This provides us with an excellent
opportunity to explain how retail prices are determined when firms are not
perfectly competitive. The formula: P=MC/(1+1/ɛ) isn’t particularly hard to
compute from the profit maximizing rule, but it is sufficiently difficult that
it can’t be done with a calculator. Trust us (because it requires calculus)
that it is the profit maximizing equation. P is the retail price, MC is the
marginal cost of production and ɛ (a negative number) is the price elasticity
of demand. It should be apparent that the price of a good rises as its cost of
production rises. What is not so obvious is that as ɛ falls in absolute value,
P rises.
The
elasticity of demand, ɛ, measures the responsiveness of consumer to changes in
price. It is calculated as the percentage change in quantity demanded divided
by the percentage change in price. Since people buy less of most things when
price goes up, the elasticity is always negative. The more consumers react to
price changes, the larger the elasticity number becomes (in absolute value – a bigger
negative number).
When
consumers react strongly to price changes, we call the demand “elastic”. When
they don’t respond the term is “inelastic”. The demand for a good will tend to
be elastic if there are plenty of substitutes available, if the good is not a
necessity, if the price is large relative to income, or if consumers have time
to react.
So,
back to beer. The Globe news article is looking at the monopoly retailer of
beer in Ontario: The Beer Store. There aren’t many good substitutes for beer,
and there are no substitutes when it comes to purchasing beer in Ontario. The
demand for beer in Ontario is likely to be relatively inelastic. Compare that
to most places in the U.S. where beer can be purchased at Walmart, 7-Eleven and
the local gas station. More places to buy beer means higher elasticity and
lower retail prices. The price difference between Ontario and Quebec, where
beer is available in convenience stores and grocery stores is 27%. It is safe
to assume that the production costs are the same in the two provinces, so the
price difference is caused by differences in elasticity. It shouldn’t be a
surprise that the Beer Store rejects this claim and blames the differences on
taxes.
The
major beer brands; Canadian, Kokanee, Blue, all have similar tastes (at least
after the first couple). Craft beers, on the other hand, have very different
flavours but their price is still limited by the availability of the major
brands. Wine, on the other hand, is not easily substituted. A Merlot is not a
substitute for a Riesling. A Beaujolais is not a Burgundy. In an article from
Yahoo! Travel dated Sep 24, 2013, the author takes us through all kinds of
reasons why wine is so expensive. The one reason that they miss is because restaurants
can mark it up that much. A consumer that walks into a wine store and doesn’t
like the price can choose not to purchase the wine and shop at a different
location. A consumer in a restaurant cannot say to a waiter “excuse me while I
go next door to the wine store and get a bottle for 40% of what you’re charging”.
Once a consumer has entered a restaurant the demand for wine has become very
inelastic and, because of that, the price can go up.
The
demand for beer and wine tend to be relatively inelastic and elasticity falls
as competition falls. That’s why we pay so much for beer and wine in Canada.
(It’s
also why red roses were so expensive today – Feb 14 – but we’ll save that one
for next year)
