2025 Cambridge IAL Economics (9708) Practice Paper with Answers

Introduction

A demerit good is a good, such as alcohol or tobacco, which is overconsumed in a free market due to information failure (consumers do not fully appreciate the long-term private harms) and which often generates negative externalities (costs imposed on third parties). To correct this market failure, governments can intervene using market-based policies such as indirect taxes or minimum prices.

Analysis of an Indirect Tax

An indirect tax is a tax on spending imposed on producers, which increases their costs of production. This shifts the market supply curve to the left from \(S_1\) to \(S_2\). As a result, the equilibrium price rises from \(P_1\) to \(P_2\) and the equilibrium quantity demanded falls from \(Q_1\) to \(Q_2\). If the tax is set correctly, it can internalize the external costs, reducing consumption to the socially optimal level where marginal social benefit equals marginal social cost.

Advantages of an Indirect Tax:

• Government Revenue: It generates tax revenue for the government, which can be ring-fenced to fund public services, healthcare, or educational campaigns about the dangers of the demerit good.
• Market-Based Flexibility: It allows the price mechanism to continue functioning; consumers who are willing and able to pay the higher price can still purchase the good.

Analysis of a Minimum Price

A minimum price (price floor) is a legally imposed price below which the good cannot be sold. To be effective in reducing consumption, it must be set above the free-market equilibrium price. This directly forces the price up to \(P_{min}\). At this higher price, quantity demanded falls from the equilibrium quantity \(Q_1\) to \(Q_{demanded}\), thereby successfully reducing consumption.

Advantages of a Minimum Price:

• Targeting Cheap Goods: Minimum pricing can be highly targeted. For example, a minimum unit price on alcohol disproportionately raises the price of cheap, high-strength drinks favored by heavy or underage drinkers, without significantly affecting moderate drinkers who buy premium products.
• No Government Expenditure: It requires no direct government funding to pay for subsidies, though enforcement costs exist.

Evaluation and Comparison of Effectiveness

To determine which policy is more effective, several critical factors must be assessed:

1. Distribution of Revenue: With an indirect tax, the 'surplus' created by the higher price goes to the government as tax revenue. With a minimum price, the extra revenue from the higher price is retained by the producers/retailers, which might increase their profits—an unintended and politically unpopular outcome.
2. Price Elasticity of Demand (PED): Demerit goods like alcohol are often habit-forming and possess price inelastic demand. For both policies, a relatively large price increase is required to achieve a meaningful reduction in consumption. However, the inelastic demand means tax revenues will rise significantly under an indirect tax, providing more resources for the government.
3. Distributional and Equity Impacts: Both measures are highly regressive, taking a larger percentage of income from low-income consumers than high-income consumers. However, a minimum price can be less regressive if it specifically targets cheap products, leaving higher-priced items unaffected.
4. Risk of Unintended Consequences: Both policies can encourage the growth of black markets (smuggling or illicit home production) as consumers try to bypass the higher prices.

Conclusion

In conclusion, while both policies are capable of raising the retail price and reducing the consumption of demerit goods, an indirect tax is generally more effective. This is primarily because it raises government revenue that can be used to address the root cause of the market failure (e.g., funding rehabilitation or education campaigns to correct the information failure), whereas a minimum price unjustly enriches private firms and provides no fiscal benefit to the state.

Mark Scheme

Analysis (AO1/AO2/AO3): Max 8 marks

• 7–8 marks: Clear, accurate, and detailed explanation of how BOTH an indirect tax and a minimum price work to reduce the consumption of a demerit good. Demerit goods and the nature of the market failure (information failure/negative externalities) are correctly defined. Appropriate economic concepts for both policies are clearly explained.
• 5–6 marks: Good explanation of both policies, but may lack depth in explaining the underlying market failure or may contain minor errors in economic reasoning. Alternatively, a very strong analysis of only one policy.
• 3–4 marks: Explains how at least one policy works, but explanation is limited, descriptive, or contains significant errors.
• 1–2 marks: Shows very limited understanding of the policies or demerit goods. No diagrams or irrelevant economic concepts.

Evaluation (AO4): Max 4 marks

• 3–4 marks: Offers a reasoned and balanced comparison of the relative effectiveness of the two policies. Discusses critical factors such as price elasticity of demand, the destination of surplus revenue (government vs. producers), equity/regressive effects, or the risk of black markets. Reaches a clear and supported conclusion.
• 1–2 marks: Offers some basic evaluative comments (e.g., stating that taxes raise government revenue or that both may lead to black markets) but lacks depth, balance, or a clear, well-supported conclusion.