Every time the government raises the price of cigarettes or announces a subsidy for fertiliser, it is doing the same basic thing: nudging the demand and supply curves to change what people buy, how much of it, and at what price. Taxes and subsidies are the two most common tools used to correct market outcomes that policymakers consider undesirable, whether that means too much consumption of a harmful good or too little access to an essential one. Understanding how these tools work is central to grasping the applications of demand and supply theory.
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Why governments step into the market
Left alone, a free market settles at the price and quantity where demand meets supply. But this equilibrium does not always align with what society considers desirable. A cigarette costs the smoker a certain price, but it also imposes costs on the healthcare system and on people exposed to secondhand smoke. Economists call these negative externalities. On the other hand, some goods, like fertiliser or education, generate benefits that spill over to society beyond the individual buyer, and a purely private market may under-produce them.
Taxes and subsidies are the government’s way of correcting these gaps. A tax on a good with negative externalities raises its price and discourages consumption. A subsidy on a good with positive externalities lowers its price and encourages consumption. Both work by shifting the supply curve, just in opposite directions.
How a tax reshapes the market
When the government imposes a tax on a good, it effectively raises the cost of supplying that good. Sellers now need to receive a higher price to be willing to supply the same quantity as before, so the supply curve shifts upward (or leftward) by the amount of the tax. At the new equilibrium, the price paid by consumers rises and the quantity traded falls.
Tobacco taxation in India illustrates this well. Cigarettes, pan masala, and other tobacco products are treated as “sin goods” and taxed heavily through a combination of GST, central excise duty, and additional cess. Following the GST Council’s reforms, tobacco products now attract a steep 40% GST rate, alongside excise duty layered on top, specifically to push up retail prices and discourage use. Policymakers frame this within India’s commitments under the WHO Framework Convention on Tobacco Control, which recognises price increases as one of the most effective tools for cutting tobacco consumption, particularly among young and low-income users.
Who really pays the tax? The role of elasticity
A common misconception is that the party the tax is legally imposed on is the party that actually bears its cost. In reality, the economic incidence of a tax, meaning who truly loses purchasing power, depends on the relative elasticity of demand and supply, not on who writes the cheque to the government.
The rule is straightforward: whichever side of the market is more inelastic, meaning less responsive to price changes, ends up absorbing a larger share of the tax burden. This happens because the inelastic side has fewer alternatives and cannot easily walk away from the transaction, so it has less bargaining power to avoid the price change.
Tobacco is a textbook case of inelastic demand. Because nicotine is addictive, smokers tend to keep buying even as prices climb, though not by the full amount of the increase. This is precisely why governments prefer taxing tobacco: consumption falls only modestly, but tax revenue collected from the largely unchanged quantity is substantial. Contrast this with a good that has close substitutes, where a small price increase can cause buyers to switch away entirely; there, sellers end up absorbing more of the tax because raising prices would drive customers elsewhere.
| Market condition | Who bears more of the tax burden | Example |
|---|---|---|
| Demand is inelastic, supply is elastic | Consumers | Cigarettes, addictive goods |
| Supply is inelastic, demand is elastic | Producers | Perishable farm produce at harvest time |
| Both demand and supply are moderately elastic | Shared roughly evenly | Many everyday consumer goods |
This is also why a uniform tax rate does not affect every industry the same way. A luxury item with many substitutes will see a sharp fall in quantity demanded when taxed, hurting sellers’ revenue, while an addictive or essential good will see prices rise with little change in the amount sold.
Subsidies: the mirror image of taxes
A subsidy works through the same mechanism as a tax, only in reverse. When the government pays part of a producer’s cost, whether through a cash transfer, a price concession, or a tax break, the effective cost of supplying the good falls. Sellers are now willing to supply the same quantity at a lower price, so the supply curve shifts rightward (or downward). The new equilibrium features a lower market price and a higher quantity traded, benefiting both consumers, who pay less, and producers, who can sell more.
India’s fertiliser subsidy is a clear real-world example. Under the Nutrient-Based Subsidy (NBS) Scheme, introduced in 2010, the central government pays fertiliser manufacturers and importers the difference between the market cost of producing phosphatic and potassic fertilisers and the affordable price at which farmers actually buy them. This keeps input costs low for farmers while promoting balanced and efficient use of nutrients across the agricultural sector.
Urea, the most widely used fertiliser in the country, has been sold to farmers at a fixed price of roughly ₹242 for a 45 kg bag since 2018, with the government covering the gap between this price and the actual cost of production and distribution. For the 2025 Kharif season, the Cabinet approved a subsidy outlay running into tens of thousands of crores for P&K fertilisers alone, underlining how large a share of the retail price is being absorbed by the exchequer rather than the farmer.
Why subsidies make sense here
Fertiliser has clear positive spillovers. Cheaper fertiliser raises crop yields, which supports food security for the country as a whole, not just the individual farmer buying the input. Left to a free market, fertiliser prices might rise high enough that many small and marginal farmers would use less than the socially optimal amount, hurting overall agricultural output. The subsidy corrects this by shifting the supply curve right, so the equilibrium quantity used moves closer to what is socially desirable, not just what is privately affordable.
That said, subsidies are not without costs. A fixed, heavily subsidised urea price relative to other nutrients has been shown to skew farmers toward over-using nitrogen and under-using phosphorus and potassium, creating an imbalance that can degrade soil health over time. This is a useful reminder that both taxes and subsidies, while solving one problem, can create side effects that need to be monitored and corrected through policy design.
Comparing the two tools
Taxes and subsidies sit at opposite ends of the same lever. A tax raises the price a buyer pays and lowers the quantity traded, deliberately discouraging consumption of goods considered harmful or overused. A subsidy lowers the price a buyer pays and raises the quantity traded, encouraging consumption of goods considered beneficial or underused. In both cases, the size of the price and quantity change depends heavily on the elasticity of demand and supply for that particular good.
It is also worth noting that both tools come with a fiscal dimension. Taxes generate revenue for the government, which can then be used to fund public services or, in the case of sin taxes, healthcare programmes addressing the very harm the tax is meant to discourage. Subsidies, by contrast, are a direct drain on the government budget, meaning policymakers must weigh the social benefit of a subsidy against its cost to public finances. India’s fertiliser subsidy bill, for instance, has run into lakhs of crores of rupees in recent years, making the trade-off between farmer welfare and fiscal discipline a constant policy debate.
Beyond the diagrams: economic and social objectives
Taxes and subsidies are ultimately tools for balancing efficiency with equity. A purely efficient market outcome is not always a socially acceptable one. Taxing tobacco heavily reduces a public health burden even if it slightly dents government revenue efficiency in the short run through lower sales volumes. Subsidising fertiliser supports millions of small farmers even though it distorts the “true” market price of the input. In both cases, the government is using the demand-supply framework not just to describe the market, but to actively reshape it toward broader social goals such as public health, food security, and equitable access to essential goods.
What do you think? If a government wants to both cut smoking rates and raise revenue from tobacco taxes, are these two goals always compatible, or could pushing taxes too high eventually work against one of them? And when a subsidy like the one on fertiliser starts causing side effects such as soil imbalance, should the fix be a smaller subsidy, or a differently designed one?
References
- https://cleartax.in/s/impact-of-gst-rate-on-the-tobacco-industry
- https://taxguru.in/goods-and-service-tax/reform-tobacco-taxation-highest-tax-levy-demerit-goods.html
- https://uw.pressbooks.pub/microman/chapter/3-6-elasticity-and-taxes/
- https://www.pib.gov.in/PressReleasePage.aspx?PRID=2211384®=3&lang=1
- https://www.pmindia.gov.in/en/news_updates/cabinet-approves-nutrient-based-subsidy-nbs-rates-for-kharif-season-2026-from-01-04-2026-to-30-09-2026-on-phosphatic-and-potassic-pk-fertilizers/
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