What are you driving?

What type of tax is VAT? Illustrate the effect of such a tax on a diagram and explain why the higher the price of the good, the bigger the impact of the VAT rise. How might this impact inflation?

VAT (Value Added Tax) is a type of a consumption and regressive tax. It is a tax on spending on goods and services and its value, as a percentage of households’ budget, increases inversely with the income rate.

Let’s take a 2,5% VAT rise in the UK. If you buy a cheap good (e.g. a pencil) the increase in price will not be so significant as if you decide to buy an expensive product (e.g. a car). Therefore, VAT has a larger effect on expensive items.

Increasing VAT rates could cause cost-pushed inflation, but on the other hand it could provide an incentive for people to spend less or import and, consequently, lower the inflation.

"Coupled with a 5% monthly rise in petrol prices, gas and electricity price hikes and another solid rise in food prices, this [the VAT rise] could lift the headline inflation rate up to about 4.2%," said Vicky Redwood, senior UK economist at Capital Economics.

Why are car sales expected to fall in the UK over the coming year? Given this expected trend, what might we expect to see in terms of car prices?

Car sales are expected to rise mainly because of VAT rise (from 17.5% to 20%) and forecasted public sector job losses. In order to change this situation car prices are likely to fall to encourage people to buy more.

What impact might rising petrol prices have on new car purchases? What figure would you expect to see for cross elasticity of demand?

Higher oil prices are likely to increase fuel-efficient (or electric) new cars. The cross elasticity of demand would be a positive number, because these products are subsidies. For example a 10% rise of oil prices would cause the demand for new cars to increase by 20% and figure of the cross elasticity of demand would be 2.

How might the expected decline in car sales affect the UK economy over the next 12 months?

Further decline in car sales could cause higher unemployment and lower confidence among investors. Paul Everitt, the boss of Britain's automaking association SMMT, said that he expected demand to strengthen in the second half of 2011.

What type of market structure is the car industry?

Car industry is a monopolistic competition with many independent buyers and many independent sellers.  Main characteristics of monopolistic competition are:

1. All firms produce similar yet not perfectly substitutable products.

2. All firms are able to enter the industry if the profits are attractive.

3. All firms are profit maximizers.

4. All firms have some market power, which means none are price takers.

Read more: http://www.investopedia.com/terms/m/monopolisticmarket.asp#ixzz1Z5KRebIB

How did the car scrappage scheme help car sales?

The car scrappage scheme was introduced to help the motor industry cope with falling sales after the recession. The government estimates that 4,000 jobs with manufacturers and suppliers were supported. Under the car scrappage scheme owners of cars at least 10 years old could get £2,000 off the price of a new vehicle. This encouraged people to buy new cars (with positive effect on the economy, as well as, on environment).

What might explain the different trend seen in the German car industry?

Germany is the Europe’s largest car market and produces most luxurious and expensive cars in the world. The demand for luxury goods is inelastic and, consequently, German car industry did not suffer as much as in the UK. What is more, the German government has provided much more efficient and quicker help for the industry by implementing the scrappage scheme. 

That's what I think,

MANU