Assess the effects of an increase in VAT of 5% on
externalities and consumers. (__/15 marks)
Externalities are the costs or benefits of economic activity that affect a third party not
involved in the transaction. Negative externalities are those that do harm or are not desired
by society. Positive externalities are those that serve society well.
One impact of the government’s decision to increase VAT by 5% will be a decrease in overall
demand for products. This is because for firms, a tax will result in an increase in the cost of
production, resulting in a negative shift in quantity supplied from S to S1+T, and thus an
increase in price from P to P1.
Price S1 + T S
P1
P
Q1 Q Quantity
This is because VAT is a form of advalorem tax which is a value-based tax which is usually
expressed as a percentage. Being a form of indirect tax, the burden can be transferred from
producers to consumers through higher prices, resulting in a net welfare loss equal to the
area of shaded region above. As a result, there would be a contraction in demand from Q to
Q1.
On the other hand, the extent of the contraction in demand as a result of an increase in
price for consumers is dependent of the price elasticity of demand of the given product or
service. For addictive products, the quantity demanded is price inelastic. This means that
the quantity demanded will be affected at a less the proportional amount compared to price
changes. For example, cigarettes have a relatively low-price elasticity as they are addictive
which means consumers may find it harder to alter their habits. Therefore, the effect of an
increase in VAT of 5% will not have a universally substantial effect on consumer demand for
all products.
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller eli3. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $3.94. You're not tied to anything after your purchase.
