ECO100 Economics for Business

Drinking culture is very prominent in Australia. The country has been known as the beer-drinking nation of the world. The citizens spend approximately $14.1 billion on alcohol per year. However, The Telegraph reports that in the recent years, the Australians are choosing wine over beer, and also the level of consumption is decreasing as the Australians are choosing healthy living (Pearlman, 2015). The government of Australia may impose policies to reduce the alcohol consumption to decrease the negative impact on health. Higher excise tax and price flooring are two such policies. However, the price elasticity of demand for alcohol needs to be estimated before evaluating the impacts of these policies by the government.

Cost per bottle of alcohol in Australia:

(Source: globalalcoholprices.com, 2015)

Australia has quite higher price of alcohol than in other countries. In spite of the higher cost, the consumption level of alcohol is high in Australia. The demand is not dependent on the price of alcohol. It is assumed that the alcohol consumption primarily depends on the tastes and preferences of the consumers. Thus, 1% increase in the price of alcohol does not have much effect on the demand for alcohol (Jiang et al., 2016).

If, P1 = $17.99, Q1 = 700 ml; and P2 = $20.99, Q2 = 700 ml,

Then, price elasticity of demand for alcohol, E_p =

Therefore, it can be said that, demand for alcohol is inelastic of price. Customers would still prefer to buy the same quantity even if the price rises.

Impacts of Excise Tax

Excise tax is an indirect tax. It is imposed on the sale of a good. The producers shift this tax burden to the customers by raising the price of the product. As the elasticity of price is zero for alcohol, the effect of excise tax is borne by the consumers. They willing pay the higher price to avail the same quantity of alcohol (Sornpaisarn, Kaewmungkun & Rehm, 2015).

Figure 1 depicts the effects of excise tax on the sale of alcohol. As the demand for alcohol is price inelastic in Australia, the demand curve is vertical. The government imposes excise tax of amount t per unit of the product. Due to this, the supply curve shifts upward from S1 to S2, and price increased by the tax amount t, from P1 to P2. As a result of price hike, the producers reduce their supply. However, consumers still demand the same quantity of alcohol, so quantity remains at Q, but new price is P2, which is higher than the previous price P1, by the amount of t per unit. Thus, excise tax only increases the price of alcohol but does affect the demand for it.

Imposition of minimum price: Price Floor

When the government imposes minimum prices on the producers, it is known as price flooring. It is a type of price control. Price floor must be higher than the market equilibrium price for effectiveness. When it is imposed, the sellers cannot charge any price below it. To reduce over-consumption of any product, the government sometimes impose minimum price (Mishustin, 2016).

Figure 2 represents the impacts of price floor. The demand for alcohol is price inelastic in Australia. Hence, it has a vertical demand curve. The market equilibrium is at price P* at quantity Q*. When the government imposes price floor, that is, minimum price, the price of alcohol rises to P_f  from P*. Therefore, producers increase the supply of alcohol in the market, represented by ES in the figure. This would lead to unsustainable market (Sharma, Etilé & Sinha, 2016). The sellers cannot ask for a lesser price to reach equilibrium and this may lead to market failure. To prevent this situation, either the government would have to buy the surplus production or the sellers have to absorb it (De Vroey, 2016).

Relative merits

The above discussion infers that the imposition of excise tax on the sale of alcohol has greater impact than the imposition of minimum price. In case of inelastic demand, price floor leads to market failure. However, the demand or consumption of alcohol remains unchanged in both the cases. Although, the revenue of the government increases due to excise taxes, and that can be used for the purpose of public spending. On the other hand, the impact of price floor affects the producers and not the customers. Therefore, in the case of inelastic demand, the effect of excise tax is higher than that of price floor (Grossman et al., 2013).

Figure 3 depicts the long run equilibrium of the table manufacturer. The lowest point of his long run average cost curve (LRAC) gives the price of P1, where long run marginal cost (LRMC) cuts the LRAC curve from below. Here P1 = $200. The long run price under monopolistic competition occurs at the point L, where LRAC is equal to AR or demand curve (D), and LRMC is equal to marginal revenue (MR). Thus, the profit maximizing price for the table manufacture would be P*, which is more than P1 = $200 (Vargas, Costa & do Val, 2016).

Oligopoly is a form of the market, characterized by few large sellers, many buyers and differentiated products (Baumol & Blinder, 2015). The features of oligopoly are:

• Few sellers: here there are a few sellers and many buyers. The firms have a good control over the price.
• Product differentiation: the sellers offer differentiated products, which are close, but not perfect substitutes.
• Non-price competition: differentiated products require high level of non-price competition in this market structure.
• Barriers to entry: in oligopoly market, it is difficult to enter and make profit for a new firm but there is no barrier to exit.
• Group behavior of the firms: the firms here behave like a group, thus, action of one firm affects the actions of the other firms.
• Interdependence: the firms are interdependent on each other. If one changes its price, others will change the price too.
• Price rigidity: the firms cannot engage in price wars, as that would reduce profit. Hence, price is rigid in this market.
• Lack of uniformity: the firms are of various sizes in this market, some are small, some are large (Fudenberg & Tirole, 2013).

In Australia, three major oligopolistic industries are Banking, Grocery retail and Telecommunication. Four banks, ANZ, NAB, Westpac and Commonwealth Bank dominate the banking sector. In the grocery retail, Woolworths and Coles are market giants. Telecommunication sector is dominated by Telstra, Optus and NBN Co (Dimech, 2014).

These sectors have few but large firms and many buyers. The products are slightly differentiated, hence, non-price competition is widely practiced in this market. The firms act like a group, thus, a decision of one firm affects the decision of the others. There is no price war, as that would bring loss for all firms in the respective industries. If Woolworths goes for a reduction in grocery price to grab more customers, Coles would lower its prices too, to retain the market share. These firms are already so established and have effective pricing, which creates barriers to entry for a new firm in all these industries.

Monopolistic competition is a form of imperfect competition. This market structure is characterized by the presence of many buyers and many sellers, with products that are close, but not perfect substitutes. Here, a single firm does not have the power to control the market price (Varian, 2014).

The features of monopolistic competition are:

• Many buyers and sellers: there are many buyers and sellers with limited market share and they act independently
• Product differentiation: the goods are differentiated and close but not perfect substitutes. Product differentiation occurs based on brands, packaging, shapes, sizes, colors, flavors etc.
• Free entry and exit of the firms: since the firms have competition, and limited power to control prices, thus, there are no barriers to entry and exit in this market structure. There is also absence of supernormal profits or losses.
• Non-price competition: the firms engage in non-price competition to gain more customers. As the products are close substitutes, the non-price competition is more important than price competition.
• Dearth of perfect knowledge: there is lack of perfect knowledge in the market. Sometimes customers judge a product’s quality by its high price due to lack of knowledge about its substitutes.
• Independent decision-making: as the decision of one firm does not affect the others, the firms make decisions independently, and set their own prices.
• Elastic demand: the firms reduce price to stay in the competition. Thus, the demand curve in this market is elastic (Nikaido, 2015).

The industries, such as, consumer goods, restaurant business and beverage are monopolistically competitive in Australia (Balistreri & Rutherford, 2013). All these sectors have many buyers and many sellers. They sell differentiated products; hence, the intensity of non-price competition is too high. The prices of one firm has little effect on the decisions of the other firms, hence, they can take independent decisions. There is free entry and exit for the firms, without incurring much cost. There is lack of perfect knowledge among the buyers about the products in the respective sectors (Kollmorgen, 2016).

Duopoly is a simple form of oligopoly market structure. It consists of only two sellers and many buyers. Natural duopoly occurs when there is no third seller in the market, differentiated products leading to some monopoly power, and independence between two firms.

In duopoly, a major economic model is Cournot model, which plots reaction curves of the firms in the diagram. It represents the profit maximizing output of one firm and the output expected to be produced by the other firm. The output of one firm is the decreasing function of the production of another firm (Moulin, 2014).

The Cournot equilibrium for natural duopoly. Q1 is the output of firm 1 and Q2 is the output of firm 2. The reaction curves represent the quantity produced by one firm as a function of the expected output of the competitor. In the diagram, point E* is the Cournot equilibrium. It reflects the combination of output, which both the firms produce for profit maximization by predicting the output level of the other correctly. Here, firm 1 will produce 60 units, if firm 2 produces 120 units for profit maximization. Therefore, at this situation, it is difficult for another new firm to enter the market and make profit.

References:

Balistreri, E. J., & Rutherford, T. F. (2013). Computing general equilibrium theories of monopolistic competition and heterogeneous firms. Handbook of Computable General Equilibrium Modeling, 1, 1513-1570.

Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Cengage Learning.

De Vroey, M. (2016). A history of macroeconomics from Keynes to Lucas and beyond. Cambridge University Press.

Dimech, A. (2014). Australian Oligopolies. The Grapevine. Retrieved from http://blog.adonline.id.au/oligopolies/

Fudenberg, D., & Tirole, J. (2013). Dynamic models of oligopoly. Taylor & Francis.

Grossman, M., Sindelar, J. L., Mullahy, J., & Anderson, R. T. (2013). Policy Watch; Alcohol and Cigarette Taxes.

Jiang, H., Livingston, M., Room, R., & Callinan, S. (2016). Price elasticity of on-and off-premises demand for alcoholic drinks: A Tobit analysis. Drug and alcohol dependence, 163, 222-228.

Kollmorgen, A. (2016). Market monopolies in Australia. CHOICE. Retrieved 22 April 2017, from https://www.choice.com.au/shopping/everyday-shopping/supermarkets/articles/market-concentration

Mishustin, M. V. (2016). Factors of Growth of Tax Revenues: A Macroeconomic Approach. Economic Policy, 5, 8-27.

Moulin, H. (2014). Cooperative microeconomics: a game-theoretic introduction. Princeton University Press.

Nikaido, H. (2015). Monopolistic Competition and Effective Demand.(PSME-6). Princeton University Press.

Pearlman, J. (2015). Australians ditch beer for wine as alcohol consumption at 50-year low. The Telegraph. Retrieved from http://www.telegraph.co.uk/news/worldnews/australiaandthepacific/australia/11589114/Australians-ditch-beer-for-wine-as-alcohol-consumption-at-50-year-low.html

Sharma, A., Etilé, F., & Sinha, K. (2016). The effect of introducing a minimum price on the distribution of alcohol purchase: a counterfactual analysis. Health economics, 25(9), 1182-1200.

Sornpaisarn, B., Kaewmungkun, C., & Rehm, J. (2015). Assessing patterns of alcohol taxes produced by various types of excise tax methods—a simulation study. Alcohol and Alcoholism, agv065. 

Vargas, A. N., Costa, E. F., & do Val, J. B. (2016). Approximation of the Optimal Long-Run Average-Cost Control Problem. In Advances in the Control of Markov Jump Linear Systems with No Mode Observation (pp. 35-46). Springer International Publishing.

Varian, H. R. (2014). Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.

Veseth, M. (2014). Introductory macroeconomics. Academic Press.