Commentary: A Few Initial Observations on Producer Reactions to the VAT Increase

As an interesting follow-up to the discussion of last week, here are some passing observations on the immediate responses in price setting behavior.  This is by no means a scientific investigation -- just some prices I happened to notice in my personal routine.  As anecdotal and limited as this evidence is, however, it nevertheless appears quite to be illustrative.

For example, out of pure personal interest, I have been tracking the prices of several models of mobile phones offered by Vodafone and Orange at the end of June 2010.  Both offer phones for purchase, with prices depending strongly on whether or not you agree to a service contract (or extension) at the time of the purchase.   Obviously, agreeing to a contract (typically two years in length, for both companies) entitles the purchaser to a rather hefty discount on the price of the phone.

Now, to make the comparison clear, I recorded the prices of several phone models, as advertised on the Vodafone and Orange websites on 27 June 2010 (when the VAT increase was first announced).  Accordingly, I compared the price of the exact same models as listed on 1 July 2010 and 2 July 2010, respectively.  The following table summarizes the (percent) price differences, in terms of both final prices (those paid by the consumer after the VAT is applied) and base prices (those acquired by the producers -- i.e. before the VAT is applied).

	Vodafone		Orange
	Contract	No Contract	Contract	No Contract
01.07.2010	4.2%	4.2%	0.0%	4.2%
02.07.2010	0.0%	4.3--5.1%	0.0%	4.2%
final prices relative to 27.06.2010
	Vodafone		Orange
	Contract	No Contract	Contract	No Contract
01.07.2010	0.0%	0.0%	-4.2%	0.0%
02.07.2010	-4.2%	0.2--0.9%	-4.2%	0.0%
base prices relative to 27.06.2010

Again, it is important to keep in mind that the effective increase in the VAT rate is 0.05/1.19 = 4.2%.  Consequently, we observe a rather interesting dynamic: on the first day of the rate increase, Vodafone increased all final prices by 4.2%.  That is to say, they passed the entire burden of the VAT to the consumer, across the board.  Orange on the other hand, kept the prices of phones sold with contract commitments unchanged -- i.e., they absorbed the entire burden of the VAT increase for this bundle, but likewise increased the price of phones offered without a contract commitment by exactly the amount of the VAT increase.

The following day, Vodafone changed their prices once again, this time reducing the price of a phone purchased with a contract commitment to its original pre-VAT hike level.  In this sense, it appears that Vodafone followed the Orange strategy in shielding those customers committing to long term contracts (with their phone purchase) from the VAT increase entirely.  On the other hand, phones sold with no contract obligation were slightly increased in price once more.  The latter difference is quite subtle, however, and at least on the surface seems to manifest only as some type of "rounding error".

To clarify with a simple example, a phone that was €100.00 on 27 June 2010 (without a contract), was increased to €104.20 on 1 July 2010 (e.g. a 4.2% increase in line with the tax rate change).  On 2 July 2010, the same phone became listed at €105.00 (e.g. a 5.0% increase), etc.  In other words, of all the phones examined, no contract-free price increased by more than €1 between 1 July and 2 July, and all prices are now being listed with whole euro amounts.  Interestingly, Orange maintained the price levels set on 1 July through the next day as well.

In some other passing observations over the weekend, it appears that most large producers (e.g. Carrefour, Ikea, E-Mag, etc.) have chosen to bear the entire burden of the VAT increase.  That is, by resounding public announcements, many have vowed not to increase the final prices at all.  A particularly creative strategy appears to be undertaken by E-Mag, who are advertising this in terms of a promotion: in fact, they are not simply maintaining the same prices, but rather offering a limited time (until 31 July 2010) discount off the "new" prices, which just happens to equate them to the old ones.  Here is the flashy ad found on their website, in many customers' (present party included) mailboxes:

Incidentally, a loaf of bread is still 1.00 RON at the corner market near my house, but a 2L bottle of water has increased from 3.00 RON to 3.30 RON (e.g. 10%) at the mini-market downstairs of my office building.  Price dispersion, indeed!

A few simple comments are in order, related to the discussion on the effects of VAT rate increases on prices:

1. With respect to the mobile phones, the initial polarization among phones priced with and without contract commitments may be regarded as reflecting the way in which elasticity of demand and supply are perceived for the two types of products.  That is, it appears that demand elasticity overshadows supply elasticity for phones bundled with contract commitments and vise versa for phones offered without contracts.
   
   Of course, the difference is not really so drastic as the initial post-VAT increase pricing schemes imply -- for example, the demand elasticity is not infinite for with-contract phones and zero for no-contract phones (or vise versa with respect to supply).  Otherwise, the price discrepancy would have been much larger prior to 1 July 2010 as well.  In that sense, the initial effect of the VAT increase has been somewhat exaggerated in the resulting prices whereas in the future, ceteris paribus, one would expect the prices of phones offered with contracts to slightly increase and those offered with no contracts to slightly decrease.  Similar analysis applies to any industry where analogies can be drawn to the phone scenario discussed here.
   
   
2. The fact that large-scale firms have reacted by leaving final prices unchanged (equivalently, lowering base prices by exactly the amount of the VAT rate increase) is not surprising.  Again, taking into account the supply-demand framework, it is to some degree a reflection of the demand elasticity exceeding supply elasticity in the respective industry, although not necessarily to the extent that would justify the producer bearing the entire burden of the extra tax exclusively.  On the one hand, this suggests that earlier "expert claims" of hyperinflation were indeed unsubstantiated.  On the other hand, this is in fact cause for the type of concern elicited by the basic economic theory: the damaging effects of a VAT increase are not so much related to increased prices faced by consumers, but rather the decreased prices and demand quantities inevitably obtained by producers, especially small producers with limited liquidity options.
   
   Proceeding with the interpretation that large producers have dropped prices below expected equilibrium levels, one cannot ignore the implication of this reaction on their smaller sized competitors.  The problem is, multinational producers such as Carrefour and Ikea are in much better position to sustain a drop in revenues for an extended period of time than their small-level counterparts.  As discussed with respect to the mobile communications industry above, market prices in the present case may eventually adjust upward as well (again, setting aside all other influences on prices), but in the meantime small, local shops will need to compete with the under-priced products offered by the larger firms.
   
   This may in fact prove disastrous for many small firms.  Already facing a second year of sever downturn in demand, an inaccessible banking sector, overbearing new taxation measures (such as minimum tax quotas), and a variety of other adverse factors, even the smaller producer that is successful enough to have managed to survive until this point may simply not have the cash resources available to survive under these new conditions.  For many industries, the economic environment characterizing the near future will effectively reflect that of a price war.  In fact, the latter may indeed be precisely the case if, say Ikea, has opted for the zero-price-change policy strategically, knowing that many small furniture retailers around Bucharest will not be able to match this initiative for an extended period of time and may thus be eventually forced into bankruptcy.
   
   
3. One should be careful in interpreting the changes in observed prices as they evolve from here on forward.  Notice that all analyses of price dynamics above are accompanied by phrases such as "ceteris paribus," "setting aside all other influences on prices," etc.  This is because in reality, the VAT increase is most definitely not the only effect driving the prices set by producers, and those paid by consumers.  At any moment in time, the prices that we observe reflect a wide spectrum of influences, and disentangling the sources of recorded changes in prices is quite a substantial empirical challenge.
   
   That said, the prices observed in the early days of July will indeed be mostly influenced by the rise in VAT.  However, with the passing of time, other important factors (not the least of which is the continuing general decline in aggregate demand) will assume ever more significant roles in determining market prices. Thus, over weeks and months, the prices seen on retail shelves will become less indicative of the VAT increase effects and more reflective of other market forces.  This is what makes assessing the true damage of erratic fiscal policy so difficult, and what makes erratic fiscal policy itself so dangerous.