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Chapter 20 The Line Between Legal and Illegal Goods McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline • AN ECONOMIC MODEL OF MARKET FOR TOBACCO AND ALCOHOL DRUGS AND PROSTITUTION • ARGUMENTS FOR MAKING A GOOD ILLEGAL • DECRIMINALIZING DRUGS AND PROSTITUTION 20-2 You Are Here 20-3 Consumer and Producer Surplus Analysis P A P* C B 0 Q* • Value to the Consumer: • 0ACQ* Supply • Consumers Pay Producers: • OP*CQ* • The Variable Cost to Producers: • OBCQ* • Consumer Surplus: • P*AC Demand • Producer Surplus: Q/t • BP*C 20-4 Arguments for Making a Good Illegal • People have limited information about the good, are not capable of making a good decision about the good or the good is addictive and one-time users can not learn from their mistake. • There are externalities, effects of a transaction that hurt or help people who are not a part of that transaction, involved in the production or consumption of the good. • The good is immoral. 20-5 Preventing Bad Decisions • Economists are typically reluctant to assume that people can not make good decisions. • Drugs tend to be an exception to this rule because they are addictive. • Ads appeal to children – Joe Camel 20-6 Modeling Externalities Social Cost External Cost SMarginal Cost P P’ P* D(Marginal Benefit) 0 Q’ Q* The Offending Good 20-7 Examining the Externalities • Tobacco accounts for approximately $1 per pack in costs incurred by taxpayers and nonsmokers. – Medicare, Medicaid, Asthma, • Drunk Driving accounts for 32% of the 37,000 traffic accidents that cause 41,059 deaths • 27% of all violent crimes (43% for rapes) are committed while the perpetrator is on drugs. • 36% of inmates in jail, detention, or prison used drugs during the month leading up to their arrest. 20-8 Battling Negative Externalities While Creating Others • Much of the drug violence that exists, only exists because of laws criminalizing drug use. • If cocaine, methamphetamine, and marijuana were legal and inexpensive, – there would be less of a need for addicts to rob in order to get money to buy them. – there would be no drive-by shootings to protect turf. 20-9 A Twist on the Externalities Argument for Tobacco • Cigarette smokers are more likely to die – at an earlier age than they would have otherwise died. – in a less costly manner than they would have otherwise died. (e.g. heart attack rather than Alzheimer’s.) • Some economists estimate that this effect saves Social Security, Medicare and Medicaid (because they are not in nursing homes) more money than the $1 per pack in estimated external costs. 20-10 Using Taxes to Correct for Externalities Social Cost=S+tax External Cost=tax SMarginal Cost P P’ P* D(Marginal Benefit) 0 Q’ Q* Tobacco/Alcohol 20-11 The Tobacco Settlement and why Elasticity Matters • 1998 settlement between several states and several tobacco companies • $250 billion spread over 20 years • Demand for tobacco products is fairly inelastic. This means that the percentage change in prices will be more than the percentage reduction in smoking. 20-12 A Tax on Tobacco with Inelastic Demand S+tax tax SMarginal Cost P P’ P* D(Marginal Benefit) 0 Q’ Q* Tobacco/Alcohol 20-13 Elasticity Estimates • Elasticity of Demand – for Tobacco • -.2 for adults • -.5 for children – For Beer • -.53 • Implications – A dollar increase in the tax on cigarettes would reduce consumption by adults by 10% and reduce consumption by children by 25%. 20-14 The Importance of Elasticity for Drugs • If people are addicted to a particular drug, their demand for it will be inelastic. • Drug interdiction efforts shift the supply curve to the left. • This will cause prices to rise – Addicts will not reduce quantity demanded much – Recreational users will reduce quantity demanded more 20-15 The Impact of Decriminalizing Drugs or Prostitution P Sillegal Slegal Pillegal Plegal Dlegal Dillegal Qillegal Qlegal Q 20-16 Legalization with Taxes • Applying Figure 16.5 to drugs, legalization could deal with the external costs. • Making the tax too high would induce a black market. 20-17