Sunday, 28 February 2016

Alcohol minimum pricing, elasticity and profits

One of the common refrains from public health advocates is that New Zealand should introduce unit minimum pricing for alcohol, similar to Scotland and Canada (and soon to be introduced in Ireland). A recent article in the New Zealand Medical Journal made the case (gated; I don't see an ungated version anywhere), which was picked up by the New Zealand Herald, and critiqued by Eric Crampton.

I want to take a different angle, of relevance to my ECON100 students. What would be the effects of alcohol minimum pricing, if it was introduced. For simplicity, I'm going to ignore the existing excise tax on alcohol, and any externalities, and just concentrate on the minimum price.

The effect is shown in the diagram below. Without minimum pricing, the market equilibrium price is P0, and the quantity of alcohol sold (and presumably consumed) is Q0. But with a binding minimum price (above the equilibrium price) of P1, the quantity of alcohol demanded falls to Q1. In other words, alcohol consumption falls.


Now consider the economic welfare effects. The consumer surplus is the difference between the price the consumers are willing to pay, and the price they actually pay. Without the minimum price, consumer surplus is AEP0, but with the minimum price this falls to ABP1 (which makes sense - consumers consume less alcohol with the minimum price than without it, and pay a higher price for that alcohol). The producer surplus is the difference between the price the alcohol retailers receive, and their costs (which are shown by the supply curve). Without the minimum price, producer surplus is P0EF, but with the minimum price producer surplus is P1BCF. However, we can't easily tell if producer surplus has increased or decreased - retailers are selling less alcohol, but they are receiving a higher price for it.

Whether producer surplus increases or decreases when minimum pricing is introduced depends mainly on the price elasticity of demand for alcohol. If alcohol is price elastic, then alcohol consumers are relatively sensitive to price changes. That means that if price increases by x%, then the quantity of alcohol demanded will decrease by more than x%, and the firm's revenue (price multiplied by quantity sold) will decrease. Whether that results in decreased profit depends on whether the loss of revenue is larger than the costs saved by selling fewer units (which in most cases it will be).

On the other hand if alcohol is price inelastic, then alcohol consumers are relatively insensitive to price changes. That means that if price increases by x%, then the quantity of alcohol demanded will decrease by less than x%, and the firm's revenue (price multiplied by quantity sold) will increase. Given that costs will likely decrease (because the firm is selling fewer units), then profits will necessarily rise.

So, is demand for alcohol price elastic or price inelastic? There is a fair amount of debate on this point, and Eric Crampton has some of the latest evidence here. However, we need not go too far to determine whether the sellers themselves believe that demand is price elastic - if they think that is the case, they will argue against any minimum pricing (because if demand was price inelastic, minimum pricing would increase their profits!). And indeed, supermarkets (who have the largest market share of the retail alcohol market) are arguing against this policy. That suggests alcohol demand is price elastic. [*]

As an addendum I recently had a student, who worked for a large brewer, estimating the price elasticity of demand for products (note: not for alcohol as a whole). This student (who I can't name given their position in the industry) found that demand for specific products was highly elastic. This shouldn't be too surprising - there are many substitutes for a specific brand of beer. However, the student's results also suggests that consumers are very willing to shift to cheaper options (within the beer category).

Overall then, it appears that alcohol minimum pricing would reduce profits (else the retailers would be less likely to argue strongly against it), suggesting that alcohol is price elastic.

[*] The supermarkets might also argue against the policy if they believed that it would increase their costs, such as if they had to change their pricing policies. The costs of complying with minimum pricing don't seem to me to be large, so this seems unlikely as an explanation.

3 comments:

  1. Hi Michael,

    I wouldn't be so quick to infer price elasticity from industry complaint. Even if prices are inelastic, if you've fixed investments in plant capacity for a certain scale, reductions in overall demand induced by regulatory measures like minimum pricing can yield objection - and especially so where what would otherwise potentially look like cartel rents (govt enforcement of what cartels can only dream of) get eroded away either through competition on quality or on provision of bundled goods that consumers value (like contest tickets and the like).

    I also note that Auld estimated the elasticity of alcohol demand in Canada with respect to minimum prices at around -0.34 overall. While demand for any category of alcohol was highly price elastic with respect to its own category's minimum prices, that's just those substitution effects you'd noted. Overall, it was -0.34.

    I talked about it here. http://offsettingbehaviour.blogspot.co.nz/2012/07/about-that-canadian-study.html

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  2. Fair points. Although on the fixed capacity investment, if alcohol firms believed demand was inelastic, they would still have little to fear from minimum pricing. With inelastic demand, by definition the increase in pricing would have little effect on quantities, and thus the industry's average costs would not rise appreciably.

    On another note, having talked to folks about minimum pricing since writing that post, I wonder what proportion of sales would be affected by minimum pricing? Also, I suspect the effect would be rather heterogeneous by type of outlet and type of beverage, and (assuming there weren't separate minimums for off-licence and on-licences) I imagine the effects would be felt most greatly by supermarkets, and have the greatest effect on low-margin high-volume products.

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  3. They have less to fear under relatively inelastic prices, but not nothing. If the price of lower cost alcohol went up by 10% under minimum pricing (suppose), you still get a 3.4% drop in production.

    You're definitely right about heterogeneous effects. Supermarkets have volume / price advantages that would be eroded under minimum pricing.

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