(2024) A Level H2 Econs Paper 2 Essay Q3b

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Introduction

The ability of firms to increase prices by the full amount of a goods and services tax (GST) increase depends on the price elasticity of demand (PED) for the goods they supply. PED measures the degree of responsiveness of the quantity demanded of a good to a change in its price, ceteris paribus. When the GST rate rises, it increases the cost of supplying the good, leading to a pivoted leftward shift of the supply curve. However, whether firms can pass on the entire tax burden to consumers depends on the PED of the goods in question.

Case where firms can increase the price of products by full amount of goods and service tax increase

Firms can fully transfer the GST increase to consumers only when the demand for the good is perfectly price inelastic. Perfectly price inelastic demand implies that the quantity demanded remains constant regardless of changes in price. In such a scenario, the entire tax burden can be passed on to consumers, resulting in a price increase equal to the amount of the tax.

As shown in a theoretical diagram, a leftward shift of the supply curve from SS0 to SS1​, caused by the GST increase, leads to an increase in price from P0 to P1 that fully reflects the tax amount. Since the quantity demanded does not decrease, the firm bears no loss in sales volume.

However, perfectly inelastic demand is largely a theoretical concept. In reality, no goods are perfectly price inelastic. Hypothetically, a bottle of water sold to someone lost in a desert with no alternative source of hydration could exhibit perfectly price inelastic demand. For most goods, firms cannot fully pass on the tax increase.

(diagram will be available in the TYS answers published with SAP)

In most cases - firms will not be able to increase the price by the full amount of the goods and services tax increase

In most cases, firms cannot increase prices by the full amount of the GST increase because demand for most goods is either relatively price inelastic or relatively price elastic.

For goods that are necessities, such as groceries like eggs or rice, demand tends to be relatively price inelastic. Consumers will continue to purchase these goods even if prices rise, but the decrease in quantity demanded is not zero. For these goods, the leftward shift of the supply curve from SS0 to SS1​ will result in a price increase from P0 to P1 that reflects most, but not all, of the GST increase. Firms are able to pass on a significant portion of the tax to consumers because their demand is less sensitive to price changes.

(diagram will be available in the TYS answers published with SAP)

For goods with close substitutes or those considered less essential, such as cars or luxury items, demand is relatively price elastic. Consumers are more responsive to price changes and are likely to reduce their quantity demanded significantly if prices rise. In this case, the leftward shift of the supply curve from SS0 to SS1​ results in only a small increase in price from P0 to P1 as firms absorb a larger share of the tax burden to avoid losing customers. Thus, the extent of the price increase is minimal compared to the full tax amount.

(diagram will be available in the TYS answers published with SAP)

Conclusion

Whether firms can increase the price of all products by the full amount of a GST increase depends on the price elasticity of demand for those goods. While theoretically possible in cases of perfectly price inelastic demand, this is rare in practice. For goods with relatively inelastic demand, firms can pass on most of the tax increase to consumers, but for goods with elastic demand, they are limited in their ability to do so.

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