2007 Essay Question 1

Question

In 2005 the rate of Goods and Services Tax (GST) in Singapore rose from 3% to 5%. Incomes rose by approximately 4.5% in 2005.

(a) Explain the likely effect of this change in GST on expenditure by consumers on different types of goods. [10]

(b) Discuss whether the combined effect of the rise in incomes and the rise in GST is likely to cause the quantities of different types of goods sold to rise or fall. [15]

Answer (Part A)

Decrease in Supply

An indirect tax is a tax imposed on a good or service. Goods and services tax (GST) is an indirect tax. There are two types of indirect taxes: specific tax and ad valorem tax. An ad valorem tax is an indirect tax of a certain percentage of the price of the good. GST is an ad valorem tax. An increase in GST will lead to a rise in the cost of production. When this happens, firms will increase price by the amount of the tax at each quantity supplied to maintain profitability. In other words, they will decrease quantity supplied at each price which will lead to a decrease in supply. Students need to explain why an increase in GST will lead to a pivotal upward shift in the supply curve. When the supply of a good falls, the price will rise and the quantity will fall. Although the rise in the price will increase the consumer expenditure, the fall in the quantity will decrease the consumer expenditure. When the supply of a good falls, whether the consumer expenditure will rise or fall will depend on the price elasticity of demand, which will depend on the nature of the good.

Price Elasticity of Demand for Different Types of Goods

Luxury

There are three types of goods: luxury, necessity and inferior good. A normal good is a good whose demand rises when consumers’ income rises. A luxury is a normal good whose demand rises by a larger proportion when consumers’ income rises. An example of a luxury is private cars. Luxuries are generally expensive and hence the demand is likely to be price elastic due to the large proportion of income spent on the goods. Therefore, when the supply of a luxury falls, the quantity is likely to fall by a larger proportion than the rise in the price and hence the consumer expenditure is likely to fall. Students need to draw a diagram showing a leftward shift in the supply curve with a flat demand curve and shade the area which represent the consumer expenditures before and after the shift.

Necessity

A necessity is a normal good whose demand rises by a smaller proportion when consumers’ income rises. An example of a necessity is agricultural products. Necessities are generally essential goods and hence the demand is likely to be price inelastic due to the high degree of necessity. Therefore, when the supply of a necessity falls, the price is likely to rise by a larger proportion than the fall in the quantity and hence the consumer expenditure is likely to rise. Students need to draw a diagram showing a leftward shift in the supply curve with a steep demand curve and shade the area which represent the consumer expenditures before and after the shift.

Inferior Good

An inferior good is a good whose demand falls when consumers’ income rises. An example of an inferior good is public transport. Inferior goods are generally cheap and hence the demand is likely to be price inelastic due to the small proportion of income spent on the goods. Therefore, when the supply of an inferior good falls, the price is likely to rise by a larger proportion than the fall in the quantity and hence the consumer expenditure is likely to rise.

Conclusion

The conclusion can simply be a summary or recommendation as there are no evaluation marks.

Answer (Part B)

Luxuries

The income elasticity of demand for luxuries is greater than one. Therefore, an increase in national income will lead to an increase in the demand for luxuries. When this happens, the quantity will rise. An increase in GST will lead to a rise in the cost of production of luxuries. Therefore, the supply will fall. When this happens, the quantity will fall.

As the increase in the demand will lead to an increase in the quantity and the decrease in the supply will lead to a decrease in the quantity, the quantity will be indeterminate. Students need to consider the relative price elasticities of demand and supply and the relative changes in the demand and the supply to determine the effect on the quantity.

The relative price elasticities of demand and supply
Luxuries are generally expensive and hence the demand is likely to be price elastic due to the large proportion of income spent on the goods. The supply of luxuries is likely to be price inelastic as the production time is likely to be long given that they are typically high quality goods that generally undergo stringent quality control. Due to the inelastic supply, the increase in the demand is likely to lead to a small increase in the quantity, and due to the elastic demand, the decrease in the supply is likely to lead to a large decrease in the quantity. Therefore, the quantity is likely to fall.

The relative changes in the demand and the supply
As a 4.5% increase in national income is fairly large and the income elasticity of demand for luxuries is high, the increase in national income is likely to lead to a large increase in the demand. Therefore, the increase in the demand is likely to be greater than the decrease in the supply and hence the quantity is likely rise.

Combining the effects of the relative price elasticities of demand and supply and the relative changes in the demand and the supply on the quantity, the quantity will be indeterminate. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves, assuming the effect of the relative price elasticities of demand and supply is greater than the effect of the relative changes in the demand and the supply, or vice versa.

Necessities

The income elasticity of demand for necessities is between zero and one. Therefore, an increase in national income will lead to an increase in the demand for necessities. When this happens, the quantity will rise. An increase in GST will lead to a rise in the cost of production of necessities. Therefore, the supply will fall. When this happens, the quantity will fall.

As the increase in the demand will lead to an increase in the quantity and the decrease in the supply will lead to a decrease in the quantity, the quantity will be indeterminate. Students need to consider the relative price elasticities of demand and supply and the relative changes in the demand and the supply to determine the effect on the quantity.

The relative price elasticities of demand and supply
Necessities are generally essential goods and hence the demand is likely to be price inelastic due to the high degree of necessity. The supply of necessities is likely to be price elastic as the production time is likely to be short due to the limited focus on the quality. Due to the elastic supply, the increase in the demand is likely to lead to a large increase in the quantity, and due to the inelastic demand, the decrease in the supply is likely to lead to a small decrease in the quantity. Therefore, the quantity is likely to rise.

The relative changes in the demand and the supply
As a 4.5% increase in national income is fairly large, the increase in national income is likely to lead to a large increase in the demand. Therefore, the increase in the demand is likely to be greater than the decrease in the supply and hence the quantity is likely rise.

Combining the effects of the relative price elasticities of demand and supply and the relative changes in the demand and the supply on the quantity, the quantity is likely to rise substantially. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves.

Inferior Goods

The income elasticity of demand for inferior goods is negative. Therefore, an increase in national income will lead to a decrease in the demand for inferior goods. When this happens, the quantity will fall. An increase in GST will lead to a rise in the cost of production of inferior goods. Therefore, the supply will fall. When this happens, the quantity will fall. Combining the effects of the decrease in the demand and the decrease in the supply on the quantity, the quantity will fall.

Conclusion

The conclusion can simply be a summary as the evaluation marks are awarded to the combined effects which have been discussed.

A more elaborate answer to 2007 Essay Question 1 will be provided in the economics tuition class.

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