Tuesday, April 29, 2008

Alcopop Tax Folly

The Australian Government's new Alcopop Tax Hike, in addition to being an unfortunate attempt at paternalism, suffers from an even greater shortcoming: failure to understand what economists call the substitution effect. It is fairly obvious that increasing the tax on the alcohol content of premixed drinks by 70% will reduce the consumption of these drinks, but the Rudd Government doesn't seem to have asked the question of where these consumers will now choose to spend their money. I'm pretty sure the answer is not bubble gum and soda pop. I'm willing to bet that we simply see a substitution away from premixed drinks into hard liquor, beer, or wine, and I'd be surprised if this substitution wasn't pretty much on a 1-for-1 basis.

Wednesday, April 23, 2008

Butter Crisis in Japan

This article from The Age was recently brought to my attention, with the attendant question of "if free markets are so good, why can't they get butter in Japan?" The article argues that it is a result of supply and demand. Supply and demand shocks in an unfettered market might lead to shortages in the very short run, but these shortages would cause prices to rise. As prices rise, domestic producers would be expected to increase output and foreign producers would export more butter to Japan. While it is true that the short run elasticity of supply is very inelastic, the price should simply rise to the point where supply equals demand. In other words, after an initial shortage of short duration, rising prices would lure more butter to Japan. Sure, prices would be higher. But there would still be butter on the shelf. Supply and demand shocks alone cannot account for this long lasting shortage. The question remains, then, what is to blame?

I will address this question by starting with a bit of history. In 2006, commentators on Japanese markets noted a large reduction in dairy demand, including butter. Accordingly, dairy prices fell dramatically, and domestic suppliers left the dairy industry. A large proportion of the Japanese dairy cows were slaughtered, leaving the domestic dairy industry incapable of increasing output in response to the recent increase in demand. However, as stated above, this shouldn't lead to a drastic shortage, as imports should enter the Japanese economy to meet the surging demand. Something else must be interfering with the market's ability to respond, and as it turns out, that something else is the Japanese government's protectionist trade policy.

Japan has set a tariff on butter at a rate of 30%, plus 1,159Y per kilogram. Evaluated at the current world butter price of approximately 350Y per kilogram, this implies an import price of around 1,600Y, an effective tariff of nearly 450%. Add on various shipping costs and retailer markups, one would expect the price of butter on the shelves at Japanese supermarkets to hit prices around 2,000Y per kilogram, which is roughly $20 per kilo (or $9 per pound). These are high prices to be sure, but even this high tariff wouldn't be expected to cause shortages.

The key to understanding the butter crisis comes toward the end of the article:

Last week, as the prices of wheat and barley continued their relentless climb, the Japanese Government discovered it had exhausted its ¥230 billion ($A2.37 billion) budget for the grains with two months remaining. It was forced to call on an emergency ¥55 billion reserve to ensure it could continue feeding the nation.

In addition to the hefty tariffs, the Japanese government has an additional layer of protectionism called the ALIC (Agriculture and Livestock Industries Corporation). The ALIC, a government agency, has exclusive importing rights to butter. It is illegal for any corporation other than ALIC to import butter. And the ALIC is a government agency, with a government budget, which effectively limits the amount of butter they can afford to import. The stiff tariff, combined with the ALIC's monopoly status and limited budget, add up to a highly prohibitive quota system. In a market with highly inelastic (perhaps perfectly inelastic, due to livestock import restrictions) domestic supply, the result is widespread and pervasive shortages.