You are on page 1of 3

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.
(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
and fall.

Part (a)
Goods and Services Tax (GST) is a type of indirect tax, which is a levy
imposed by the government on the production of goods and services. The
increase in GST from 3% to 5% means an increase of marginal cost of production
of the good. The units of outputs that are produced at higher marginal cost
become unprofitable at lower prices, thus firms cut back output to minimise
losses, resulting in a decrease in supply. In specific, GST is an ad valorem tax, a
tax levied as a percentage of price per unit of output, thus absolute amount of
tax is lower at lower price level than it is at higher price level. This can be seen
as a pivotal shift of the supply curve leftwards in Fig. 1.1 and Fig 1.2. The effect
of the increase in GST on consumer expenditure is determined by the price
elasticity demand of the good in question.
Price elasticity of demand (PED) is a measure of the degree of
responsiveness of quantity demanded for a good to a change in the price of the
good itself, ceteris paribus. Demand of goods can be price elastic or price
inelastic, determined by several factors. Firstly, the availability and closeness of
substitutes. The greater the availability of substitutes and the closer the
substitutes are for a particular good, the more price elastic the demand of the
good, ceteris paribus. Secondly, the proportion of income spent on the good. The
greater the proportion of a persons income that is spent on a good, the more
price elastic the demand of the good, ceteris paribus. Thirdly, the degree of
necessity. The more essential a good is to the survival of consumers, the more
price inelastic the demand of the good. Time period is also a factor. The longer
the time period in which a consumer makes a purchasing decision, the more
price elastic the demand, ceteris paribus.
When demand of a good is price elastic, a given change in price leads to a
more than proportionate change in quantity demanded in the opposite direction,
ceteris paribus. An example of a price elastic good would be branded bags. As
branded bags take up a large proportion of ones income, an increase in price
would result in a significant reduction in consumers purchasing power, hence
the response in quantity demanded is greater. When supply for branded bags
decreases, price increases as buyers competing for the good bid up prices, as
seen in Fig 1.1 from P0 to P1. When price of branded bags increases, lesser
consumers are willing and able to consume the good, as their marginal benefit
from consuming the good is lesser than the marginal cost. Hence they decide to

drop out of the market, resulting in a more than proportionate fall in quantity
demanded from Q0 to Q1. This leaves behind consumers that are willing and
able to pay the higher price, accounting for the increase in expenditure due to
increase in spending per unit. As the decrease in expenditure (area abQ1Q0) due
to consumers that are unwilling and unable to consume the good is greater than
increase in expenditure (area P0P1ca) due to increased spending per unit of
consumers that choose to continue consuming the good, there is a net decrease
in expenditure.
When demand of a good is price inelastic, a given change in price leads to
a less than proportionate change in quantity demanded in the opposite direction,
ceteris paribus. An example of a price inelastic good is rice. As rice is a necessity,
consumers cannot do without it and will have no choice but to accept the price,
hence the response in quantity demanded is very small. When supply for rice
decreases, buyers bid up prices, as seen in Fig 1.2 from P0 to P1. When price of
rice increases, a small number of consumers are less willing and unable to
consume the good, as their marginal benefit from consuming the good is lesser
than the marginal cost. Hence they decide to drop out of the market, resulting in
less than proportionate fall in quantity demanded from Q0 to Q1. This leaves
behind majority of the consumers that are willing and able to pay the higher
price, accounting for the increase in expenditure due to increase in spending per
unit. As the number of consumers unwilling and unable to consume the good is
lesser than the number of consumers that choose to consume the good despite
the price increase, decrease in expenditure (area abQ1Q0) is lesser than increase
in expenditure(area P0P1ca), hence a net increase in expenditure.
In conclusion, the increase in rate of GST has brought about an increase in
marginal cost prices, and hence decreased supply of goods. When supply of
goods decreases, price increase, resulting in a decrease in consumer expenditure
on price elastic goods and an increase in consumer expenditure on price inelastic
goods.
Part (b)
The increase in income of consumers means an increase in the purchasing
power of consumers. This means that consumers can now consume a larger
quantity of the same good or other goods. Income elasticity of demand (YED) is a
measure of the responsiveness of demand to changes in income, ceteris paribus.
Goods can be normal or inferior. A normal good is one whose demand changes in
the same direction as the change in income, ceteris paribus. Consumers seeking
to maximise their utility will increase their demand for normal goods when their
higher incomes gives them greater purchasing power. Normal goods can be
further classified into two categories necessities and luxuries. An inferior good
is one whose demand changes in the opposite direction as the change in income,
ceteris paribus. The classification of goods as necessities, luxuries and inferior
goods are relative to each individuals income level, and there is no fixed
category that a good belongs in.

Necessities are income inelastic. When a good is income inelastic, a given


change in income leads to a less than proportionate change in quantity
demanded in the same direction, ceteris paribus. As necessities such as food are
essential to survival of households, the demand for these goods has little
dependence on income. When income rises, the demand for necessities remains
relatively unchanged as although necessary for survival, there is a limit to how
much more of the good that can be consumed. Hence, demand for necessities is
less affected by changes in income. When demand for necessities increases,
while supply for necessities decreases
Luxuries are income elastic. When a good is income elastic, a given
change in income leads to a more than proportionate change in quantity
demanded in the same direction, ceteris paribus. As luxuries are goods that are
consumed only after expenditure on necessities has been accounted for, the
demand of these goods are highly dependent on changes in income. When
income rises, demand for luxury goods increases as consumers choose to
consume more luxury goods for higher standards of living and greater
satisfaction. Thus, when income of consumers rises by 4.5%, this causes the
demand curve to shift rightwards from D0 to D1 as seen in Fig 2.1, as demand
increases by a large extent due to luxuries being income elastic. This causes the
quantity demanded to rise. At the same time, supply decreases due to the
increase in GST on goods produced, causing quantity demanded to fall. The
combined impact of both is dependent on the one that causes a stronger impact
on the quantity demanded. It is most likely that the increase in quantity due to
rise in income would outweigh the decrease in demand due to increase in GST,
leading to an overall rise in quantity demanded.
Inferior goods