Taxing sugar - should Australia follow the UK?

Yesterday the UK announced a tax on sugary drinks. It might increase some own brand cola products by 80%.

The tax is tackling an negative externality. This time the problem is a  lack of information leads consumers to value sugary drinks too highly. This then causes obesity and imposes higher costs on the public health system. Therefore sugar is a demerit good in this case.

As the last post was on externalities I'll just draw the diagram and link to and ABC article on the subject. Jamie Oliver, a prime mover in the campaign for the 'sugar tax' has urged Australia to follow suit. They should.

The problem with sugary drinks is that consumers don't consider the full costs of them. There is a lack of information about the negative effects of the sugar in the drinks. We could represent this as an additional external cost, but instead here it is shown as consumers overestimating the private benefits of sugary drinks. Therefore Demand (Marginal Private Benefit) is to the right of Marginal Social Benefit.

Placing a tax on the drinks pushes the supply curve to the left. There is a new equilibrium price (0P2) and lower quantity (0Q2). In this case the socially optimal output is achieved, because exactly the right tax has been applied and the deadweight loss of the externality is completely eliminated.

Note that not all of the tax is paid by consumers. Part of the tax comes out of firms profits. How this is divided between consumer and producer is determined by the elasticities of demand and supply.

The ABC article is here

VCE students should note how governments deal with externalities (Unit 3, outcome 1). IB students will need to understand the way markets fail in the technical way the diagram shows it and is an excellent example of tackling demerit goods.

Do icecream makers actions mean market failure theory is wrong?

Both Unilever, who are the worlds major icecream brand, and Mars, one of the major chocolate makers are shrinking the size of their products to help consumers make 'healthier choices'.

This seems to contradict the standard economic theory which says in the presence of externalities a free market will fail to allocate resources efficiently.

First let's recap what a free market is. There is no government intervention and so firms produce an amount that maximises profit and consumers maximise the benefit (utility) they can derive from their income. Competition is the only force restraining the behaviour of firms and households.

Economic theory tells us that when there are externalities present the market will not allocate resources in an optimal way. With ice-cream and chocolate we find there are negative externalities of consumption. Consumers over-estimate the benefits of consuming the good because they do not consider all of the costs of consumption, such as the dangers of high sugar and fat consumption (I'm going to assume you know the details of this danger).

The standard market outcome is shown below, in this case for cigarettes.

The market provides no incentive for firms to reduce production (and so consumption) to 0Q*. The market fails when left to itself.

So why has Mars and Unilever decided to take action to effectively reduce their output from 0Q1?

There are a number of explanations. In no particular order:
1. Competition. Doing this first gains the firms market share. Those who feel they should act to improve their health are attracted to the new smaller products. Mars and Unilever increase profit.
Note that competition will make other firms follow if successful.

2. Higher profits. Smaller portions will not be matched with proportional price cuts.

These first two reasons means the free market is alive and well. It has just adjusted to the new market conditions.

3. Better information has changed household preferences. The problem of negative externalities in consumption is a 'lack of information'. Many years of better education has led to a better informed public and pressure for firms to behave ethically. Consumers want to make a better choice.

There are a number of ways to correct market failure, such as tax and legislation. However here we have an example of the market reacting to better information which is closing the gap between Marginal Social Benefit and Marginal Private Benefit (MPB has moved to the right).

For some the conclusion will be a victory of the free market. For others it will be seen as the victory of many years of publicly funded research and education.

The Guardian covers the story here.

This post is more suited to IB Economics, but Market Failure is part of VCE Unit 3 where the MSC/MSB analysis is not required, but the principle is.

If used for an IB Internal Assessment the theory can be closely applied and explanations of motive explored.

Sunbeds banned in Queensland - a good move?

Merit goods are technically 'lack of information goods', where consumers do not have all the information necessary to make a decision on consumption, or ignore information that is relevant.

Demerit goods, such as tobacco, are similarly lack of information goods. Where they are present in the market an inefficient allocation of resources will occur. Consumers will overestimate the benefits and underestimate the costs of the good.

The result  is that the quantity consumed in the market is more than the allocatively efficient level.

 

The diagram shows that consumers consider the good to give benefits equivalent to the demand curve D and consume quantity 0Qmkt. However the true benefits are given by the curve MSB and the efficient quantity to consume is 0Qef.

Usually an economists would say that the market price should be raised until consumers only want to buy 0Qef. But sometimes this leaves costs that are still too high.

In Australia it has long been recognised that ultraviolet radiation causes skin cancer. It appears that sunbeds cause a much greater amount of harm than natural sunlight, but consumers do not consider the full information on harmful effects and continue to use sunbeds.  Therefore Australian governments are starting the process of closing solarium's.

Queensland are the latest state to ban sunbeds. The reason for a ban rather than a tax is that any consumption is harmful. As with all policy choices there are costs of acting. There is no guarantee that it will work for a while as second hand sun beds are traded and who knows if there will be a trade in illegal sunbeds from states that do not act?

The Brisbane Times reports the ban here

Market failure - demerit goods

In Unit 3 outcome 1 merit and demerit goods are studied. Merit goods are technically 'lack of information goods', where consumers do not have all the information necessary to make a decision on consumption, or ignore information that is relevant.

Demerit goods, such as tobacco, are similarly lack of information goods. Where they are present in the market an inefficient allocation of resources will occur as consumers maximise perceived private benefits weighted against private costs.

They consume to the point where Marginal Private Benefit equals Marginal Private Cost. With demerit goods Marginal Private Cost understates the true costs of consumption and so the market fails.

One way to correct this is through price. A tax will raise private costs and reduce consumption. But what if the harm done by the good is so great that the optimal level of consumption is zero? Then regulation must be used to ban the good or service.

In Australia it has long been recognised that ultraviolet radiation causes skin cancer. It appears that sunbeds cause a much greater amount of harm than natural sunlight. Therefore Australian governments are starting the process of banning sunbeds.

The Victorian government are dragging their feet a little, but they should soon join the movement towards the elimination of this particular demerit good.

The costs of the move? There is no guarantee that it will work for a while as second hand sun beds are traded and who knows if there will be a trade in illegal sunbeds from states that do not act? Of course zero may not be the optimal level of consumption of sunbeds, for example some people suffer from a lack of vitamin D and need them to correct this. All regulation is a guess and can be a sledgehammer to crack a walnut.

The Age report on progress in Victoria to ban sunbeds here