IB HL Economics Commentary #1 - Microeconomics (Alcohol)

Commentary #1: Microeconomics Adelene Lai Word Count: 707 12th November 2009

Demerit goods tend to be over-consumed by the free market because they are over-provided by market forces. Governments see demerit goods as socially undesirable as their consumption leads to negative third party costs known as negative externalities. Externalities cause market failure as resources are not being allocated optimally. Many governments try to remedy this by setting a price floor, a minimum price, on the demerit good because in theory consumption would decrease all other things being equal (ceteris paribus). However, the amount consumers are willing and able to pay over a range of prices, otherwise known as demand, is not solely affected by price. The existence of non-price factors of demand can affect its price elasticity and therefore the responsiveness of demand to a price change. Alcohol consumption causes a negative externality because it is a demerit good. This is illustrated in Fig 1.1. The socially optimal level of consumption is Q1, where the Marginal Social Benefit (MSB) curve intersects the Marginal Social Cost (MSC) curve. However, consumption occurs at Q2, where the Marginal Private Benefit (MPB) cuts the MSC curve. At this level of consumption, we see that the social benefit is less than private benefit.

Drinking is pleasurable to the consumer but burdensome to society overall. The disparity between society’s benefit and the individual’s (MSB-MPB) is shown by the double-headed arrow, while the deadweight loss to society is shaded. The market fails because of this loss as there is a lack of allocative efficiency.

The overconsumption of alcohol is caused by its over-affordability. A minimum price could correct this. For a minimum price to be effective, it must be set above equilibrium price. Fig 1.2 illustrates the effect of a price floor of 50p (Pmin) above the current price of 9p (Pe). The market would clear at a instead of c. This increase in price would cause demand to contract in Fig 1.2, as quantity demanded falls from Qe to Q1.

Undeniably, the quantity of alcohol consumed has fallen (Qe-Q1) because of the price floor. It has an immediate effect on consumers and so may be seen as the best solution in the short term. The price floor is also effective in tackling alcohol-related crime because it hits youths and other low-income earners – those most prone to crime – hard. These people have slightly greater price sensitiveness because of their low incomes, and thus would decrease demand substantially now that alcohol takes a greater proportion of their income. Decreased alcohol consumption amongst youths benefits the labour force in the long run, which is the most important argument for the efficacy of the price floor. Furthermore, alcohol-related NHS spending would fall. This is good for government, who would now have an extra £2.7billion to spend on projects like the London 2012 Olympics, or could even lower taxes to encourage spending during the post-recession. The least important argument is that it increases producer revenue.

However, the most pressing argument against the price floor is the fact that alcohol is demand inelastic. Consumers are not very price sensitive, meaning that the decrease in quantity demanded is very small compared to the increase in price, thus rendering it rather ineffective. Also, consumers are likely to change their consumption habits to accommodate the price increase in the long run because alcohol is addictive. Furthermore, one could argue that it is difficult to place a value on the externality, and 41p could be an over- or under-estimation, while some say that the price increase is unfair to responsible drinkers. Ultimately, this could lead to a black market because of the excess supply ab shown in Fig 1.2. This could create further problems if uncontrolled sales to underage drinkers ensue. Because of its price inelasticity, government should look to non-price remedies like negative advertising, education campaigns, and restricting alcohol-vendor licenses if they want alcohol consumption to decrease substantially in the long run. Measures like these would shift the MPB curve inwards closer to the MSB curve so that the disparity between private and social benefit and indeed welfare loss is reduced as shown in Fig 1.1. Though there might be timelags before their effects, they are most effective in the long run and counter the issue of black markets.