California’s State Board of Equalization imposed a higher tax on “alcopops,” flavored beers containing more than 0.5% alcohol-based flavorings, such as vanilla extract (Guy L. Smith, “On Regulation of ‘Alcopops,’ ” San Francisco Chronicle, April 10, 2009). Such beers are taxed as distilled spirits at $3.30 a gallon rather than as beer at 20¢ a gallon. In response, manufacturers reformulated their beverages to avoid the tax. By early 2009, instead of collecting a predicted $38 million a year in new taxes, the state collected only about $9,000. Use an isocost-isoquant diagram to explain the firms’ response. (Hint: Alcohol-based flavors and other flavors may be close to perfect substitutes.)
4. Lower Costs in the Long Run