Rates for Air Passenger Duty - Assignment Example

Table of Contents Table of Contents 1 Answer to Question (a) 2 Answer to Question (b) 3 Answer to Question (c) 5 Answer to Question (d) 6 Answer to Question (e) 8 References 11 Baumol, W. J. & Blinder, A. S. (2008) Microeconomics: Principles and Policy (11th Edition). New York: Cengage Learning. 11 Frank, R. H. & Bernanke, B. S. (2006) Principles of Economics (3rd Edition). New York: McGraw-Hill. 11 Hüschelrath, K. (2008) Competition Policy Analysis: An Integrated Approach (Vol. 41). Germany: Physica-Verlag. 11 Mankiw, N. G. (2008) Principles of Microeconomics (5th Edition). New York: Cengage Learning. 11 Torgler, B. (2007) Tax compliance and tax morale: a theoretical and empirical analysis. London: Edward Elgar Publishers. 11 Bibliography 11 Answer to Question (a) APD is scheduled to rise from £11 to £12 for the short-haul flights. Using simple demand-supply tools we will now examine the effects of this decision on the market for short-haul flights. The new price-quantity equilibrium must satisfy the following two equations: (1) Quantity demanded = Quantity supplied and (2) Pd = Ps + £12; where Pd = Buyers’ price and Ps = Sellers’ price. Figure 1: Supply and demand analysis to examine the effects of this tax increase on the market for short haul flights The free market equilibrium is given by the point E, i.e. the intersection between the demand curve D0 and the supply curve S. The equilibrium airfare is P* and the quantity is Q*. After the imposition of APD = £11, the demand curve shifts downward to D1 such that the vertical distance between D1 and D0 is £11. The price-quantity equilibrium with APD = £11, is shown by points A and B in Fig: 1. The fare that the consumers pay is given by Pd1 and the amount that the sellers receive is shown by Ps1. The difference between these two prices, given by AB (= £11), is collected as the duty fee per unit by the government. The equilibrium supply of the short-haul trips is Q1. Now with the hike in APD, demand curve falls further to D2. As again, the vertical distance between D2 and D0 is £12. The new equilibrium quantity and prices are now given by the points C and D. Fares that the buyers pay is now Pd2 and the sellers receive as much as Ps2. Again the difference between these two prices, i.e. CD (=£12) is taken as the duty fee per unit by the government. The equilibrium quantity of short haul trips now reduces to Q2. Thus the entire effect of this decision can be summarised below: a) Buyers’ price rises from Pd1 to Pd2 , b) Sellers’ reward falls from Ps1 to Ps2 , c) Quantity of short-haul trips reduces. From the society’s point of view the dead weight loss from the taxation also rises. With APD = £11, it is equal to the area of the triangle ABE, but with the hike of £1 in APD, the dead weight loss will be equal to the area of the larger triangle CDE. Hence the deadweight loss or the loss in social welfare accumulates with this decision (Mankiw, 2008, p. 164). Answer to Question (b) It is evident from the Fig: 1 that a hike in the buyers’ price + the fall in the sellers’ price = the total rise in APD which is equal to £1. This is to say that, dPd + dPs = dt ……………………………….. (1); where dPd = change in the buyers’ price dPs = change in the sellers’ price and dt = change in the tax rate. Again price elasticity of demand Ed = [(dQd / Qd) / (dPd / Pd)] and Price elasticity of supply Es = [(dQs / Qs) / (dPs / Ps)]. Rearranging equation (1) and inserting the elasticity formulae, the following equation is arrived at. dPd = [ Es /( Ed + Es )]. dt …………………… (2) and dPs = [ Ed /( Ed + Es )] . dt ………………….....(3) Thus the buyers’ price will rise exactly by the hike in the rate of tax, i.e. £1, only if Ed = 0, which means the price elasticity of demand is equal to zero which further means that the demand curve is vertical and perfectly inelastic. In case of perfectly inelastic demand the buyers will not try to look for alternatives even if the price of that commodity rises. They will not try to shift their consumption to elsewhere very easily. Producers will, in such cases, try to take advantage of buyers’ strong inclination towards their product. They will pass the entire burden of increased taxes onto the buyers successfully. Thus if the demand is perfectly inelastic, buyers have to bear the entire burden of tax. But in this case there is no reason to assume at the first place that the demand for flight service is perfectly inelastic. Therefore the demand curve may be negatively sloped instead of a vertical line and price or airfare may rise by an amount less than the rise in the tax rate. Thus the price for short-haul flights will not necessarily increase by £1, i.e. by the amount of increased tax rate (Baumol & Blinder, 2008, p. 118). Answer to Question (c) The following demand-supply diagram might be considered in order to analyse how the decision of raising the APD from £11 to £12 will actually affect the market for train journeys. Figure 2: Supply and demand analysis, to examine how increases in short haul prices will affect the market for train journeys The demand function for the train journeys can be written in extensive form as: Qd = D (Pd, Py, M)……………………….. (1) Where, Pd = own price of demand, Py = price of related products or ‘cross price’ and M = money income of individuals. The demand curve for the train journeys are drawn in the price-quantity plane as a function between the quantity and own price, while keeping the other two factors constant. This is known as the ‘ceteris paribus’ demand curve. Now short-haul flights are those which cover only a short distance of 800 Km in terms of distance or 1.5 hrs in terms of time. Thus they are indeed a very close substitute of train journeys and vice versa. If the fare of the short haul flights rises, people may choose to cover the small distances by train which will probably take few more hours to reach the destination but save money for them. This choice between more time and less money is less difficult in case of a short haul flight and train journey. Individuals may easily substitute one for another, of course if they are not in an emergency situation or they do not have strong preference bias towards either mode of communication. Thus the short haul flights and the train journeys can be considered as the substitute means of transport. Again it is know that if price of substitute rises then demand for a product also rises. As the price of the short haul flights rises, more and more people will try to take up train journeys for transportations which will reduce their spending considerably. Thus if the buyers’ price of the short haul flight, denoted by Py here, rises then the demand for train journeys will also rise. This rise in ‘demand’ is depicted by a rightward shift of the entire demand curve from D0 to D1. As a result equilibrium point shifts from A to B. Since there is no change in the supply curve for the train journeys (because producers only respond to the increased demand by raising their level of production, but supply conditions are unchanged) both the price and quantity of train journeys rise in response to the increased demand (Hüschelrath, 2008, p. 203). Hence the effects might be summarised in the following terms: (1) Price of train journeys or rail fare rises, (2) Quantity of train journeys, in terms of frequency of cars or total number of operating cars increases. Answer to Question (d) The total revenue from APD can be expressed as: TR = t x Q………… (1); where, t = rate of tax and Q = total quantities purchased. Now taking natural logarithm (i.e. logarithm with the base e) on both sides, the following equations are obtained. loge TR = loge t + loge Q…………………(2) Again taking total differential on both sides the following equation is obtained: dTR/ TR = dt/t + dQ/Q………………….(3) Equation (3) states that percentage change in the total revenue from tax is equal to the percentage change in the tax rate plus the percentage change in the quantity purchased. By definition, price elasticity of demand Ed = [ - ( dQ/ Q)/ (dPd / Pd )]. Therefore, dQ/ Q = - (dPd / Pd ) x Ed . Substituting this into the equation (3) it is found, dTR/ TR = dt/t - (dPd / Pd ) x Ed ………………….(4) Now suppose t rises by 10%. If the demand of flights is highly inelastic and the supply too is highly inelastic then (dPd / Pd ) will not be very high (since the elasticity of supply is very low) and Ed will be very low. Hence their product, i.e. the last term on the right-hand side will be less than 10 and there will be a net increase in the total revenue. Thus a low demand elasticity accompanied by low supply elasticity is a necessary condition for increase in the total revenue from the taxation. On the contrary if the demand elasticity happens to be very high, even a small increase in the tax rate which eventually raises the buyers’ price, will replace consumption so much that the total revenue, which is the product of tax rate and total consumption, will fall. Hence an inelastic demand for flights will help to raise the tax revenue from increased tax rate and the opposite will take place in case of an elastic demand. By similar reasoning it might again be contended that with a higher elasticity of demand, people will try to replace the consumption of flight service with a relatively higher intensity. Therefore even a little hike in price of the flights, caused by increased taxation, will probably lead to severe reduction in the demand for flight service. Now under a normal supply curve with a moderate elasticity of supply, the total quantity of flight service will actually fall. Thus a very high elasticity of demand compared to the elasticity of supply, will reduce the no. of flights or deter flights. While talking of environment, a very simple but plausible assumption that flight probably pollutes more than the trains, might be understood. The principal reason behind this may be that flights use refined fossil fuel and creates huge noise-both of them are very much polluting. Whereas trains are principally run by the electricity and they don’t make noises which may exceed the permissible level. Thus train journeys can be assumed to be more environment friendly compared to the flights. Hence from this aspect, a rise in the APD will be considered as an eco-friendly decision, only if it can replace sufficient people from taking flights to boarding trains to reach their destinations. Therefore the price elasticity of demand for flights has to be sufficiently high in order for this policy of raising the tax rate to be an environment friendly policy (Frank & Bernanke, 2006, p. 103). Answer to Question (e) Both the positive and negative aspects of the policy of raising APD will now be considered together. The positive effects or merits as well as the negative effects are listed below: (A) Demerits: The hike in the tax rate reduces the consumer surplus (since buyers are now required to pay even higher an amount) as well as the producer surplus (since sellers are getting an even lower amount). Although the govt generates revenue from taxation, but this revenue falls short of the total loss in consumer and producer surplus. Thus a part remains as the social deadweight loss in the market. After the tax rate is raised, the equilibrium quantity of flight service reduces-which means the policy of raising tax will deter flights. (B) Merits: Although there is deadweight loss, but an increase in APD generates significant revenue for the government which may be used for different developmental activities, building infrastructure etc. Since flight service is considered to be a luxury good, taxing this industry heavily does not affect the poor; rather using the revenue drawn from this industry, for the poorer section of the society will be conducive to the redistribution of wealth in the country, which will reduce social inequality. Finally, a rise in APD helps to protect the environment from the damage caused by the excessive flights leaves only those people in the market who have highly inelastic demand for them (Torgler, 2007, p. 294). Thus looking at the merits and demerits together it may be concluded that the rise in APD surely helps the society, the government and the environment at the cost of increased price of flights. Compared to an egalitarian distribution of wealth, a better environment and accumulated revenue, the loss of welfare of some of the rich segment of society is not much. Hence the policy appears to be justified from various aspects-be it redistribution or environment. References Baumol, W. J. & Blinder, A. S. (2008) Microeconomics: Principles and Policy (11th Edition). New York: Cengage Learning. Frank, R. H. & Bernanke, B. S. (2006) Principles of Economics (3rd Edition). New York: McGraw-Hill. Hüschelrath, K. (2008) Competition Policy Analysis: An Integrated Approach (Vol. 41). Germany: Physica-Verlag. Mankiw, N. G. (2008) Principles of Microeconomics (5th Edition). New York: Cengage Learning. Torgler, B. (2007) Tax compliance and tax morale: a theoretical and empirical analysis. London: Edward Elgar Publishers. Bibliography Pindyck, R. S. & Rubinfeld, D. L. (2005). Microeconomics (6th Edition). USA: Pearson. Read More