Economists Do It With Models

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The Economics of Cocktails And Taxes…

June 3rd, 2009 · 10 Comments
Econ 101 · Policy

A couple of weeks ago a friend of mine posted a link on Facebook about a Massachusetts sales tax increase. The current sales tax rate in Massachusetts is 5 percent, and the new legislation will bring that to 6.25 percent as well as remove the sales tax exemption on alcohol. My friend’s comment regarding the link was the following:

“Boooooo. Does this mean that the average price of a cocktail in Boston will go from $10.00 to $10.63? Lame.”

In a way, she is right- it is lame. 🙂 Sadly, she is also right in that, despite what economic theory has to say on the matter, the price of her cocktail will likely go from $10.00 to $10.63 (though I may have made a nerdy comment otherwise on her profile). Let’s consider the situation:

In general, the burden of a tax gets shared by producers and consumers, and it doesn’t really matter who physically pays the tax. What this means is that, when a tax is imposed, consumers pay part of the tax because the (after-tax) price to them goes up. It also means that producers pay part of the tax, since the amount that they get to keep after the tax gets paid goes down. This would imply that the price of the cocktail to the consumer would be indeed more than $10.00, but less than $10.63. It would also imply that the producer, net of the tax, would get an amount somewhat less than $10.00 (but more than $10.00-$0.63=$9.37). Let me illustrate this with a picture:

(I apologize for the pink. I couldn’t find my black Sharpie. Or a pen, apparently.) That is what Econ 101 would predict. So why am I predicting otherwise? A few reasons:

  • The Econ 101 model assumes that both producers and consumers think about prices “rationally”- i.e. that they only care about the price that they pay after the tax is added in or subtracted out. In practice, people tend to focus on the price that is on the price tag for the product or menu or whatever and fail to account for the fact that that price will get larger once the final bill comes with the tax added in. I myself have even been caught doing this before- since Massachusetts has no sales tax on clothing (at least up to a certain dollar amount per item, I think $175…scary that I know that), I get a little taken aback at the checkout when I shop in places such as New York. (And in true economist- read, cheap- fashion, I have been known to return items purchased in New York to the same stores in Massachusetts so that I could purchase them again sans sales tax. It’s a sign that I have too much free time, really.)
  • The Econ 101 model also assumes that producers can change prices costlessly- i.e. that there are no menu costs. A menu cost is pretty much what it sounds like- the cost of printing new menus when prices change. Technically, the “menu” part could refer to signage, retagging of items, whatever. The point is that even though a producer might want to change its price a little because of a new tax, the cost of printing new menus and such might prevent them from actually doing so. If the price on the menu is the price inclusive of the tax, this means that the producer eats the whole cost of the tax. (Get it? Eat? Since we’re talking about menus? Fine…*groan*) If the price on the menu is the pre-tax price, this means that the consumer has to deal with the tax in its entirety. But if the consumer is only paying attention to the pre-tax price anyway, who cares?

I do not in any way mean to imply that your Econ 101 class wasn’t helpful. I just think that Econ 101 could be clearer in its assumptions. I have to admit that I get a little annoyed when students make glib statements like “I don’t need to learn this because that’s not how it works in the real world,” and understanding more about the assumptions underlying the models would help to alleviate these sorts of complaints…and perhaps even lower the number of whiteboard erasers being thrown at students’ heads. Not that I would ever do that.

An another (nitpicky, even borderline anal retentive, though arguably important) note. Readers, let me take this oppotunity to educate you regarding the difference between the terms “percent” and “percentage points.” This difference is best illustrated via an example. Consider the following (presumably incorrect) statement from the article:

“The meals and lodging tax would stay at 5 percent statewide, but lawmakers left it to cities and towns whether to raise it by 2 percent. Mayor Thomas M. Menino has voiced support for boosting that tax in Boston.”

Hm. Raising a 5 percent tax by 2 percent would leave you with a tax of (5 + 5 * 0.02) percent, or 5.1 percent. Raising a 5 percent tax by 2 percentage points would leave you with a tax of 7 percent. Perhaps Mayor Menino meant to be partcularly modest with his tax increase, but I somehow doubt it.

Tags: Econ 101 · Policy

10 responses so far ↓

  • 1 LL Cool A // Jun 3, 2009 at 1:01 pm

    So my friend, who grew up in Boston, saw Menino on TV back in 1980~something, and as a child, she though Mayor Mumbles had XXX syndrome (aka Down Syndrome). That is to say, she thought he was mentally challenged.

  • 2 stephie c. // Jun 3, 2009 at 1:17 pm

    You’re totally right about drunk people not paying attention to how much they’re spending on booze (or even just slightly buzzed people.) But I actually tend to do the opposite of what you suggested in the article. While most people tend to not think about the tax and tip, I always think it’s going to add like, $300 to my total. OK, not $300, but a lot. And I’m not even a good tipper–I’m just mediocre at math. So when I order something, I’ll think to myself, “Hm, that thing I ordered was $15, but after tax and tip, it’s going to be at least $20.” Even though that’s not even close.

  • 3 stephie c. // Jun 3, 2009 at 1:17 pm

    P.S. This is why I cook.

  • 4 Tom // Jun 3, 2009 at 1:47 pm

    i think that your critisism of the econ 101 assumption you wrote under the chart is really all that needed to be said. no one (at least my friends and i) would ever think to consider the tax on our drinks, especially after we’ve already had a few. i highly doubt any one will change their prices or drink less.

  • 5 Mike Visser // Jun 3, 2009 at 3:50 pm

    The marketing folks will never let the bars print menus with a price of $10.63. It will be $11. I like to think that behavior is rational up to rounding error. That is, economic principles are very good at qualitative predictions, but precision forecasting is best left to the tarot card readers.

  • 6 Scott Ritchie // Jun 3, 2009 at 4:06 pm

    I think in Texas there is literally a law prohibiting displaying prices inclusive of sales tax. I’d have gone the other way, but at least it’s a standard.

  • 7 Paul R. Dorasil // Jun 9, 2009 at 2:27 am

    Lets be fair. The issue isn’t that drinkers don’t consider tax when purchasing drinks, per se. The issue is that the demand for alcohol is not perfectly elastic and a 1.25% increase in the sales tax won’t produce a noticeable change in menu prices or consumption.

    If the tax were increased enough, we would certainly see people consume less alcohol or find ways around the tax.

    My professor taught price-elasticity in principles of microeconomics… and we also discussed menu costs. Is that uncommon?

  • 8 Krzysztof Wiszniewski // Jun 12, 2009 at 7:15 pm

    I’d agree with Mike Visser: if the bars do raise prices because of the tax increase (which is likely), it will be more than the actual increased tax (this also solves the menu costs problem).

    Since demand for alcohol tends to get progressively less price-elastic with every consecutive drink (subject to the size of one’s wallet and strength of one’s stomach), the price hike may actually do the bar-owners some good in the long run…

  • 9 SteveO // Jun 17, 2009 at 1:04 am

    As Paul and Krzysztof (whew, can I buy a vowel?) touch on, I think elasticity of demand and marginal utility would play significant parts here.

    Alcohol (for me at least) has an very steep diminishing marginal utility.

    It’s been a while since I talked d.e. in micro, but if I remember correctly, the general point is that if the consumer is very elastic, the bar would eat the tax. If the consumer is very inelastic, the consumer eats the tax.

  • 10 econgirl // Jun 17, 2009 at 1:07 am

    @ SteveO: I think the phrase you are looking for is “whoever can run from the tax will.” So yes, the more inelastic party ends up with more of the tax burden.

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