AS Microeconomics and AS Macroeconomics: the VAT increase

From 1 January 2011, the rate of VAT will rise from 17.5% to 20%. The price of a £100 product in a shop was, up to now, made up of £85.11 (for the retailer) and £14.89 of VAT. This amount will rise to £17.02, so the product will cost £102.13 in 2011. On the macroeconomics front, the VAT rise means that both the Retail Prices Index and the Consumer Prices Index will go up quite significantly, making an interest rate rise by Bank of England more likely.

On the microeconomics front, retailers may well suffer. They have suffered from rises in the costs of raw materials such as cotton, oil and copper. Retailers may try to "absorb" some of the VAT rise by only putting up their prices a little bit. Some, however, may use this opportunity to raise prices by more than the VAT increase because they think that consumers won't notice so much. Here is an analysis of how retailers might react: