A tax on a good raises its price

1. An indirect tax adds to a producer's costs, so less is offered for sale at every price and the market price rises.
2. The quantity traded falls, because at the higher price some buyers drop out of the market altogether.
3. Buyers and sellers share the burden, and how it splits depends on how much the quantity demanded responds to price.
4. Where demand responds little, as with petrol or cigarettes, almost all of the tax ends up in the price the customer pays.
5. A subsidy works the other way, lowering costs so that more is supplied, the price falls and the quantity traded rises.

The mechanism by which a cost change shifts supply and moves the market price is set out in 2.3.5.

Government spending changes market demand

1. Spending aimed at one market raises demand in it directly, so more is bought at the going price and the price itself tends to rise.
2. Free provision goes further, because a service supplied at no charge is taken up far more heavily than one people pay for.
3. Spending on one market spills into others, since a firm winning a government contract hires workers who then spend their wages elsewhere.

The same tools move the whole economy

1. A tax cut raises the income households keep, most of which is spent, so total spending across the economy rises.
2. Higher government spending adds to total spending immediately, because the government is itself a buyer of goods, services and labour.
3. Higher total spending raises output and employment where firms have spare capacity to meet it.
4. Where the economy is already near capacity the same increase raises prices instead, because output cannot expand to meet it.
5. The effect also builds, since the workers hired spend their wages, which raises demand for someone else's output in turn.

Chains run in both directions

1. Contractionary policy runs every chain in reverse, so a tax rise cuts spending, output and employment while easing pressure on prices.
2. Capital spending has a second effect the others lack, because a new road or railway raises what the economy can produce in future as well as demand today.
3. Effects also arrive at different speeds: a change in VAT reaches prices within weeks, while a railway takes years to alter capacity.
4. A full analysis therefore names the market or the objective it is tracing, follows one chain at a time, and says how long the effect takes to arrive.