Use Economic Theory - Free Essay Example

  The objective of this essay is to analyse and discuss the potential effects of a minimum pricing strategy on the alcoholic beverage industry. It will focus on three main economic agents: consumers, producers and the government. In doing so, the essay will first provide a definition on minimum pricing and its purpose in the economy, before discussing the potential effects it will have on each agent according to economic theory. Finally, the economic theory covered will be applied to the Scottish alcohol market to analyse the extent to which such a pricing strategy is a benefit and/or a disadvantage to each economic agent. Minimum pricing, also known as a price floor, is defined as a method of government (or other economic agent) intervention that aims to correct or lessen instances of market failure by setting the price above the equilibrium level. Figure 1 depicts a model market for a good (or service); at equilibrium, the quantity of the good being produced is qE units, and the market price is P. If the government then intervenes by setting a minimum price above the equilibrium, the new market price will be associated with an increase from P to P. In theory [assuming ceteris paribus], the rise in price should create a market surplus meaning that the quantity of the good being demanded (qd) would be greater than the quantity being supplied (qs). The law of supply states that a rise in the price of a good/service will generally increase its suppliers incentives to produce (higher prices will allow suppliers to earn a profit), suggesting the increase in the quantity supplied from qE to qs. Meanwhile, the law of demand dictates that the rise in price should prevent some consumers from purchasing the good, leading to a contraction along the demand curve from q to qd. This method of intervention is often used in instances where the equilibrium conditions of the market lead to a social [or economic] outcome that is less than desirable e.g. negative consumption externalities that arise from the overconsumption of demerit goods such as tobacco and alcohol (to be covered later), or in a price support scheme to protect producers incomes (Sloman et. al 2018:56) in markets prone to fluctuations in supply, such as the agricultural market. Hence price stabilisation is often used to help the government achieve one of their key macroeconomic objectives and serves as an example of how governments can intervene to prevent, correct or lessen market failure). Imposing a minimum price on a good or service will have various effects on the community surplus (the sum of consumer surplus and producer surplus) as the consumption and production of a good can also impact unrelated third parties who are not directly involved in its consumption or production. One reason why a minimum price may be useful in the economy is that they can reduce demand for demerit goods. A decrease in the consumption of demerit goods would therefore reduce the number of negative externalities that occur from their consumption, such as drink-driving accidents, anti-social behaviour and alcohol-related hospital admissions (this would create a snowball effect as healthcare resources become increasingly scarce). This can be depicted using a negative consumption externality diagram as shown in Figure 2. Given that the marginal social benefit (MSB) of consuming the good is less than the marginal private benefit (MPB = demand curve), the effect of a price floor on demand can be represented by the fall in quantity demanded from QFM (the free market level of consumption) to QSO (the socially optimal output where negative consumption externalities are diminished or eliminated). Figure 3 illustrates how imposing a price floor affects both the consumer and producer surplus. The first effect is the reduction in consumer surplus (represented by the change in CS1 to region CS2). This is due to the rise in price, leading to a smaller wedge between the highest price consumers are willing to pay and the price that is eventually paid (P1). On the other hand, Figure 3 also illustrates a potential increase in producer surplus from PS1 to PS2 due to the price floor. Hence in this example it is notable that a portion of the consumer welfare in this market has been absorbed by the producers the suppliers of the good have benefitted from the governments intervention while consumers have been negatively affected due to the rise in price. The imposing of a price floor has introduced a deadweight loss to society. This is defined as a cost to society resulting from allocative inefficiency (when market supply and demand are not at equilibrium). However, the magnitude of the effect that a price floor will have on consumption and production depend greatly on the price elasticities of both demand and supply. Figures 4-6 illustrate the extent of the change in quantity based on the PED and PES of the good. Figure 4 illustrates the effect on a good with a high PED qd falls by the greatest magnitude as demand is much more responsive to the rise in price. Therefore, imposing a price floor on a good may only be suitable when PED is elastic rather than inelastic. The price elasticity of supply also determines the extent to which a price floor will affect the quantity traded. Figure 5 depicts a good with price-inelastic supply, showing that an increase in price will only lead to a minimal increase in the quantity supplied. When supply is price-elastic, Figure 6 demonstrates the fact that producers will be greatly responsive to the change in price, leading to a leap from in the quantity supplied (qE to qs). The Scottish Government recently intervened in the alcoholic beverage market on February 2018 by placing a minimum price of 50p per unit on drinks (The Economist:2018). The aim of the regulation will be to lessen the external costs imposed on third parties. Using Figure 2, the external costs of alcohol consumption can be represented by a contraction along the MSC curve from P1 down to P2. As a product that is overconsumed in a free market and considered addictive by many consumers, it is widely recognised a demerit good; intoxication harms not only drinkers but also the wider society, posing several risks to consumer health such as an increased likelihood of contracting liver disease, heart disease and stroke as well as a greater number of fatal car accidents resulting from drink-driving. Statistics from an NHS report taken in 2015 indicate that ?approximately 57,000 deaths (1 in 15 of the Scottish population) were caused by alcohol (Alcohol Focus Scotland:2018). One reason why the minimum price may benefit Scottish consumers is that reduced consumption should reduce the number of alcohol-related accidents and health complications resulting from misuse, likely leading to a healthier population and a more productive workforce. This is highly likely given that alcohol is produced in a competitive market with many substitutes and at low prices the price strategy is described as a ?price hike on cheaper, stronger drinks (BBC News:2018). Suggesting that demand for the good is fairly price elastic, it would mean that a 20% rise in the price, for example, should result in a percentage fall in demand that is larger than 20%. With reference to Figure 5, it can thus be inferred that a price floor of P1 on alcohol should successfully reduce demand from QE down to Qd. However, the price floor may do some Scottish consumers more harm than good Figure 3 shows that a rise in price will cut consumer surplus short (CS2 has shrunken in size in comparison to CS1). This may be problematic for low-income households among the Scottish population who only consume alcohol occasionally since a per-unit price rise will comprise a greater proportion of their income than those with more income. This group of consumers will be much more price-elastic in demand due to the differing levels of household income and their consumer preferences. Therefore, minimum pricing can be also criticised as it would disproportionately reduce Scottish consumers spending powers based on their income. A possible benefit of using minimum prices to Scottish producers is that it increases the price that they producers receive from the sale of the good. This may be beneficial for smaller firms as they may gain greater profit and subsequently use this profit to invest into their products, potentially resulting in produce of a higher quality. However, the price floor may unintentionally cushion inefficient producers of the good by allowing them to avoid cutting their costs. This could be potentially harmful to the industry if resources are not being fully optimised and waste becomes commonplace in the market. The price floor can beneficial to the Scottish Government a healthier workforce may afford to work more often and/or for longer hours. However, a concern arising from the imposition of a minimum price revolves around the treatment of the market surplus (qs-qd, see Figure 4). The government may incur additional costs in having to buy up the excess supply or destroy it. This may be an unfavourable outcome for the government the surplus may be considerably large if alcohol is to have price-elastic demand or supply (or even both, making the procedure even more costly. To conclude, minimum pricing will have both positive and negative connotations for all three economic agents. The extent of these are determined by the size of the price floor. There may be better methods to reduce market failure from the consumption of such a demerit good, such as a progressive tax (e.g. a duty on alcohol) or a subsidy on alternative merit goods (healthcare) to increase external benefits. Bibliography Sloman et al. (2018) Economics. 9th edn. London: Pearson The Economist. (2018). Scotlands minimum price for alcohol may have unexpected effects. [online] Available at: https://www.economist.com/britain/2018/03/01/scotlands-minimum-price-for-alcohol-may-have-unexpected-effects [Accessed 15 Nov. 2018]. Alcohol Focus Scotland. (2018). Alcohol facts and figures. [online] Available at: https://www.alcohol-focus-scotland.org.uk/alcohol-information/alcohol-facts-and-figures/