Effects of a higher excise tax on price elasticity of alcohol products

Q1a. Effects of a higher excise tax on price elasticity of alcohol products

Price elasticity shows how responsive the quantity demanded of a commodity is to the changes in its price (Salvatore, 2011). The price of the commodity will be affected by an excise tax imposed on the commodity. An increase in excise tax will most likely increase the price of the commodity.

According to Salvatore (2011), the coefficient of the price elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in price. Since quantity demanded and price usually have an inverse relationship for normal commodities such as alcoholic products, the coefficient will bear a negative sign. However, we are more interested in the coefficient rather than the sign and thus we can ignore the sign.

Alcoholic products comprise of beer, wines and spirits. These products are different in taste, smell, colour, alcohol content and prices. To observe the effect of a higher excise tax on alcoholic products, we will consider their price elasticity.

Srivastava et al (2014), calculated estimates of compensated price elasticity of demand for beer, wine, and spirits. For beer, the compensated price elasticity of demand was 0.718, while it was 0.968 for wine, and 0.254 for spirits.

According to these figures, the general price elasticity of alcohol products is inelastic. This is because the coefficients of price elasticity all lie between zero and one for the three products in context meaning that the percentage change in demand is smaller than the change in price(demand is unresponsive to price).

The figure above shows the shift in equilibrium due to the government setting an excise tax on consumption of alcohol products. When a tax is imposed on alcohol products, the price of the products will increase from P* to P¹. Consequently, the supply will shift to the left from SS to S^IS^I. This shift of the supply curve will move the market equilibrium to E¹. The area AEE¹ represents the deadweight loss to the consumers due to the reduction in the quantity demanded from Q* to Q¹. Because the consumers have little or no options to the alcohol products, the tax burden will be borne by the consumers.

b. As an alternative to imposing an excise tax on individual commodities, the government can put a minimum price. Minimum pricing is directly related to the price of alcohol products. A minimum price will set a floor price that the units of alcohol products will be sold at or above. No unit can be sold below this price. Because a minimum price is not a tax, the retailers will retain the revenue together with the profits that will increase.

Alternative to imposing an excise tax on individual commodities

For a minimum price to work, it has to be set above the equilibrium price otherwise the market will not sell below the equilibrium hence the minimum price will be ineffective. In the figure above, the minimum price is set at P^f. the consumers will not be willing to pay more and thus the quantity demanded will fall from equilibrium quantity Q* to Q^d. on the other hand, the suppliers will bring more of the commodity to the market and the quantity supplied will increase from Q* to Q^s. This will create a problem where the quantity supplied is more than the quantity demanded hence a surplus in the market. The surplus is the difference between Q^s and Q^d.

The area ABE represents the deadweight loss to both the producers and the consumers due to the minimum price set by the government. The consumers lose due to the reduced quantity that they will consume while the producers lose on the surplus that they will avail to the market but will not be consumed in the end. The area represents the amount of money that the society loses due to inefficient trade in the market.

c. A minimum price setting presents a deadweight loss to both the suppliers and the consumers: the society in general. It creates a surplus in the market where the producers will supply more to the market and the consumers will not be willing to purchase. Such a scenario can lead to some producers exiting the market. However, the price elasticity of demand for the consumption of alcoholic products is inelastic and the changes in the quantity consumed will change slightly with the changes in price. A big change in price will not affect consumption in a significant way. In addition, the revenue received by the government can be used to compensate for the inefficiencies in the market through subsidies in case the supply falls below demand.

In this case, of controlling the consumption of alcohol products, it will be better for the government to impose an excise tax rather than to set a minimum price (Salvatore, 2011).

Q2a. Long run equilibrium under a monopolistically competitive market

Under a monopolistic competition, firms are price makers and have the freedom to fix prices and thus make price decisions as if they were a monopoly. In addition, for the firm to maximise profits, it will produce at the point where marginal cost equals marginal revenue. The point where the profit maximising quantity lies on the average revenue curve will determine the profit maximising price (Chand, 2017).

Long-run equilibrium under a monopolistically competitive market

In the figure above the lowest point of the average cost curve is the point where the marginal cost curve cuts it. At this point, the cost of producing one table is $200. The monopolist being a price maker will set the price equal to the $200 because of the effect of monopoly like pricing.

The effect of monopolistic like pricing causes the demand of the tables made by the firm to reduce. This is opposed to the case in the short run where the firm can make economic profit. The fall in demand of tables will increase the need of the firm to differentiate its tables hence in the process increasing its average total cost of production. The increase in production cost coupled with the fall in demand will cause the demand curve and the LRAC curve to form a tangent at the point where the profit maximising price of the tables lies.

The tangential relationship between the demand curve and LRAC has two effects on the firm. First, it implies that the firm operating under the conditions of a monopolistically competitive market will produce a surplus of tables in the long run. The second implication is that the firm will not be able to make any economical profit in the long run. By setting the price equal to the cost of production at $200, the firm will only be able to break even in the long run and recover its costs.

b. An oligopolistic market is a market structure that is dominated by only a few large firms. A market that is shared by only a few large firms is referred to as a concentrated market. However, it is possible to find a few small firms operating within the market. There is no exact definition of the number of firms but each firm operating within the market controls a significant portion in the total output (Chand, 2017).

An oligopolistic market structure has the following features:

• There are high barriers to entry into the market such as large capital needed to start. This explains the existence of few firms in the market and it allows the firms to firms to make abnormal profits in the long run.
• Firms are interdependent and the decision on pricing and output made by one firm will affect the activities of other firms in the market. A firm has few competitors and therefore it has to consider the moves and countermoves of the rival firms.
• Competition in the market is not based on commodity price and there is price rigidity where price does not change irrespective of changes in demand and supply. All firms have the ability to influence price but will avoid to competing on price basis to avoid price wars. Other methods such as advertising and better customer service are used in competition instead.

Examples of oligopolistic markets in Australia include the market for motor vehicles, the mining sector, and the soft drink retail where coca cola and Pepsi dominate. These industries have few firms dominating the market with high barriers to entry due to a large capital requirement.

c. A monopolistic competitive market is a market structure that bears the characteristics of both a monopoly and a perfectly competitive market. characteristics of a monopolistically competitive market include:

• The firms operate independently in decision making regarding prices, output, and market for their products, and costs of production and the activities of a particular firm will not affect those of the other. The independence of firms in decision-making increases risk hence the entrepreneur has a significant role than in firms in perfect competition.
• Participants in the market have good knowledge about the activities in the market although the knowledge is not necessarily perfect.
• There are no major barriers to entry and exit and therefore firms are free to enter or leave the market at their own will in the long run.
• Different to a perfectly competitive market where there is a homogenous product, the products in a monopolistic competitive market is differentiated. This means that although the products are similar many ways, differences are brought about by packaging, advertising, and marketing which differentiates them in terms of brand features, logos, quality, and identity. This makes competition in the market not to be based on prices only but on a combination of the features and services that are attached to the product.
• There is a large number of firms in the market and each control a small share of the market. Due to this, the firms have limited control of the market prices.

Features of oligopolistic market structure

Examples of firms operating under a monopolistic competitive market in Australia include restaurants, hairdressers and general specialist retailing. These industries have freedom of entry and exit because of low barriers such as low costs of establishment. In addition, the firms are able to differentiate their products through advertising.

d. High barriers to entry into the market may bring about a duopoly. Such barriers include huge capital requirement to set up, patents, and control over resources and raw materials by only two firms. Another condition that may cause a duopoly to occur is government policy that will regulate a sensitive industry and license only two firms to operate in the market. This is usually to protect the consumers and avoid exploitation of certain resources that are important to the entire society.

the market demand curve and the cost curves for a duopoly are shown in the figure below.

References

Alepuz, M. D., Sempere, J. J., & Urbano, A. (1998). Duopoly price communication. Valencia: Instituto Valenciano de Investigaciones Econo?micas.

Chand, S. (2017). Price Determination under Monopolistic Competition | Economics. YourArticleLibrary.com: The Next Generation Library. Retrieved 20 April 2017, from https://www.yourarticlelibrary.com/economics/price-determination-under-monopolistic-competition-economics/28881/

Chand, S. (2017). The Oligopoly Market: Example, Types and Features | Micro Economics. YourArticleLibrary.com: The Next Generation Library. Retrieved 20 April 2017, from https://www.yourarticlelibrary.com/oligopoly-market/the-oligopoly-market-example-types-and-features-micro-economics/9140/

Etro, F. (2014). Endogenous market structures and the macroeconomy. Place of publication not identified: Springer.

Explaining Price Elasticity of Demand | tutor2u Economics. (2017). tutor2u. Retrieved 19 April 2017, from https://www.tutor2u.net/economics/reference/price-elasticity-of-demand

Fellner, W. (1965). Competition among the few: Oligopoly and similar market structures. New York: A.M. Kelley.

Gray, D. (2012). Is the demand for alcohol in Indigenous Australian communities ‘price inelastic’?. Drug And Alcohol Review, 31(6), 818-822. https://dx.doi.org/10.1111/j.1465-3362.2012.00425.x

Kumar, M. (2017). Top 9 Characteristics of Oligopoly Market. Economics Discussion. Retrieved 20 April 2017, from https://www.economicsdiscussion.net/oligopoly/top-9-characteristics-of-oligopoly-market/7342

Long Run Outcome of Monopolistic Competition. (2017). Boundless. Retrieved 20 April 2017, from https://www.boundless.com/economics/textbooks/boundless-economics-textbook/monopolistic-competition-12/monopolistic-competition-75/long-run-outcome-of-monopolistic-competition-284-12381/

Price elasticity of alcohol demand [Updated]. (2017). Offsettingbehaviour.blogspot.com. Retrieved 19 April 2017, from https://offsettingbehaviour.blogspot.com/2012/07/price-elasticity-of-alcohol-demand.html

Price Floors – Economics. (2017). Economics.fundamentalfinance.com. Retrieved 19 April 2017, from https://economics.fundamentalfinance.com/micro_price-floor.php

Salvatore, D., & Salvatore, D. (2011). Microeconomics. New York: McGraw Hill.

Slavin, S. L. (2014). Microeconomics. New York, NY: McGraw-Hill Education.

Srivastava, P., McLaren, K. R., Wohlgenant, M., & Zhao, X. (2014). Econometric modelling of price response by alcohol types to inform alcohol tax policies. Clayton, Vic: Dep. of Econometrics and Business Statistics, Monash Univ.

Stockwell, T. (2014). Minimum unit pricing for alcohol. BMJ, 349(sep30 4), g5617-g5617. https://dx.doi.org/10.1136/bmj.g5617

Stockwell, T., Auld, M., Zhao, J., & Martin, G. (2012). Does minimum pricing reduce alcohol consumption? The experience of a Canadian province. Addiction, 107(5), 912-920. https://dx.doi.org/10.1111/j.1360-0443.2011.03763.x