Econ8069 Business Economics : Demand Assessment Answers

1.Assume the government wishes to reduce alcohol consumption by considering a higher excise tax on alcohol products. Collect information on estimates for the price elasticity of demand for alcohol products. Based on these elasticity estimates illustrate using a demand/supply diagram(s) who bears the burden of the higher excise tax, consumers or producers.

As an alternative for reducing alcohol consumption assume the government is also considering the imposition of a minimum price on alcohol products. Using a demand/supply diagram illustrate the consequences of imposing a minimum price on alcohol for the consumption of alcohol products.

Provide comment on the relative merits of increasing excise taxes compared to imposing a minimum price on alcohol products for reducing alcohol consumption.

2.a)    Assume that in long-run equilibrium the minimum point of the LRAC curve for a table manufacturer’s tables in $200   per table. Under conditions of monopolistic competition, will the long-run price of a table be above $200, equal to $200 or less than $200. Explain your answer.

1.As per the given information, the government is currently mulling the option of imposing a higher excise tax on alcohol sale. It is apparent that excise tax is an indirect tax which would lead to changes in demand supply for alcohol as has been indicated below (Arnold, 2008).

The excise duty is charged on the various manufacturers of alcohol which would be imposed on the customers and hence the supply curve for alcohol would shift upwards. The demand curve in the short term tends to remain constant and hence there would be an increase in the price of alcohol which would theoretically lead to a lower production as is apparent from the diagram indicated above. In this manner, the alcohol abuse menace can be controlled (Pindyck and Rubinfeld, 2001).

However, a key relevant factor in this regard is the underlying elasticity of the alcohol products. This is an essential factor as if the elasticity is high, then majority of the tax burden would have to be borne by the manufacturers and suppliers  This is because if a higher tax burden is passed on to the consumers, the price would become high and the demand would drop. On the other hand, low elasticity would indicate that customers would be relatively less sensitive to increase in prices and thereby a larger tax burden could be passed on to the end consumers (Nicholson and Snyder, 2011).

The demand for alcohol can be taken as inelastic with an estimated price elasticitiy ranging in the interval of -0.2 and -0.4. As a result, the distribution of the tax burden can be summarised as follows.

It is apparent from the above figure that even though most of the tax burden has been passed on to the buyer but still the decrease in the quantity consumed is minimal as indicated from a change to Q to Q₁.  This is made feasible by the relatively inelastic demand of alcoholic products as these are addictive in nature (Krugman & Wells, 2008).

Another method through which the government may try to resolve the problem of alcohol and lower the consumption is by a minimum price which would be above the equilibrium price and thus would allow in reducing the negative externality associated with the consumption of alcohol. The relevant diagram in this regards is stated below (Besanko & Braeutigam, 2010).

It is apparent from the above graph that imposing a minimum price of alcohol leads to a creation of excess supply as the demand at a higher price would essentially be lower as determined by the underlying demand function. As a result, the equilibrium quantity of consumption would come down to Q₂ as has been indicated in the graph shown below (Mankiw, 2014).

The merits of putting a minimum price on alcohol are as follows (Mankiw & Taylor, 2011).

• The consumers tend to pay for the social cost associated with alcohol.
• It tends to be highly effective for young consumers who tend to over consume alcohol.
• As a result, of the minimum prices, it is possible that people would tend to drink in pubs rather than procure liquor from various supermarkets.

However, the minimum price approach also has significant demerits such as it would adversely affect the people with lower income making alcohol take away a higher proportion of salary, lead to increase in profits by the private players while the government does not get any incremental funds (Pindyck and Rubinfeld, 2001).

In comparison, the merits of an excise tax on alcohol are indicated below (Arnold, 2008).

• It tends to lead to decrease in the consumption of alcohol by increasing the price.
• It leads to the collection of a significant amount of revenue for the government which can be used for creating awareness specially amongst the young users of the perils of alcohol and strengthen the rehabilitation centers.
• It tends to adversely impact the profit margins of suppliers and may put some of them out of business thus resulting in overall reduction in supply of alcohol.

On the basis of the above discussion, it may be concluded that relative merits of the imposition of the additional excise duty are higher in comparison with imposition of minimum price. The key advantage of hiking excise duty is in the form of additional revenues which could be used to cater to the addicted individuals and youngsters so as to manage the demand side and further lower the consumption of alcohol.

Hence, in the given case, the price would be equal to the LRAC of $ 200.

• The market has a presence of only a few producers.
• There are barriers to entry which are greater than the perfect competition market structure but less than monopoly.
• The firms tend to sell differentiated products and as a result marketing assumes a key role.
• With regards to decisions in relation to price and output, there is interdependence amongst the firms as these would tend to depend on the corresponding decisions taken by the rival firm.

Three industries where oligopoly may be observed in Australia are as indicated below (Mankiw & Taylor, 2011).

• Supermarkets – The market is dominated by two major firms i.e. Woolworths and Coles along with presence of other smaller players. Barrier to entry exists in the form of capital investment and strong supply chain. Competition is not only price based but also non-price based.
• Mining – The market is dominated by two major firms i.e. BHP Billiton and Rio Tinto. However, there are other smaller players as well. Barrier to entry exists in the form of capital investment and also mine availability. Competition is not only price based but also based on ore quality.
• Banks – The banking industry is dominated by certain major players but there is existence of other smaller players also. Further, barriers exist to entry in terms of capital investment requirement and also approval from RBA (Reserve Bank of Australia). The competition in the industry is based on pricing but also service standards.

• The number of buyers and sellers present in the market is large.
• There are low barriers to firm entry and exit.
• There is differentiation of product quality.
• The customers lack perfect knowledge which is observed in case of perfect competition.
• Advertisement is a key aspect of this market as product differentiation is practiced.

Three industries where may monopolistically competitive market be observed in Australia are as indicated below (Mankiw & Taylor, 2011).

Coffee industry – There are a host of coffee cafes and the entry and exit barriers are minimal. Besides, there is product differentiation also in terms of product also.  Further, in order to attract customers, advertisement is significant.

Hairdressers – There are a host of service providers and customers. Entry and exit barriers are minimal. Also, there is differentiation of services offered. Further, in order to attract customers, advertisement is significant.

Fast food industry - There are a host of fast food outlets and the entry and exit barriers are minimal. Besides, there is product differentiation also in terms of product also.  Further, in order to attract customers, advertisement is significant.

d.The various conditions for natural duopoly are as follows (Krugman & Wells, 2008).

• Large upfront capital expenditure required for setting for enabling infrastructure to provide the relevant product or service.
• Government restriction to entry as government approval may be required.

Consider a natural duopoly which is in equilibrium as indicated in the graph below.

In the given case, if a third player would enter the market, then the equilibrium of the market would be disturbed as there would be an increase in the production  and hence there would be a reduction in the price which would be partly done  in response to the competition. As a result, the MR curve would shift to a point where all the firms in the industry would be making losses. While the established firm would be able to sustain losses, it would be difficult for a new player and eventually a duopoly would be again restored (Nicholson and Snyder, 2011).

References

Arnold, A.R. (2008). Microeconomics (9^thed.), Sydney: Cengage Learning.

Besanko, D. & Braeutigam, R. (2010).Microeconomics (4^thed.), New York: John Wiley & Sons.

Krugman, P. & Wells, R. (2008) Microeconomics (2^nded.), London: Worth Publishers.