields substantial revenue. The inelasticity of demand is what makes the consumer bear the larger share of the burden and what keeps the fall in quantity small.
Part (b): the consequences of indirect taxes and subsidies for different stakeholders [15]
Introduction
A subsidy is a payment from the government to producers per unit of output, which lowers their costs, shifts the supply curve down by the subsidy, lowers the price consumers pay and raises the quantity traded. Where an indirect tax discourages output and raises revenue, a subsidy encourages output and costs the government money. A stakeholder is any party affected by the policy: here principally consumers, producers, the government and, where there is an externality, third parties. This answer discusses how taxes and subsidies redistribute welfare among these groups, and argues that the verdict for each stakeholder depends on elasticity, on how the revenue or spending is used, and on whether the intervention corrects a genuine market failure.
Consequences of an indirect tax
Consumers who keep buying a taxed good pay a higher price and, when demand is inelastic, bear most of the burden, which can be regressive because tobacco, fuel and sugary drinks take a larger share of poor households' incomes. Producers receive a lower net price, sell less and lose revenue, and in a competitive industry some marginal firms may exit. The government gains revenue, and when the tax is corrective it also reduces a negative externality, improving welfare for third parties. The UK Soft Drinks Industry Levy, introduced in 2018, illustrates a more subtle stakeholder effect: because it was tiered by sugar content, many producers reformulated their drinks to fall below the threshold rather than pass the tax on, so the headline burden on consumers was smaller than the simple model predicts and the public-health gain came partly through reformulation. Mexico's 2014 tax on sugary drinks, by contrast, was passed through to prices and is associated with a measurable fall in purchases, especially among lower-income households who were also the most exposed to the cost.
Evaluation. The consequences hinge on PED. With inelastic demand the consumer burden and the revenue are large but the fall in quantity, and so the externality correction, is small; the tax is better at raising money than at changing behaviour. The use of the revenue matters too: if it funds health care or compensation, the third-party and consumer losses are partly offset, but if it simply fills a budget gap the regressive impact stands.
Consequences of a subsidy
A subsidy reverses the distribution. Consumers gain from a lower price and higher consumption, which is the point when the subsidy supports a merit good such as public transport, renewable energy or vaccination, where consumption carries positive externalities. Producers gain a higher effective price and higher output, which supports incomes and employment. The losers are taxpayers, who fund the subsidy, and the burden carries an opportunity cost, because the money could have gone elsewhere. Fuel subsidies are the cautionary case: many governments, from Indonesia to Nigeria, have spent very large sums holding fuel prices down, only to find that the benefit flows disproportionately to richer households who consume more fuel, that the subsidy encourages over-consumption and pollution, and that the fiscal cost becomes unsustainable. When Nigeria removed its fuel subsidy in 2023 the immediate consequence was a sharp price rise that hit poor consumers hardest, showing how entrenched the consumer interest in a subsidy becomes.
Evaluation. A subsidy is justified for stakeholders as a whole when it corrects a positive externality, because the gain to third parties can outweigh the taxpayer cost. Where it props up consumption of an ordinary or polluting good, the taxpayer cost and the environmental harm make the net effect negative. Elasticity matters again: an inelastic good needs a large subsidy to raise consumption much, which is expensive.
Evaluation and judgement
Taxes and subsidies are mirror images that redistribute welfare among stakeholders rather than simply creating or destroying it. For an indirect tax, consumers and producers lose while the government and, if the tax is corrective, third parties gain; the split depends on PED, and the regressive impact depends on how the revenue is used. For a subsidy, consumers and producers gain while taxpayers lose; whether society gains depends on whether a positive externality is being corrected and on the fiscal cost. Two threads run through both. First, elasticity decides the size and incidence of the effect. Second, a tax or subsidy that targets a genuine market failure can raise total welfare, whereas one that merely shifts an ordinary market away from equilibrium imposes a deadweight loss. The supported judgement is that indirect taxes and subsidies are powerful redistributive tools whose consequences for any one stakeholder cannot be read off in the abstract: they depend on the elasticity of the good, on the presence of an externality, on how the revenue is spent or the subsidy funded, and on the time horizon, since both taxes and subsidies become harder to remove the longer the stakeholders who benefit come to rely on them.