Demand Economic Model of Price Determination in a Market: Alcohol Consumption in Australia - Example

Article Analysis Executive Summary The purpose of this report is to carry out an article analysis on the subject of alcohol consumption in Australia with the aim of using economic models to support the proposal that volumetric taxation should be introduced in order to reduce alcohol consumption. The report will analyze the article by use of the supply and demand economic model of price determination in a market as well as the elasticity concept. This model is based on the idea that the unit price of a given good will change until it reaches a point where it settled and this is the point where the quantity demanded by consumers will be equated to the quantity supplied by producers. This leads to an economic equilibrium of quantity and price. Table of Contents Executive Summary………………………………………………………………………….1 Introduction………………………………………………………………………………….3 Purpose of Report…………………………………………………………………………….4 Economic Model and Concept…………………………………………………………….....4 Analysis………………………………………………………………………………………5 Elasticity……………………………………………………………………………………..6 Externalities………………………………………………………………………………….8 Supply Schedule……………………………………………………………………………...9 Demand Schedule……………………………………………………………………………11 Conclusion…………………………………………………………………………………...12 Reference List……………………………………………………………………………….13 List of Figures Figure 1………………………………………………………………………………………6 Figure 2………………………………………………………………………………………7 Figure 3………………………………………………………………………………………8 Figure 4……………………………………………………………………………………….9 Figure 5………………………………………………………………………………………10 Figure 6……………………………………………………………………………………….11 Introduction Analysis of Article 1: ‘Experts Want Alcohol Prices to Increase,’ by Rose, D. (2010) The core of this article is to explain the ways of reducing the consumption of alcohol in Australia since it has been shown to be among the worst abusers of alcohol in the world (Rose 2010). The major proposal that has been presented in order to mitigate this problem among the population of Australians is to introduce volumetric tax on alcoholic beverages (Rose 2010). The effect of taking this step is that it will make alcohol more expensive, and people will drink less. It is also stated that a volumetric tax would result in the replacement of the 13 different alcohol rates of tax in the nation with a ‘single per-volume levy that would not differentiate between alcoholic beverages’ (Rose 2010, paragraph 8). Analysis of Article 2: ‘The Avoidable Costs of Alcohol Abuse in Australia and the Potential Benefits of Effective Policies to Reduce the Social Costs of Alcohol,’ by Collins, D. and Lapsley, H. (2008) The main idea presented in the article is the social costs of alcohol and ways of preventing such negative effects among the people of Australia. The author states that the abuse of alcohol in Australia is grave problem and its social costs in 2004/05 have been approximated to be more than $15 billion (Collins and Lapsley 2008). The article estimates the ways in which these costs can be reduced by the implementation of public policy interventions such as the introduction of taxation. The authors agree that there is sufficient evidence indicating that higher taxation for alcohol, through raising of alcohol prices, can be effective in the reduction of alcohol consumption. The authors propose that a strong and ideal case would be a form of uniform tax rates across all forms of alcohol (2008, 16). The estimates of the reduction in social costs of abuse of alcohol which would be attained through time by increasing the levels of alcohol taxation are shown in the table below. Table 1: Potential Reduction in Social Costs Due to Increased Alcohol Taxation (2004/05 Prices) Norway United States Italy Reduction in other countries’ per capita 38.8 % 14.3% 18.4% Reduction in Australian social costs $m $m $m Total Tangible Costs 4,200 1,550 1,990 Total Intangible Costs 1,740 640 820 Reduction in total Australian Social Costs 5,940 2,190 2,810 Purpose of the Report The purpose of this report is to carry out an article analysis on the subject of alcohol consumption in Australia with the aim of using economic models to support the proposal that volumetric taxation should be introduced in order to reduce alcohol consumption. Economic Model and Concept The report will analyze the article by use of the supply and demand economic model of price determination in a market as well as the elasticity concept. This model is based on the idea that the unit price of a given good will change until it reaches a point where it settled and this is the point where the quantity demanded by consumers will be equated to the quantity supplied by producers (Saffer and Dave 2002). This leads to an economic equilibrium of quantity and price. There are major principles that drive demand and supply especially in relation to the Australian market for alcohol. This will be further discussed in the analysis of the articles. Elasticity is a concept in the theory of demand and supply and it means how strongly the supply and demand of quantities responding to many factors, including price as well as other determinants. Arc elasticity calculates elasticity over a range of values while point elasticity utilizes differential calculus in determining the elasticity at a given point (Room 2004). Analysis According to Rose’s (2010) and Collins (2008), if volumetric taxation is effectuated, suppliers will eventually be led to the production of a greater quantity (Q) of alcohol if they see that they can get a relatively high price (P) from it. Another principle with regard to supply and demand and volumetric taxation is that suppliers will, in the long run, produce a lesser quantity (Q) of alcohol if they believe they will get a relatively low price (P) for the product. This is more practical bearing in mind that the cost of purchasing the alcohol products by the supplier will be higher. The third principle is that consumers will demand a lesser quantity of alcohol given the introduction of volumetric taxation if they believe that they can only obtain the product at a relatively high price (P). On the contrary, when the price (P) of alcohol is low, consumers will demand a greater quantity (Q) if they believe that they can get the alcohol at a relatively low price (P). In the same light, suppliers will decrease their asking price (P) for the alcohol when demand (Q) for the product (at current price) is lower than expected. Additionally, consumers will raise their asking price (P) for alcohol when its supply (Q) at current price is lower than is expected. Figure 1: Graphical Presentation of Supply and Demand Changes in the Equilibrium of the Market Elasticity It is crucial to determine how strongly the quantity of alcohol supplied or demanded will change when the price changes as a result of volumetric taxation. This is referred to as price elasticity of supply or price elasticity of demand. Such knowledge will aid in the prediction of the size of the resulting effect on the quantity demanded. If the quantity of alcohol supplied or demanded changes by a greater percentage than the price did, then the supply or demand is said to be elastic. If the quantity changes by a decreased percentage than the price did, supply or demand is said to be inelastic. If supply is perfectly inelastic, implying it has zero elasticity, then there is a vertical supply curve. Figure 2: Graphical Representation of Elasticity Income is a variable that is used in determining elasticity. It is applied by determining how strongly the demand for a good changes if the income decreased or increased. In this case, if the income of alcohol consumers increased then they would be in a position to increase the demand because their purchasing power will have increased. The relative percentage change is referred to as income elasticity of demand. Externalities The measure taken by the Australian government to introduce volumetric taxation would be a positive externality because it would have a positive impact on the lives of the alcohol consumers. Additionally, such a measure will result in a decreased social cost because individuals will reduce alcohol intake hence lead responsible lives. The number of deaths and diseases reported as a result of alcohol will also reduce. Figure 3: Graphical Representation of Positive Externality Source: Ritter and Cameron 2006 According to the graph above positive externalities in the market imply that social cost is less than private cost. The marginal benefit curve to the producers is less than marginal benefit curve to the society (Room 2004). This implies that less is produced than the socially optimal level. As per the curve, when a positive externality is present in the alcohol market, consumers pay a low price and consume less alcohol than the socially efficient outcome. According to the graph, consumers pay price P’ as well as consuming quantity Q’, but at that quantity society will be required to pay more. At P’Q’ the marginal benefit to the society is higher than the marginal cost, leading to the deadweight welfare loss. The socially outcome that is efficient is to pay price P* as well as consume quantity Q*. in this quantity and price the marginal benefit to society is equated to the marginal cost. Supply Schedule in Relation to Alcohol Prices The supply schedule as demonstrated in the supply curve (figure 2) is a representation of the amount of goods (in this case alcohol) some producers are willing to sell at different prices with the assumption that all the determinants of supply instead of the price of alcohol , such as factors of production, remain similar. Figure 4: Graphical Representation of Supply Curve Source: National Health 2007 Under perfect competition, supply is determined by marginal cost. Marginal cost is the modification in the total cost of alcohol that arises when the quantity produced changes by a single unit. In other words, it is the cost of producing one more unit of a single good. Figure 5: Typical Marginal Cost Curve Source: Loxley et al 2004 Manufacturers of alcohol will produce additional output so long as the cost of producing an extra unit of output is lesser than the price they will receive. In that regard, viewing a supply curve needs the manufacturers to be a perfect competitor, implying, the manufacturer has no influence in the price of the market. This is because each point in the supply curve answers the question as to whether the manufacturers are faced with the potential price, and how much output they will be able to sell. Demand Schedule in Relation to Volumetric Taxation and Pricing This curve gives a representation of the amount of goods, in this case alcohol, that buyers are willing to buy at various process. According to Rose (2010), “volumetric taxation would increase the price of alcohol” and this includes all kinds of alcohol. As per the law of demand, the demand curve is given a representation of a downward slope, implying that as price of alcohol decreases, consumers will buy more of alcohol. On the contrary, the increase of the price of alcohol results in the decrease of the number of consumers of alcohol. Figure 6: Graphical Representation of Demand Curve Source: Junor et al 2004 Demand curves are determined by marginal utility curves. Consumers will show willingness to buy alcohol, a given price, if the marginal utility of additional consumption is equal to the opportunity cost arrived at by the price. Hence, with regard to the Australian alcohol market, demand schedule is the willingness as well as the ability of the consumer to purchase alcohol at a given price and time. Conclusion The report has shown that increase in the price of alcohol will affect the supply as well as the demand of alcohol. If the quantity of alcohol supplied or demanded changes by a greater percentage than the price did, then the supply or demand is said to be elastic. If the quantity changes by a decreased percentage than the price did, supply or demand is said to be inelastic. The theory and concept of elasticity, supply and demand, as well as positive externalities have well explained the articles. If the Australian government takes the step of introducing volumetric taxation, it will have a positive impact on society since it will reduce social cost as well reduce the consumption of alcohol. Reference List Collins, D. and Lapsley, H. 2008. The Avoidable Costs of Alcohol Abuse in Australia and the Potential Benefits of Effective Policies to Reduce the Social Costs of Alcohol. www.health.gov.au/internet/drugstrategy/publishing.../mono70.pdf (accessed September 6, 2010) Junor, W., Collins, D. & Lapsley, H. 2004. The macroeconomic and distributional effects of reduced smoking prevalence in New South Wales. The Cancer Council New South Wales,June. Loxley, W., Toumbourou, J. W., Stockwell, T., Haines, B., Scott, K., Godfrey, C., Waters, E., Patton, G., Fordham, R., Gray, D., Marshall, J., Ryder, D., Saggers, S., Sanci, L. Williams, J. 2004. The Prevention of Substance Use, Risk and Harm in Australia: a review of the evidence. Ministerial Council on Drug Strategy Monograph. National Health and Medical Research Council 2007. Australian alcohol guidelines for low-risk drinking. Draft for public consultation. Ritter, A. and Cameron, J. 2006. A review of the efficacy and effectiveness of harm reduction strategies for alcohol, tobacco and illicit drugs. Drug and Alcohol Review, November, 25, 611-624. Room, R. 2004. Disabling the public interest: alcohol strategies and policies for England. Addiction, 99, 1083-1089. Rose, D. 2010. Experts Want Alcohol Prices to Rise. Saffer, H. and Dave, D. 2002. Alcohol consumption and alcohol advertising bans. Applied Economics, 34, 1325-1334. Read More