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Theories and Applications of Demand & Supply

Hwa Chong Institution Economics Unit. All Rights Reserved. (Tutors copy) 1
QUESTION ONE: TYS N2007 Q1

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 impact 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]

(a)
INSTRUCTIONS:
(1) Rephrase/paraphrase the question:
How would the increase in GST affect consumers spending on different types of goods?

(2) Organise using Schematic Planning
Introduction
Key Issue
To explain impact of GST on expenditure by consumers on different types of goods.

Body
Developmental paragraph 1 Explain, using a diagram that for a good that has price elastic demand consumers
expenditure will fall with the increase in GST.

Developmental paragraph 2 Explain, using a diagram that for a good that has price inelastic demand consumers
expenditure will increase with the increase in GST.
Conclusion
Make a stand that expenditure by consumers will fall if demand is price elastic and increase if demand is price
inelastic

(b)
INSTRUCTIONS:
(1) Rephrase/paraphrase the question:
How would the increase in GST and income affect the quantity sold of different types of goods.

(2) Organise using Schematic Planning
Introduction
Key Issue
To discuss impact of both GST and rising incomes on quantities purchased by consumers on different types of goods.

Body
Developmental paragraph 1 Explain, using diagram, that for inferior good demand will fall with the increase in
income (YED<0). Leftward shift of demand and equilibrium quantity falls. Combined with the rise in GST which shifts
supply leftwards as well, equilibrium quantity definitely falls (synthesis).

Developmental paragraph 2 Explain, using diagram, that for normal good demand will increase with the increase in
income (YED>0). Demand shifts rightwards hence equilibrium quantity increases. Extent of shift in demand may be
different for different types of goods. Goods with YED>1, demand will shift to a greater extent whereas goods with
0<YED<1, demand will shift to a smaller extent.

Developmental paragraph 3 Combined with the rise in GST which shifts supply leftwards, the ultimate equilibrium
quantity is indeterminate. For goods with YED>1 if the demand shifts rightward>leftward shift in supply then
equilibrium quantity will increase. For goods with 0<YED<1, the rightward shift in demand is likely to be less than
leftward shift in supply then equilibrium quantity is likely to fall. (synthesis)


Theories and Applications of Demand & Supply


Hwa Chong Institution Economics Unit. All Rights Reserved. (Tutors copy) 2
Conclusion
The combination of the rise in income and the rise in GST has different effects on equilibrium quantities of various
goods. For inferior goods, regardless of the magnitude of the YED, the net effect is that the equilibrium quantity will
definitely fall, albeit that its fall is of varying magnitude. For normal goods, the equilibrium quantity will fall if they are
necessities while the equilibrium quantity will rise if they are luxury goods.



Theories and Applications of Demand & Supply


Hwa Chong Institution Economics Unit. All Rights Reserved. (Tutors copy) 3
SUGGESTED ANSWERS

Part (a)
Examiners report: Errors
1. Students can say that for a price inelastic demand curve, a rise in price would cause quantity demanded
to fall by a smaller percentage but many students then say incorrectly that expenditure would also fall.
2. Misconceptions and errors about the impact on consumers who have different income levels.
3. Misconception: Only rich have demand curves that are price-elastic.
4. Misconception: Only the poor buy inferior goods.

Introduction

Key Issue
GST is a tax on goods and services imposed by the government to raise revenue for public expenditure.
Ceteris paribus, an increase in GST is expected to cause prices of goods and services to increase as
producers passed on the tax to consumers. I shall explain how the impact on expenditure on different types
of goods may vary according to differences in price elasticity of demand.

Alternative introductory paragraph:
PED is a measure of the degree of responsiveness of Qd to a change in price of a good, ceteris paribus.
In this essay, I shall explain how PED can be used as tool of analysis to determine the impact on expenditure
on different type of goods following an increase in GST.


Body

Scenario 1:

Goods with PED > 1: goods with close substitutes and a high proportion of income and generally non-
necessities (luxury goods)
























Figure 1


A E
0
E
1
P
1
S
0
D
e
P
0
Q
0
Quantity
Price
S
1
Q
1

B


Theories and Applications of Demand & Supply


Hwa Chong Institution Economics Unit. All Rights Reserved. (Tutors copy) 4
With reference to the diagram in figure 1:

Rise in GST pivotal shift of SS to left
DD remaining constant shift of SS to left will cause Qe to drop but magnitude of drop will depend on types of
goods and their PED.
PED responsiveness of quantity demanded as a result of change in price


Focus: Impact on TR or TE (i.e. P x Q sold)
Rise in GST causes SS to shift from S
0
to S
1

Eqm price rises Qd falls more than proportionate to price rise expenditure on these goods falls A < B




Theories and Applications of Demand & Supply


Hwa Chong Institution Economics Unit. All Rights Reserved. (Tutors copy) 5
Scenario 2:

Goods with PED < 1: goods with few substitutes and a small proportion of income and generally necessities
(basic or essential goods)

















Figure 2


With reference to the diagram in figure 2:

Rise in GST causes SS to shift from S
0
to S
1

Eqm price rises Qd falls less than proportionate to price rise expenditure on these goods rises A > B


Conclusion
In summary, the expenditure on goods with PED > 1 will be likely to fall while the expenditure on goods with PED < 1
will be likely to rise following the increase in the rate of GST.

This is to be expected as goods with price-elastic DD are likely to be dispensable with availability of close substitutes
such as expensive overseas tours which can be replaced by cheaper ones. As for goods with price-inelastic DD,
consumers will continue to buy them albeit in smaller quantities as these goods are less likely to have substitutes.

L3
(7-10m)
No issues with breadth and depth of analysis + relevance/application to given context.
L2
(4-6 m)
Issues with breadth ( lop-sided) and/or depth of analysis ( superficial, sketchy, skimpy)

Prescription:
Learn to brush up on SSP and SEEDs technique.

L1
(1-3m)
Issues with the lack of economic analysis. Answers tend to be too descriptive or even off tracked.

Prescription:
Brush up on using the 3C dissection technique to get to the key issues + expected approach
Learn plenty of economic concepts and principles ( beef up your conceptual muscles) to do a good
economic analysis.






Q
2
Q
0

B
A
E
0
E
2
P
2
S
0
D
i
P
0
Quantity
Price
S
1


Theories and Applications of Demand & Supply


Hwa Chong Institution Economics Unit. All Rights Reserved. (Tutors copy) 6

(c) 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]


Examiners report: Errors
1. Incoherent & overly long explanations of the effects on low, middle and high income earners. Attempts at
combining the SS and DD shifts often become muddled distinct lack of good evaluative comments.

2. Many students incorrectly thought that a rise in GST would cause disposable income to fall. Can say that a rise in
price due to rise in the rate of GST would cause real income to fall but students unable to develop their answers
further.

3. Worrying observation: Large no. of students believe that the rise in income only applicable to rich while poor has
not income rise at all! Many also believe that luxury goods relevant to rich people and inferior goods only to poor
people leads to incorrect conclusion: poor people are faced with inelastic or negative income-elastic goods and
rich with income-elastic gds. NOTE: Candidates should be taught that one persons inferior good might be another
persons luxury

INTRODUCTION
Bridging introductory paragraph:
In part (a), the concept of PED is a useful tool to explain how consumers expenditure may vary for different types of
goods. I shall proceed in part (b) to use the concept of YED to discuss the impact on the quantity purchased by
consumers for different goods brought about by the simultaneously rise in incomes and rise in GST.


BODY
















Figure 3

NB: Relevance of PED
Does the slope of the D curve affect the outcome or impact on quantity purchased? Why not?
Reason: The focus of the analysis is on quantities (Q) and not expenditure ( P.Q) as stated in the question.

Scenario 1: Normal Goods Necessities (0<YED<1)
With reference to the diagram in figure 3:
Rise in GST causes SS to shift from S
0
to S
1
Rise in Income rise in DD by less than proportionate for necessities
Rise in DD from D
e
to D
1

DD shifts rightwards < SS shift leftwards
income-elastic DD (YED positive/low)
Due to necessities Eqm qty will fall to Q
1


E
D
2
D
1
E
0
E
1
S
0
D
e
P
Q
0
Q
2
Quantity
Pric
e
S
1
Q
1


Theories and Applications of Demand & Supply


Hwa Chong Institution Economics Unit. All Rights Reserved. (Tutors copy) 7
Scenario 2: Luxury Goods (YED>1)

Rise in GST causes SS to shift from S
0
to S
1

Rise in Income rise in DD by more than proportionate for luxury goods
Rise in DD from D
e
to D
2

DD

shifts rightwards > SS shift leftwards
income-elastic DD (YED positive/high)
Eqm qty will rise to Q
2

Evaluative comments
(1) In the above cases it is not always the case that consumers will end up buying more of non-
inferior goods if income increases. At the end of the day, consumers have to weigh both the two
key factors that influences demand viz. affordability and desirability. For necessities it may be
likely that quantity purchase is likely to fall because a more affluent consumers usually prefer to spend a
bigger proportion of their income on luxuries rather than necessities.


(2) Relevance of PED
It should be noted that in both cases, the analysis of the outcome of the impact on equilibrium quantity does not
depend on differences in PED. So long as the demand curve is shifting rightwards because of a
positive YED, the quantity purchased will increase for non-inferior goods regardless of whether demand is
price elastic or inelastic. However, the net effect on quantity purchased would depend on the
supply side. This can easily be proven by drawing a diagram.




Theories and Applications of Demand & Supply


Hwa Chong Institution Economics Unit. All Rights Reserved. (Tutors copy) 8
(2) YED< 0 (inferior goods)




















Figure 4
Rise in GST causes SS to shift from S
0
to S
1
Rise in Income fall in DD for inferior goods
Fall in DD from D

to D1 income-elastic DD (YED negative)
Eqm qty will fall to Q1.


CONCLUSION - Judgement or stand supported by economic analysis.
In conclusion, the above analysis shows that the simultaneously increase in incomes and GST is bound to reduce the
quantities purchased for inferior goods. This is because the market for such goods suffer a double whammy of a fall
in both supply and demand. There is clearly no good reason for consumers to increase purchase of inferior goods
that are now more expensive if they are indeed better off. Such consumers are likely to turn to better non-inferior
alternatives.

On the other hand, in the case of normal or non-inferior goods, the impact on quantities purchased is not clear cut.
This is because the D and S curves shifted in opposite direction. In other words cost rises but so did income. At the
end of the day, consumers may purchase less if the goods are non-inferior necessities but more if they are luxury
goods.


L3 (9 -11m) No issues with Breadth, Depth of analysis and Relevance to the given context
L2 (6 9 m) Issues with Depth of analysis ( superficial, sketchy, skimpy) and/or Breadth ( lop-sided) of
analysis.
L1 (1-5 m) Issues with the lack of economic analysis. Off tracked.
E2 (3 4 m) For an evaluative judgement based on economic analysis
E1 (1- 2 m)

For an unexplained judgement that is not supported by analysis



E1


D
1
Q
1
Q
0


E

S
D

P
Quantity
Price
S