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.

<Fig 1.1>

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.

<Fig 1.2>

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.