Minimum drink prices - responsibility or idiocy?

[Update 05/10/2010: UK home secretary Theresa May has announced today at Conservative Party conference that the government will be imposing a similar policy at UK level - banning the sale of alcohol below cost. "Below cost" is almost impossible to define - how much fixed costs do they include? - but at least it's not quite as simplistic as the Scottish version. Still not a smart policy.]

Today the Scottish Executive announced that it wants alcohol in Scotland to be sold at a minimum price of 45p per unit.

From time to time, governments around the world have imposed maximum prices on various products - petrol is a typical one - usually with the intention of helping their poorer citizens, and with a secondary effect of causing shortages.

The Scottish Executive's goal is instead to reduce consumption - and setting a minimum price is, according to economic theory, a valid way to do that. Naturally, if two litres of cider has to be sold at £3.80 instead of £1.32, fewer people will buy it.

But there will be other consequences too.

The short-run effect will be an increase in the gross margins of retailers. Currently, that cider costs them 70p and is sold at £1.32 - a markup of 88%. After the floor price is introduced, the cost will still be 70p - but it will be sold for £3.80. That's a markup of 442%! This sounds like a great bonus scheme for retailers at the expense of low-income drinkers.

This is one reason why most economists would suggest a tax instead of a minimum price. If a 35p/unit tax were imposed on alcohol, at least the public purse would benefit instead of the supermarkets. Then, the disproportionate impact on poor people could be balanced with an increase in public spending or benefits to that group. And the cost would be imposed across all alcohol drinkers instead of cut off at an arbitrary limit.

However, the tax has two political drawbacks:

1. It is a tax. People don't like taxes (even in Scotland)
2. It would hit middle-class people as well as cheap cider drinkers. The minimum price, because it will only affect cheap alcohol, affects mainly poor people - who are less likely to vote and are not politically influential (even in Scotland). And it's hard to target the tax to affect only cheap products, because retailers would simply raise their prices to avoid it, and we'd have the same situation as in the proposed law.

So we won't have a tax, we will have a minimum price. But the effects of that are more complicated than they appear at first.

Aside from the increase in retailer margins, we would of course expect a reduction in volume of alcohol sold. However, it is likely that total alcohol revenues will go up. Supermarkets are not currently maximising revenue because there is competition between them ensuring they keep prices lower than the optimal (monopoly) level. This policy would effectively remove some competition and probably allow them to generate more revenue. Whether revenue goes up or down depends on whether elasticity of demand is less than or greater than 1. I suspect that overall alcohol demand is not very elastic, so revenue should go up.

The next effect is a substitution towards higher quality products. If you now have to pay £3.80 for 2 litres of appalling cider, you may as well spend the same £3.80 on some decent cider. Or you could buy Magners.

Some people may prefer the cheap cider, but over time those habits - formed out of cheapness - will diminish. Competition will operate on quality instead of price, driving up what you get for your money.

There's only so much extra sales you can get from incremental quality improvements - so manufacturers are likely to compete on incentives instead. We would expect to see lots of generous competitions on cider bottles - giving away holidays (perhaps to countries where alcohol is cheaper) - or free gifts, or other non-price-based promotions.

And whether the customers buy cider-with-a-free-holiday or Magners, the manufacturers' prices will be higher, and the retailers' margins back down to the more normal level of 40-50%. So some of those extra retailer profits will go away.

Indeed, with a normal level of margin but a reduced volume, retailers would be expected to end up with lower profits in the long run than at present.

On the other hand, whoever makes Magners (an Irish company called C&C) will do better, at the expense of whoever makes White Lightning. The low-cost producers may go out of business or have to reinvent themselves. Interestingly, Heineken last year discontinued production of White Lightning in order to "cease encouraging irresponsible drinking". I wonder if they foresaw this effect or if it was purely a public-image decision.

A further outcome will be an income effect on those who cannot (or choose not to) reduce their alcohol consumption. Some poor people may become poorer. Some might even become homeless. Thus, if the main concern of policymakers is to reduce the number of drunks on the streets of Glasgow, they might be better to reduce the price of alcohol than to increase it.

And of course, one hidden loss will be a reduction in the happiness of drinkers. Any time the government removes a choice that citizens currently have (to buy or sell cheap alcohol), some people who would have made that choice will have to opt for a less attractive option. Perhaps the increased happiness of others will compensate for this, but the cost should at least be acknowledged.

So the Scottish Executive is proposing a policy to benefit Magners at the expense of cheap local producers, impoverish its poorest and most vulnerable citizens and make Scotland a more miserable place. Sounds like the perfect SNP policy.