Due to the high sugar in energy drinks leading to an increase in the number of students and young adults getting diabetes, the government of the UAE has decided to introduce an Excise Tax, in hopes to change consumer behaviour as well as increase the state’s revenue. In this case, energy drinks are considered demerit goods, which are goods as having a negative impact on the consumers who consume them as well as society as a whole. The government sees thus and so they try to reduce the consumption of such goods, and do by either banning the good completely or introducing a tax on it.
The government decided to add an indirect ad valorem tax (percentage tax) of 100% on energy drinks, doubling their retail prices overnight.
Energy drinks are an example of a negative externality of consumption which almost always leads to market failure which could lead to market failure. Market failure occurs when resources are not allocated in the most optimal manner in a free market. For energy drinks the consumer will not care about the effects the drinks will have to the society around them, ignoring the negative externality that is being created by them. Their marginal private benefit (MPB) will greater than the marginal social benefit (MSB), causing welfare loss to society. This means the consumers will over-consume energy drinks at Q1 cans at the price of P1, where the MPB=MSC, instead of the socially efficient point of Q*, where the MSB=MSC. In order to reduce the welfare loss suffered by society, the government of UAE decided to implement an ad valorem tax.
The effect of the ad valorem tax on the demand and supply curve of energy drinks. The equilibrium price and quantity are at Qe and Pe but are disturbed due to the introduction of the tax. The tax causes the supply curve to move vertically upwards from S1 to S1+tax. Due to the tax being a percentage of the selling price, the gap between S1 and S1+tax will increase as the price of the drinks increases. Producers would prefer to raise the price to P2, passing the entire tax onto the consumer however at that price there is excess supply so the price needs to fall until a new equilibrium point is reached, at price P1, where Q1 is being both demanded and supplied. As the law of demand states, an increase in price causes a decrease in demand.
Since the introduction of the tax, firms that produce energy drinks have seen a massive fall in revenue and have been forced to reduce the scale of production due to low sales. This may also lead to a slight fall in the GDP of the UAE.
However, in the long run, the government will be able to reach its goal of changing consumer behaviour, reducing the chance of diseases such as diabetes as well as increasing state revenue, giving the government opportunities to invest in sectors such as healthcare and tourism.
However, this may not be a long term solution. We can assume that Dubai’s economy is stable enough to allow a large number of its goods and services to be price inelastic demand. Price inelastic demand means that there is a small change in demand when the price is increased. The high prices of energy drinks may become a norm and demand could rise.
Another disadvantage is that smaller companies suffer much more from revenue losses compared to larger businesses as large businesses have more capital at there disposal compared to smaller firms and can easily change their scale of production in the long run (all factors of production can change in the long run) whereas smaller firms struggle to be able to sustain in the market.
There are also very close substitutes to energy drinks, ones which are healthier or are more natural for consumers while having the same effects that energy drinks have, thus leading an increase in demand for these goods. Since they are substitutes, they would be cross elastic with energy drinks. Considering the alternatives are more beneficial to society as well as the consumer, it would reduce the welfare loss suffered by society.
To conclude, the government will be able to reduce welfare loss to society and increase state revenues while keeping MSC=MSB but at the loss of revenue for firms.