Tax on Alcohol - Differences between comparative advantage and absolute advantage- Economics Assessment Answer

January 08, 2019
Author : Andy Johnson

Solution Code: 1IHF

Question: Economics Assignment

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Solution:

Question 1: Tax on Alcohol: will it be effective in reducing consumption?

Introduction

The imposition of higher taxes on alcohol bottles would be effective in reducing its consumption is the point highlighted by the Minister of Health in the Department. His concerns on reducing the country wide consumption of alcohol has been understood by many as it has become a major social problem in the Australian Economy. The imposition of higher taxes on the alcohol supply would increase the costs of supply and hence there would be a decrease in the supply. This decrease in supply of alcohol would ultimately result in the reduction of alcohol consumed in the economy due to higher prices as this would affect the affordability of alcohol of labour forces.

Analysis:

Taxation on products will shift the supply curve to the left as only lesser quantities could be sold at higher prices as shown in the following figure. However the incidence or the burden of the taxation will fall either on the consumer or the producer depending upon how responsive the consumer is to the price changes or in other words the price elasticity of demand will determine the incidence of the tax burden.  In the following figures, we have three parts, where the price elasticity of demand is inelastic (consumer is unresponsive to the price changes); price elasticity of demand is relatively elastic (where the consumer is relatively responsive to price changes) and when price elasticity of demand is unitary elastic (when there is a unit change in price, there is a unit change in quantity demanded) (Hubbard, Garnett, Lewis, & O’Brien, 2013).

In the above figure, we can see on the left panel where the demand is inelastic, which means that the consumers are unresponsive to price changes and an increase in the taxation would shift the supply curve to the left from SS1 to SS2. Consequent to the change in supply curve, we can see that the price has increased from Pe to Pc and quantity has decreased from Qe to Qt. However, since the demand is relatively inelastic, we can see that the quantity sold has decreased only a little, even though there is a huge price increase from the equilibrium price. The habits of the consumers towards alcohol make them unresponsive to price increases and they continue to consume the same quantity, and the effect of taxation to bring down alcohol consumption is very little. In the right panel however, since the demand is relatively elastic to price changes (PED> 1), when there is a decrease in supply due to taxation, the price increases to a smaller extent from Pe to Pc and since the demand is elastic, the burden of taxation falls on the producer and in this case, the imposition of higher taxes on alcohol is very effective since the PED is greater than one.

Conclusion:

From the above discussion, we can conclude that when the price elasticity of demand is relative elastic or greater than one, then an imposition of taxation to bring down alcohol consumption in the society would be much more effective than if the demand is relatively inelastic. Even when the demand is unitary elastic, the effect of taxation would be beneficial for the society as it would reduce alcohol to certain extent.

Question 2: Differences between comparative advantage and absolute advantage:

Introduction:

It has been highlighted by many economists, that trade and specialisation can benefit countries which are limited in their resources to make all the products by themselves. However the earliest of the international theories of trade between countries have their theoretical approach attached to absolute advantage and comparative cost advantage theory of international trade. In absolute advantage theory, countries which can produce more quantity of a commodity with its available resources will specialise in that commodity, where comparative cost advantage theory emphasises that the country with the least or lower opportunity costs in the commodity will specialise in that commodity.

Analysis:

We will take the example of two countries, two commodities model. Country A and country B producing food and clothing with the available resources they have. Country A can produce either 20 million tonnes of food or 30 million meters of clothing, whereas country B can produce only 15 million tonnes of food or 20 million meters of clothing. The PPF of the two countries and the table showing absolute advantage is shown below.

Food Clothing
Country A 20 30
Country B 15 20

We can see that with the available resources, country A has an absolute advantage in the production of both the goods. This does not mean that they both cannot trade with each other. They would specialise in the commodity in which they have least opportunity cost or the comparative advantage. For example if the table below represents the number of hours needed for countries to produce the two commodities.

Food Clothing
Country A 8 10
Country B 10 14

If country A requires 8 hours of labour to produce food and 10 hours of clothing to produce clothing and similarly country B requires 10 hours of labour to produce food and 14 hours of labour to produce clothing, we can calculate the opportunity costs for the same as follows.

For Country A, the opportunity cost of producing food is calculated as (labour hours of producing food divided by labour hours of producing clothing which is)  8/10 = 0.8 and similarly opportunity costs of producing clothing is the calculated as (labour hours of producing clothing/ labour hours of producing food which is) 10/8 = 1.25 (Krugman & Obstfeld, International Economics: theory and policy, 2006). For country B, the opportunity cost of producing food is calculated as (labour hours of producing food/ labour hours of producing clothing) which is 10/14 = 0.71 and opportunity cost of producing clothing is 14/10 = 1.4.

Since country A has lower opportunity cost in producing clothing which is lower at 1.25 (than country B at 1.4) and country B has lower opportunity cost in the production of food  at 0.71 than country A at 0.8, country A specialises in clothing and country B specialises in clothing and they both trade with each other and can consume more of the two products (Krugman, Wells, & Graddy, Essentials of economics, 2nd Edition, 2011).

Conclusion:

The main difference between absolute advantage and comparative advantage is that while absolute advantage refers to the rate at which the output is produced, comparative advantage is based on the input efficiency and opportunity costs. The above example explains the fact that though country A has absolute advantage in the production of both the goods, they specialise in the commodity in which they have comparative advantage and thus will be able to benefit from specialisation and trade with each other.

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