Essay, Micro: Demand and Supply, GST and Rising Incomes
In 2007 the rate of Goods and Services Tax (GST) in Singapore rose from 5% to 7%. Incomes also increased in that year.
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)
def Goods and Services Tax (GST) is a form of ad valorem tax, which shifts the supply curve left. This is shown in the figure:
This leads to a fall in the equilibrium quantity and a rise in the price. Depending on the price elasticity of demand for the good, total expenditure can either rise or fall.
Price elastic demand In the figure above, demand is price elastic and the rise in price is met with a more than proportionate fall in quantity demanded. This leads to a fall in total revenue, as can be seen by comparing the revenue lost, area
A, with the revenue gained, area
B. Examples of price elastic goods could be items which take up a large proportion of households' income, or luxury goods.
Price inelastic demand For goods which are relatively more price inelastic, there will be an increase in expenditure as households reduce their quantity demanded less than proportionately to the increase in price. For example, neccessities such as food, or goods habitually consumed, such as cigarettes would have an increase total consumption. This is seen by comparing the revenue lost, area
A, with the larger revenue gained, area
B in the figure here:
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)
The rise in incomes will lead to a rise in the demand for goods whose YED is positive, i.e. normal goods. This is represented in the figure below as a shift to the right of the demand curve.
The extent to which the demand for different types of goods will increase depends on the magnitude of the income elasticity of demand for the good. For example, luxury goods such as branded handbags will see a larger increase in demand compared to necessities such as water.
As the rise in GST will decrease supply, the overall effect on the quantity of goods sold will depend on which factor is relatively more important.
For the case of luxury goods, the increase in demand is likely to be large as YED is more than 1, and an increase of incomes by 1 percent will lead to an increase in demand of more than 1 percent. This leads to a rise in quantity sold and a sharp increase in price in equilibrium as the demand increase outweighs the fall in supply. This is shown in the figure here:
All things equal, a more price elastic supply will lead to a bigger increase in quantity and a smaller increase in price.
For normal goods such as necessities with a positive YED less than one, demand will increase less than proportionately than the increase in incomes. In such a case, the fall in supply might dominate the increase in demand, leading to a fall in quantity. However, the price still increases, but by a lesser extent than if the goods were luxuries. This is shown in the graph here:
conclusion In conclusion, the rise in income will affect the extent to which demand rises for different goods differently. For luxury goods, the increase in demand is likely to be significant in increasing the equilibrium quantity as it outweighs the fall in supply due to GST. For other normal goods, this increase might be outweighed by fall in supply leading to lower quantity. However, in all cases we would expect price to rise.
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