An interesting application of supply and demand to addictive...

An interesting application of supply and demand to addictive substances compares alternative techniques for supply restriction. For this problem, assume that the demand for addictive substances is inelastic. a. One approach (used today for heroin and cocaine and for alcohol during Prohibition) is to reduce supply at the nation's borders. Show how this raises price and increases the total income of the suppliers in the drug industry. b. An alternative approach (followed today for tobacco and alcohol) is to tax the goods heavily. Using the tax apparatus developed in Chapter 4 show how this reduces the total income of the suppliers in the drug industry. c. Comment on the difference between the two approaches.

An interesting application of supply and demand to addictive substances compares alternative techniques for supply restriction. For this problem, assume that the demand for addictive substances is inelastic.
a. One approach (used today for heroin and cocaine and for alcohol during Prohibition) is to reduce supply at the nation's borders. Show how this raises price and increases the total income of the suppliers in the drug industry.
b. An alternative approach (followed today for tobacco and alcohol) is to tax the goods heavily. Using the tax apparatus developed in Chapter 4 show how this reduces the total income of the suppliers in the drug industry.
c. Comment on the difference between the two approaches.

Key Concepts

Total Revenue Implications

Total revenue for suppliers is calculated as the product of the price received and the quantity sold. In cases where demand is inelastic, a reduction in supply can raise total revenue by increasing the price while maintaining quantity, whereas a tax can reduce total revenue by lowering the effective price received by suppliers, even if the quantity sold does not change much.

Supply and Demand

This fundamental economic model explains how the interaction between the availability of a product (supply) and the desire for that product (demand) determines its market price and quantity sold. In this context, reducing the supply shifts the supply curve leftward, resulting in higher prices if demand remains constant, while a tax effectively increases the cost of production, shifting the supply curve upward.

Inelastic Demand

Inelastic demand describes a situation where the quantity demanded by consumers does not significantly change in response to price changes. When demand is inelastic, increases in price due to supply restrictions or taxation lead to relatively stable quantities sold, which has distinct implications for total revenue received by suppliers.

Taxation Effects on Markets

Taxation imposes an additional cost on goods which shifts the supply curve upward by the amount of the tax. This leads to a higher market price for consumers and a lower effective price received by suppliers when the tax is partly or fully passed on, thereby potentially reducing suppliers' total revenue despite the inelastic nature of demand.

Policy Comparison in Regulation

Comparing supply restrictions with taxation highlights different approaches to regulating markets with inelastic demand. Direct supply restrictions raise market prices and tend to benefit producers by increasing revenue, while taxation, even though it may raise consumer prices, typically decreases suppliers’ net revenue due to the tax burden, illustrating different strategies and outcomes in regulatory policy.

Transcript

00:01 Looking at the demand for addictive substances and assuming inelastic demand.

00:05 So you can see that the demand curves in each of these have a very steep slope to indicate that inelastic demand.

00:11 Let's look at two different possibilities or two different ways to reduce this usage of addictive substances.

00:17 So starting with part a, if we are reducing supply at the borders.

00:21 So this comes down to things like heroin, right, drugs that are illegal.

00:26 So in this case, if we were to reduce the supply at the borders, what's going to happen is, of course, is going to shift leftward.

00:32 So we'll see this leftward shift of the supply curve from s1 to s2, which gives us a new equilibrium.

00:38 So if we take a look at where it started, we were at a price of p1 and our quantity was down here at q1.

00:47 But now because demand is inelastic, this shift of the supply curve only reduces the quantity by a small amount, but raises the price by quite a lot.

00:56 And what's happening here, because supply it has shifted as a result of just a basic reduction at the borders, this increase in price goes directly to the producers of the drugs.

01:09 So these drug producers are actually making more money.

01:17 Because what you see, because of that inelastic demand, quantity demanded didn't change a whole lot.

01:22 This quantity is very similar to where it was, whereas the price has gone up by a lot.

01:27 And that increase in the price then goes to those who are producing the drug.

01:31 Now if we go ahead and look at drugs being or addictive substances being heavily taxed, so things like cigarettes and alcohol or otherwise substances that are legal, what we see is this taxation on these substances is also going to decrease the supply curve.

01:48 So we'll see a similar shift from s1 to s2, which gives us again a new equilibrium...

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