Fashionista Need Not Sweat Over Inditex Rising Prices

Based on the article ‘Inditex to maintain prices,will absorb Vat tax hike', fashion retailer and owner retail chains of Zara, Pull & Bear, Massimo Dutti, Bershka, Stradivarius, Oysho, Zara Home and Uterque have announced on July 11, 2012 that it will absorb VAT tax hike imposed by the Spain government. Loyal customers of the retail chains need not worry the increase in price of the items.

The Spain government has announced an increase in the general VAT rate from 18% to 21% in order to meet requirement agreed with Europe. However, Inditex, world’s largest fashion retailer and owner of group’s retail chain such as has made decision to absorb the VAT tax hike and maintain its prices. The company said in a press release, “Inditex is maintaining its price stability policy which it used to absorb Spain’s last VAT hike by identifying efficiencies in other parts of the business.” When government imposed tax on an item, the burden of a tax is divided between buyers and seller which is known as tax incidence. If the price of an item rises to the full amount of the tax, buyers would have to bears all the taxes. If the price doesn’t rise at all, the sellers bear the tax. In this case, Inditex is determined to bear the taxes and will not pass on the Spain’s VAT-rate hike to its customers. When sellers pay the tax, the amount of price is decrease by the amount of tax paid. For example, the price of a t-shirt without tax is $10 and 100 pieces is sold per week. Now, a tax of $2.50 is absorbed by the seller which is Inditex and it is only willing to supply 100 t-shirt at the price of $12. Thus, a new supply curve(S+tax on sellers) shift leftwards and new equilibrium is achieved. The equilibrium quantity decreases to 50 pieces per week, the price paid by buyers rises to $11 and the price received by sellers falls to $9.50 per piece.

-Tax on Seller graph-

It is said that the demand from consumers will not change after Inditex absorb the VAT tax. However, I think that Inditex might reduce the price of its items so that quantity demanded will increase and more profits can be earned to cover the losses. According to ‘The Law of Demand’, if the price of the good decreases, quantity demanded will increase, provided other factors remaining the same. Items like shirt, trousers, dresses supplied by Inditex have high elasticity of demand. This is because clothes have close substitutes and can be find everywhere unless you are brand conscious like me. If the items already have high elasticity of demand, tax imposed will be covered by the sellers. No buyers are willing to pay a high price for goods that can be found elsewhere. For example, if Zara sell a dress in $179 which includes $20 tax and Mango sell a similar dress in $159 which doesn’t include tax, obviously I would go for the one which cost less. Thus Zara have to bear the $20 tax and lower the price to $159 to attract consumers.

-Tax with Perfectly Elastic Demand graph-

From my observation, the prices of clothes in Zara are getting less expensive. This may be one of their sales strategies to gain more customers and earn more profits. Nevertheless, consumers are not neglected to gain benefits. Customers gain consumer surplus when received excess benefit from a good over the amount paid for it. In this case, consumers gain happiness out of wearing the beautiful clothes which makes them look ravishing. They do not concern about the low price deal. Obviously, the sellers are not at loss too. It’s a win-win situation. Producer only sell when they are willing to accept the price sold. Sellers gain producer surplus when they have excess amount of benefit from the sale of a good over the cost of producing it. Let say the cost of producing a dress is $50 and the market value is $150. The producer gets $100 profit due to high market value. Therefore, the consumer surplus and producer surplus are maximized and the market is efficient.

In addition, a tax imposed will change the price that buyers are willing to pay (marginal social benefit) and the price that sellers are willing to receive (marginal social cost). A tax makes marginal social benefit exceed marginal social cost which shrinks the consumer surplus and producer surplus, and creates deadweight loss (insufficient quantities provide to the society). Although, Inditex claimed to absorb the VAT tax hike, but there are chances a small amount of the tax is included in the price of the items. Of course, these are just my point of view.

For example, with no tax, 5000 dresses are produced in a week and the price of a dress is $200. When government imposed a 10% tax, the cost of the dress becomes $220 and the tax burden is shared between buyers and sellers. The buyers’ price rises to $205 and the sellers’ price drop to $185. Furthermore, the quantity decreases to 4000 dresses a week. Consumer surplus shrinks to the green area and producer surplus shrinks to the blue area. Part of the loss of consumer surplus and producer surplus goes to the government as tax revenue (pink area) and other become a deadweight loss to the society(gray area).

 -Taxes and Efficiency graph-

Any firm’s goal is to maximize profit including Inditex. Yet, Inditex will find it hard to maximize profit when they decide to absorb the Spain’s VAT-rate hike. Inditex might face a market constraint. The price of goods sold received by Inditex is now reduced by the amount of tax so Inditex will have to find ways to expand their market to increase sales. Moreover, they will have to compete with other firms’ marketing efforts. In addition, the tax paid by Inditex could have been use to serve other purposes. The opportunity cost of paying tax could be developing a more advanced capital to increase output or buying a land to expand their brand.

Author: Student ID: 0312558