VJC H2 Econ P2 Answer

1 Answers to 2014 H2 Economics Prelim Exam (Paper 2) Question 1 The Spanish government, which is struggling to cut one of the Eurozone's largest public deficits during a recession, has raised taxes on tobacco. Source: http://www.eurocare.org, 26 June 2013, accessed on 25 August 2014 a) Explain why an increase in indirect tax on a good like tobacco tends to cause consumers to suffer more than producers. [10] b) Discuss how the combination of a recession and increases in indirect taxation might affect the markets for different goods. [15] a) Intro:  Definition of indirect tax o A compulsory levy on goods and services and producers have the legal responsibility to pay the tax to the government  To examine the impact on co nsumers and producers, we will have to make use of the concepts of price elasticity of demand and supply. Body:  Equilibrium price and quantity is determined by the intersection of the demand and supply curves.  Initial equilibrium was at point E 1, where the demand curve D 1 intersects with supply curve S1, and equilibrium price and quantity is P1 and Q1 respectively.  When a tax is levied on goods and services, it has the effect of increasing the marginal cost of production, repr esented by an upward shift of the supply curve from S 1 to S 2.  At the initial equilibrium price of P 1, the quantity supplied is Q3 and quantity demanded is Q1, resulting in a shortage of Q 3Q1 unit of goods. In light of the shortage, frustrated consumers will be willing to pay higher prices an d this signal to the producer will result in producers increasing the quantity supplied. Quantity demanded will fall and quantity supplied will increase until quantity dem and equals quantity supplied at point E 2, where quantity demanded and supplied will be Q2, and equilibrium price is P2.  Consumers will suffer as t heir expenditure on the good has now increased from OP1E1Q1 to OP2E2Q2.  Producers also suffer as their total revenue has fallen from OP 1E1Q1 to OP3BQ2

2  The relative impact on consumers and producers will depend on the relative price elasticity of demand and supply. o Price elasticity of demand measures the degree of responsiveness of a change in quantity demanded to a change in price, ceteris paribus and price elasticity of supply measures the degree of responsi veness of a change in quantity supplied to a change in price. o Consumers will suffer more because the demand for cigarettes is relatively more price inelastic due to the fact that it is habit forming and there are no close substitutes for cigarettes. Thus, firms are able to pass on the tax burden to the consumers. o This can be seen from the diagram where the tax burden for consumers, represented by the area P 2E2AP1 is larger than the tax burden for producers, P1AP3B. Conclusion Consumers will bear a greater burden when the demand for the good is relatively more price inelastic than supply. Level Descriptor Marks 3 Detailed, complete and accurate explanation of how consumers will bear a greater tax burden. 7-10 2 Underdeveloped explanation of how consumers will bear a greater tax burden. 5-6 1 Mere listing of relevant ideas with limited explanation 1-4 b) Intro:  When there is both a recession and an increase in indirect tax, it will affect the markets for goods differently based on the nature of the goods. The nature of the goods will determine how demand changes in times of a recession and therefore, affect how the price and quantity of the good sold will change. Body:  Effect of an indirect taxation on supply curve o Decreases supply, represented by an upward shift of the supply curve  Recession o Fall in income affects demand as there is a fall in the ability of consumers to pay for goods o Lowers demand for normal goods  Q definitely falls, effect on P depends on whether demand or supply saw a greater change o Increases demand for inferior goods  P definitely rises, effect on Q depends on whether demand or supply saw a greater change Normal Good  Nature of good is determined by how demand changes when income changes  Income elasticity of demand (E Y) measures the degree of responsiveness of a change in demand to a change in income, ceteris paribus.

3 Scenario 1: Fall in demand, shifts more than supply  Extent of shift of demand will be larg er when the good is a luxury good – EY > 1  When there is a decrease in income, there will be a more than proportionate decrease in demand for luxury goods such as branded bags and cars.  Initial equilibrium was at E 3, where equilibrium price and quantity is P3 and Q3  Demand will decrease from D 3 to D4, new market equilibrium is at E 4, where equilibrium price decreases from P3 to P4 (because there is a surplus at the original equilibrium price) and quantity decreases from Q3 to Q4 Scenario 2: Fall in demand, shifts less than supply

4  Extent of shift of demand will be smal ler when the good is a necessity - E Y < 1 (illustrate with example, effect on P & Q)  When there is a decrease in income, there will be a less than proportionate decrease in demand for necessities such as food.  Initial equilibrium was at E 5, where equilibrium price and quantity is P5 and Q5  Demand will decrease from D 5 to D 6, new market equilibrium is at E 6, where equilibrium price increases from P 5 to P 6 (because there is a shortage at the original equilibrium price) and quantity decreases from Q5 to Q6 Inferior good Scenario 3: Demand increases, shift more than supply  During a recession, the demand for inferior goods such as canned food would increase.  Impact on P and Q would depend on the relative magnitude of shift of demand and supply.  Initial equilibrium was at E 7, where equilibrium price and quantity is P7 and Q7  Demand will increase from D 7 to D 8, new market equilibrium is at E 8, where equilibrium price increases from P 7 to P 8 (because there is a shortage at the original equilibrium price) and quantity increases from Q7 to Q8 Scenario 4: Demand increases, shift less than supply  Analysis similar to Scenario 3 except th at equilibrium quantity would decrease instead of increasing Sharpness of change in price In the above scenarios, how sharply price ch anges depend on the extent of the change in demand / supply and the price elasticity of demand and supply. The more price inelastic are demand and supply, the sharper is the change in price required to clear the market. As demand and supply t end to be price inelastic in the short-run compared to the long run (it takes time for consumers to find substitutes and firms are constrained by fixed factors in the short-run), the change in prices tend to be sharper in the short-run compared to long run.

5 Conclusion Effect on the different markets depends on the nature of the goods, which then affects how much the demand curve would shift by. It also dep ends on the extent of t he rise in indirect taxation. The combined effect on P & Q depends on the relatively magnitude of shift for demand and supply. The analysis is also dependent on the type of countries we are looking at as different countries and different societies would view the same good differently. A cheap car may be seen as in inferior good in an affluent country whereas the same car may be seen as a luxury good in a developing country. Ev en within one country, different consumers may view the same products as different types of goods. The overall impact on demand would depend on the relative size of the proportion of the market that views the same products differently. Level Descriptor Marks 3 Well-developed analysis of the combined effect of an increase in indirect taxation and a recession on the price and quantity of different types of goods and services 9-11 2 Underdeveloped analysis of the combined effect of an increa