1.)

a) Explain the difference between a specific tax and an ad valorem tax. Give an example of each and discuss their impact on consumers and producers. (10 marks)

Taxes are an important tool used by governments to generate revenue for public spending, as well as to regulate economic activities. There are several types of taxes that governments may use, including specific taxes and ad valorem taxes.

A specific tax is a tax that is levied on a fixed amount per unit of a good or service, regardless of its price. For example, if the government imposes a specific tax of $1 per unit on cigarettes, the tax will be applied to every pack of cigarettes sold, regardless of the price of the pack. This means that the amount of tax paid will be the same regardless of the price of the product.

On the other hand, an ad valorem tax is a tax that is levied as a percentage of the value of a good or service. For example, if the government imposes an ad valorem tax of 10% on a luxury car that costs $50,000, the tax paid will be $5,000. The tax rate remains constant, but the amount of tax paid increases with the price of the good or service.

The impact of specific and ad valorem taxes on consumers and producers can vary. In the case of a specific tax, the burden of the tax is borne entirely by the consumers. This is because the tax is added to the price of the product, and the consumer is forced to pay the increased price. This leads to a decrease in demand for the product, as consumers will look for cheaper alternatives. Producers, on the other hand, may see a decrease in sales, but their profit margins remain the same, as the tax is added to the price of the product.
In contrast, the burden of an ad valorem tax is shared between consumers and producers. As the tax is a percentage of the price, the consumer pays a portion of the tax through the increased price of the product, while the producer pays the remainder. As the price of the product increases, demand decreases, and producers may see a decrease in sales and profit margins.

To illustrate the impact of specific and ad valorem taxes, consider the example of a tax on alcohol. If the government imposes a specific tax of $2 per liter on alcohol, the price of a $10 bottle of wine will increase to $12. This will decrease demand for the product, and producers may see a decrease in sales, but their profit margin remains the same.

In contrast, if the government imposes an ad valorem tax of 20% on alcohol, the tax on a $10 bottle of wine will be $2, and the price of the product will increase to $12. This increase in price will lead to a decrease in demand for the product, and producers may see a decrease in sales and profit margins.
In conclusion, specific and ad valorem taxes are two different types of taxes that can have different impacts on consumers and producers. A specific tax places the burden of the tax entirely on consumers, while an ad valorem tax is shared between consumers and producers. The choice of tax type depends on the government’s objectives, and policymakers must consider the potential impact on various stakeholders before implementing a tax.

b) Using diagrams, to what extent does an indirect tax minimise negative consumption externalities? [15 marks]

There is an urgent need for increasing the tax on the sale of tobacco products, such as bidis, which are considered demerit goods as they are harmful to society. They create negative consumption externalities – costs that are suffered by a third party. For instance, as a consequence of passive smoking, non-smokers bear costs such as an increased risk of lung cancer. The market overallocated resources for this demerit good, leading to market failure. Let’s use the example of cigarettes to illustrate the impact of the indirect tax.
In Fig.1, the additional benefit incurred by the Indian consumers from consuming an extra tobacco product, Marginal Private Benefit (MPB), is greater than the additional benefits to society, Marginal Social Benefit (MSB). The demand curve depicts the MSB accrued to society, and MPB, whereas the supply curve represents the Marginal Social Cost (MSC), which includes the existing tax.

For tobacco, the external cost to society is represented by the vertical distance between MSB and MPB. The social optimum quantity is determined by the intersection of the MSB and MSC curves. However, there is excessive production of tobacco products as seen at Qm. Hence, the consumption of tobacco is greater than the socially optimal quantity, leading to a welfare loss.
To minimize the production of such demerit goods to achieve the social optimum quantity (Qopt), economists recommend a hike in the indirect tax on tobacco products. Theoretically, this will lead to a decrease in tobacco supply as there is an increase in production costs. This is represented in Fig.2 by an upward shift of the supply curve from Marginal Private Cost (MPC) to S1. The quantity produced and consumed would drop from Qm to Qopt due to the intersection of curves S1 and MPB. As a result, the price would rise from Pm to Pc.

A high price may be a disincentive for consumers to purchase tobacco products or even initiate the usage of such, predominantly amongst the youth. Moreover, the Indian government would generate revenue. This revenue can not only be reinvested into crucial sectors of the economy such as healthcare and education.
However, there are several drawbacks to this policy since the addictive nature of tobacco products makes their demand inelastic, i.e. the market demand does not fall drastically when there is a price increase. Thus, the actual effect of this indirect tax likely does not completely shift the quantity of consumption close to Qopt (Fig 2). This is demonstrated in Fig 2 where the MPC curve does not fully overlap S1, but rather shifts to S2. It causes the price of tobacco products to rise from Pm to Pa, whereas quantity reduces from Qm to Qa (Fig 2). Shifting the quantity from Qm to Qopt will require a very high indirect tax which has regressive effects such as inefficiencies in correcting market failure as firms reduce production or may even close down in the long run. Although the recommendation of the tax amount is 75% of the retail price, the government may not have perfect information. While this level of taxation may be effective for lower socioeconomic classes, higher social classes may not be as affected. However, in the long run, millions of other lives would be affected as they depend on the trade of bidis for sustenance. Furthermore, there is a possibility of black markets emerging as individuals may not be willing to pay higher prices.
Instead, non-market-based policies, such as regulation, can be implemented to correct this market failure. For instance, the government could limit the amount of tobacco products produced or impose a ban on tobacco use in public places where consumption is high. They could impose severe penalties for consumers who violate the ban which further deters their consumption. Importantly, this policy is not affected by the price elasticity of demand, which is crucial in the case of tobacco products as they are highly inelastic. However, one major drawback with regulation is that it may disrupt equity between firms. If regulation policies are enforced upon firms who are not producers of tobacco products, but have a small percentage of tobacco in their products, the regulation may be unfair. Moreover, the government may incur significant costs to enforce this policy. Threats from black markets also remain an inevitable consequence under both policies. Overall, despite these drawbacks, regulation would be more effective than indirect taxes due to the inelastic nature of tobacco, lack of information and regressive effects.

2.)

a) Explain two factors which might cause economic growth. (10 marks)

Economic growth refers to an increase in the production of goods and services in an economy over a period of time. It is a key macroeconomic objective for governments as it is associated with rising living standards, increased employment opportunities, and higher tax revenues. There are various factors that can cause economic growth. In this essay, we will focus on two key factors – technological advancements and an increase in aggregate demand.

The first factor that can cause economic growth is technological advancements. Technological advancements refer to the creation and application of new and improved technologies, which can lead to an increase in productivity and efficiency. This, in turn, can lead to an increase in output and economic growth.
For example, in the 19th century, the invention of the steam engine led to the development of new industries such as textiles, transportation, and agriculture. This resulted in an increase in productivity and output, which led to economic growth. Similarly, in the 20th century, the invention of the computer and the internet has led to the development of new industries such as software, e-commerce, and telecommunications. This has resulted in an increase in productivity and output, which has contributed to economic growth.

Another factor that can cause economic growth is an increase in aggregate demand. Aggregate demand refers to the total amount of goods and services that households, firms, and governments are willing to buy at a given price level. An increase in aggregate demand can lead to an increase in output and economic growth.

One way to increase aggregate demand is through fiscal policy. Fiscal policy refers to the use of government spending and taxation to influence the level of aggregate demand in an economy. For example, the government can increase its spending on infrastructure projects such as roads, bridges, and airports. This will create jobs and increase the income of households, which will lead to an increase in consumer spending. This, in turn, will lead to an increase in output and economic growth.

Another way to increase aggregate demand is through monetary policy. Monetary policy refers to the use of interest rates and the money supply to influence the level of aggregate demand in an economy. For example, the central bank can lower interest rates, which will encourage households and firms to borrow and spend more. This will increase consumer spending and investment, which will lead to an increase in output and economic growth.

In conclusion, technological advancements and an increase in aggregate demand are two key factors that can cause economic growth. Technological advancements lead to an increase in productivity and efficiency, while an increase in aggregate demand leads to an increase in output and consumer spending. Governments can use a combination of fiscal and monetary policies to stimulate economic growth by promoting technological advancements and increasing aggregate demand.

b) Evaluate the effectiveness of the expansionary monetary policy. [15 marks]

The Central Bank manipulates its interest rates in an attempt to bolster the economy from a recession. A recession is a period of a decline in economic activity, as a result of negative economic growth for two consecutive quarters. The Central Bank enforces an expansionary monetary policy – the reduction of interest rates – to increase the economy’s Aggregate Demand (AD). AD is the total demand for goods and services in an economy at different price levels.

As seen in Fig.3, the reduction in interest rates from I1 to I2 does not occur on its own, but is a response from increasing the money supply from S1 to S2. As this supply rises, the demand for money (Dm) expands, reducing the cost of borrowing.

Reduced interest rates boost the components of AD such as consumption and investment as households and firms tend to spend more and save less, consequently increasing AD. This is represented by a rightward shift from AD1 to AD2 in Fig.4. To meet with higher demands, markets and businesses would expand production by increasing employment, which results in a hike in wages. This contributes to their cost of production, directly affecting price level as shown from PL1 to PL2.

Keynes, a British economist, argued that AD is the primary driving force in an economy for which prices and wages are inflexible. In the Keynesian model, an increase in AD leads to a higher real GDP. However, this only occurs while spare capacity is prevalent, as represented by the horizontal region of the Aggregate Supply (AS) curve. Once the spare capacity is exhausted, the firm is forced to produce at a higher price level. Hence it is efficient to produce at the full employment level of output (Y2), resulting in economic growth.

Firstly, the increase in AD will eventually lead to economic growth. It can then be inferred that economic growth will give rise to multiple benefits such as reduced poverty due to higher incomes and better education, improving society as a whole. Stakeholders such as consumers are able to borrow and spend with ease, hence resulting in higher living standards. Firms could benefit from the lower interest rates by increasing their investment in R&D, which could lead to increased efficiency and lower prices, making it prudent for the health of the economy in the long run.

However, there are a few drawbacks. Although consumption and investment may increase, it could take several months for a distinctive change to occur as interest rates are only a component of the various deciding factors. This policy also disfavors lower-income groups as it not only leads to inflation as firms set higher prices, but also reduces their ability to borrow loans as banks fear that the consumers will not pay them back. Lastly, the Federal Reserve may lose focus on pursuing other goals, such as exchange rate stability.

Alternatively, market-based supply-side policies could be implemented as they increase the economy’s productive potential by improving the quality and quantity of inputs. As market and business investments are one of the main ways by which the economy could prevent itself from entering recessionary territory, the appropriate policy must focus on those aspects mainly. The government may provide an incentive to work as disposable income rises when lowering income taxes. Whereas for the firms, a reduction in corporate tax gives an incentive to raise productivity by increasing the quality and quantity of capital. Furthermore, the government can increase spending on long term assets such as education and infrastructure, thereby creating jobs directly. As education allows the development of skills, there will be a larger skilled labour force in the economy, whereas infrastructure reduces production and transportation costs, increasing productivity and leading to long-run economic growth. This helps achieve all macroeconomic objectives to a larger extent. However, as they are very expensive to do, it involves an opportunity cost.

To conclude, monetary policy benefits multiple stakeholders and promotes economic growth. Nevertheless, the policy could introduce harmful impacts on society due to time lags, unpredictability, and indirect effects. Hence, an alternative policy of increasing government expenditure is recommended to stimulate economic growth with greater efficiency.