Tobacco and Alcohol



Tobacco, Alcohol, Drugs and Prostitution

Chapter Objectives

After reading this chapter you should be able to

Understand how we can apply a supply and demand model and the concepts of consumer and producer surplus to tobacco and alcohol.

See that economists endorse interference in a market for reasons related to the information and costs to innocent third parties.

See how the elasticity of demand for tobacco and alcohol determines who gets hurt by taxes on these goods.

Chapter Outline

An Economic Model of Cigarettes and Alcohol

Why Is Regulation Warranted?

Taxes on Tobacco and Alcohol

Why Are Drugs and Prostitution Illegal

Summary

Let’s face it. No mother wants her child [or "your mother doesn't want you to" ]to start smoking or drinking, using drugs, or to engaging in prostitution. These are not healthy activities. Nevertheless, economists are generally reticent to suggest that a good or service should be banned outright just because it is not good for you. This chapter uses the tools of supply and demand, elasticity, and consumer and producer surplus to look at these particular goods and services and the reason why some are regulated, some are taxed, and still others are illegal.

Twenty-three percent of the American population smokes and the average American consumes nearly 32 gallons of beer a year. With that much smoking and drinking going on, tobacco and alcohol are obviously important parts of the American economy. The tobacco industry employs 33,000 people a year, and it has annual sales of $37 billion. The alcohol industry employs 32,000 people and its annual sales amount to $23 billion. Because drug use and prostitution are illegal it is impossible to know exactly how much money is spent on those activities or how many people are employed in them. What is known is that nearly half of all adults under 35 have tried marijuana and one in seven has tried cocaine. The data on the number of prostitutes is far less precise, but anywhere from 200,000 to more than one million sell sexual services in a year. Every year, billions of dollars are spent on these activities.

Before looking closely at the economics of these goods and services, we review [we will review?] will the fundamentals of supply and demand to remind ourselves of how equilibrium within a market serves the interests of both the consumer and producer. We then [Then we will?] turn to reasons why selling and using these goods is regulated, taxed, or banned and why economists might back such restrictions. Along the way, we [we'll?] focus not only on secondhand smoke, drunk driving, the spread of STDs, and increases in crime but also on the issues of age restrictions, warning labels, and prohibition. After a brief discussion of the importance of elasticity, we'll use the concept within our supply and demand model to indicate who gets hurt by the considerable taxes that are levied on both tobacco and alcohol. Finally, we'll discuss why tobacco and alcohol are legal, why certain drugs and prostitution are not, and what decriminalization of these goods and services would likely bring. [This paragraph takes a strange tone like "We do this and we do that." I think you're trying to introduce what you intend to do within the chapter, in which case it should be in the future tense. If I've misunderstood the purpose of this paragraph, let me know.]

AN ECONOMIC MODEL OF TOBACCO, ALCOHOL, DRUGS, AND PROSITUTION

We’ll use [Again, "we use"--anything would sound better than that, such as "we'll use" or "we are using"] the market that was presented in Chapter 2 as the basis for our analysis of tobacco, alcohol, drugs, and prostitution. As we did with the market in that chapter, we will assume that there are many buyers and sellers, that the demand curve for each is downward-sloping, and that the supply curve for each is upward-sloping. For the time being, we will pretend that there are no negative consequences to innocent third parties. We will also pretend that all the people who engage in these activities know exactly what they are getting themselves into. While these are fanciful assumptions, the approach gives us a jumping-off point that we can use to look at these markets. To prove that the markets benefit both the consumers and the producers, we have to appeal to ["appeal to the analysis" doesn't work--maybe "refer to" or "recall"] the consumer and producer surplus analysis that was presented in Chapter 3.

We start with a few facts that are presented in Figure 17.1. Consumers buy Q* goods and pay P* for each. This means that consumers pay producers an amount of money that is simultaneously less than the value the consumers place on the good and more than it cost the producers to provide it. . That is, consumers are happier with the good or service than they were with the money they gave up, and producers make a profit. The gain to the consumers is P*AB and is called their consumer surplus. The profit to the producer is CP*B and is called their producer surplus.

[Art from 17.1 on page 163]

As a result of this analysis, we can state that the sale of these goods or services make drinkers, beer companies, smokers, tobacco companies, drug users, drug dealers, and prostitutes and the people who frequent them better off than they would have been without those sales. The sum of the consumer surplus and the producer surplus is CAB. If it were illegal to buy and sell these goods and services, and if everyone obeyed the law, all of the above-named parties would be worse off [when I first read this, I thought you meant that parties would be less fun if the goods and services were illegal.]. Before you have a fit at this conclusion, though, remember that it was arrived at only after we made some fanciful assumptions.

WHY IS REGULATION WARRANTED?

IT IS NOW TIME TO RECOGNIZE REALITY AND TO DEAL WITH THE VERY REAL PROBLEMS OF TOBACCO, ALCOHOL, ILLEGAL DRUGS, AND PROSTITUTION. THE GOODS THEMSELVES ARE VERY ADDICTIVE. THERE ARE HARMFUL EFFECTS TO INNOCENT THIRD PARTIES FROM SECONDHAND SMOKE, DRUNK DRIVING, AND THE SPREAD OF SEXUALLY-TRANSITTED DISEASES. THEIR PRESENCE HAS CAUSED EXPERTS IN PUBLIC HEALTH TO PERSUADE LEGISLATORS TO IMPLEMENT RESTRICTIONS, REGULATIONS, TAXES, OR OUTRIGHT BANS.

When people argue for government intervention in a market, they do so from many points of view. Economists, who tend to decry unwarranted intervention, generally categorize reasons into three broad arenas. First, they deem it possible for people to suffer from a lack of knowledge or an inability to think clearly. When that is the case, it may be appropriate for the government to step in with information or with warnings of danger. It may even be appropriate for government to make decisions for people. Second, they accept that the good or service may have adverse impacts on people other than the consumer or producer. Those costs, which are ignored in a market, must be taken into account by the government. Last, and least appealing among economists [why least appealing? It's not obvious.], is that consumption or production of the good may be immoral. That is, even though buying or selling the good may not hurt anybody in a physical sense, its production or consumption hurts society in general.

Whaaazzup, Joe Camel, and the Information Problem

For legal goods, advertising is intended to draw people to a product, and advertisers want their ads to be memorable.. The “Can you hear me now?....Good” commercials for Sprint’s wireless services clearly resonate, and for many, [but they also annoy!]. The point is they are remembered. When the advertising is for products like tobacco and alcohol, we sometimes bemoan the effectiveness of the ads. The Budweiser “Whaaazzup” ads began in late 1999, and were followed closely by the “How are you doing” [is it "how you doin?"] ads a year later. They were very effective in that the phrases entered everyday language. Similarly, the Joe Camel advertising campaign raised the market share of Camel cigarettes substantially during the middle to late 1990s. Since children cannot legally consume either product, it was of particular concern to people that the respective ads were able to capture the attention of young people.

For illegal goods, advertising is not an issue; the real “information” problem is the degree to which people do not adequately weight the likeihood or impact of addiction. Government’s reaction to this can be one of education, one of restriction, or one of prohibition. In the United States we use education to dissuade young people from using drugs and reinforce that with prohibition. In all but certain counties in Nevada, the government’s response to prostitution is simply one of prohibition.

The addiction argument clearly applies to the government may control access to marijuana, cocaine, ecstacy, or and methamphetamine. The , reasoning is that potential users may not know or fully comprehend that these drugs can be addictive and what the impact of that addiction will be on users.. We also may believe that potential new users are unaware of, or underappreciate, the manner in which an addiction can control their lives. On the other hand, we could believe that people are not smart enough to stay away from certain substances even if they know how addictive they are. The argument as it applies to prostitution is somewhat different. When prostitutes get started in the sex business, they may not fully realize the consequences of their actions. Some advocacy groups that seek to maintain and strengthen the ban on prostitution, for instance, claim that prostitutes generally begin their trade as children. As such, they do not know that they will be likely be raped on a regular basis, nor do they know that their pimp will likely attempt to get them hooked on an illegal drug in order to control them and keep them dependent. These groups also make the point that more than eighty percent of prostitutes were the victims of incest in childhood and that the industry capitalizes on this sense of degradation.

In general then, For economists suggest that the information problem can dealt with using education, age restrictions, or prohibition. The appropriate tool depends on the degree of the problem. , this means that there are cases where government should step in and regulate a market because if it does not, people in the market will make poor choices. Those unwise choices might result from inadequate information or poor judgment on the part of the decision maker. For example, the government requires that packages of cigarettes and bottles of alcohol display warning labels that describe the consequences of smoking and drinking. Thus requiring warning labels and banning tobacco or alcohol advertising on the grounds that these promotions serve only to cloud the judgment of consumers is acceptable to economists. We take the “providing knowledge” a step further when we ensure that every new generation knows the addictive nature of smoking and drinking [how?].through programs in the schools.

Of course, there are times when we simply do not trust young people to make good decisions, even when they have all the information. In these cases we either make it illegal to buy the goods or services or we require that people reach a certain age before they can buy them. Economists are not at all uncomfortable forbidding children from consuming tobacco products for two reasons. First, the vast majority of smokers began their nicotine addictions well prior to becoming adults. Second, there is evidence that the tobacco companies aided their becoming addicted through their marketing efforts. Because only a tiny fraction of smokers began smoking as adults, preventing children from having ready access to cigarettes is in society’s interest and in the child’s long-term interest.

Ultimately, this is the reason that we have age restrictions for both tobacco and alcohol, why some states prohibit cigarette vending machines, and why many economists embrace the prohibition of cocaine, ecstacy and methanphetimine , and prostitution are generally illegalis that for these the addiction . [the preceding paragraph is a bit choppy. Maybe it would help to be more specific and see how the sentences flow together. There are several levels of 'helping' people make the right decision when it comes to addictive substances. One way is to warn them, another is to educate them, and another is to restrict their use. Can you begin the paragraph w/ something like that so we can see where it's going?]

problem is often permenant.

The argument that people are too stupid for their own good is a hard one for some economists to stomach. While economists list “perfect information” as an assumption necessary for markets to perform efficiently and they have few objections to government’s providing that information, many are reluctant to believe that people make bad decisions when they have good information. Thus banning tobacco or alcohol advertising on the grounds that these promotions serve only to cloud the judgment of consumers is acceptable to economists. However, it is another story when government [why always "government" and not "the government" or "governments"?]decides to prevent informed adults from using or consuming certain products.

Nevertheless, children areincapable of making life-altering decisions in a considered fashion. Economists are not at all uncomfortable forbidding children from consuming tobacco products for two reasons. First, the majority of smokers began their nicotine addictions well prior to becoming adults. Second, there is evidence that the tobacco companies aided their becoming addicted. [I don't see why these two reasons add up to forbidding kids from smoking. You need a concluding sentence to tie it together. I especially don't get reason #2.]

External Costs

Few economists object when government interferes in a market in which someone other than the consumer or producer is hurt by the consumption or production of a good. These externalities are important considerations for market regulation because the point of market efficiency is that everyone either benefits from, or is left unaffected by, a transaction. If that does not happen, then standing by and allowing the market to take care of itself is not always acceptable.

The externalities that result from the use of tobacco are the illnesses and deaths associated with secondhand smoke and the increased health care expenditures incurred by people who do not smoke but must pay increased premiums for health insurance to cover the expenses of smokers. It is not the concern of most economists that (knowledgeable) smokers hurt themselves by smoking. It is the concern of economists that those smokers tend to pass on costs to others.

The sale of drugs often affects someone other than the buyer or seller of the drug. As a result, at least some of the costs of that market are not being accounted for by the buyer or seller. If addicts are more likely to commit crime than nonaddicts, then neither the addict nor the dealer is accounting for the rising number of innocent victims when they sell their goods. Similarly, if a john [I thought you weren't going to use "john"]person gets a venereal disease from a visit to a prostitute and passes that disease on to an unsuspecting third party, then there is an external cost. Someone who is not part of the original transaction is being affected because of the transaction.

[pic]

Establishing who should be counted as an innocent victim, though, is not as easy as it might sound. Children clearly are innocent victims, but are nonsmoking spouses? Some economists suggest that as part of the give and take of a marriage, smokers and their nonsmoking partners negotiate the rules for smoking in a household. If they decide it is all right for one to smoke and the other to be negatively affected, then smoking and its implications do not constitute an externality; it is simply one of the costs of the marriage. Other economists disagree. They suggest that regulations are needed to protect any people who are not consumers themselves.1(same as footnote 1 on page 173)

However you decide the issue of who is an innocent victim, those who are subjected to secondhand smoke have higher rates of lung-related illness than exist in the general population. Children in the presence of smokers are much more likely to die from sudden infant death syndrome (SIDS), asthma, and other lung illnesses. Airline cabin crews, servers in restaurants, bartenders, and a variety of others who have been exposed to others’ smoke also report rates of lung illness that are not only higher, but beyond those that might have occurred by chance. The costs of treating these innocent victims are ignored by both smokers and tobacco companies. Economists abhor ignored costs. Whether economists support corrective actions when there are such costs depends on the degree of those costs and whether eliminating them is worth the loss of private benefits.

In addition, there are more smokers on Medicaid than their proportion within the general population warrants. They, of course, produce some rather substantial costs to the program. If they were not smoking, Medicaid would cost taxpayers less. Here the innocent victim is the taxpayer.

Externalities also exist in less likely places. Since smokers typically die 5 to 10 years earlier than comparable nonsmokers, if they have group life insurance policies whose rates are the same for both smokers and nonsmokers, the expected net payout for smokers’ beneficiaries is more than for nonsmokers’ beneficiaries. Life insurance rates are therefore higher for nonsmokers than they should be and the rates for smokers are lower than they should be.2(same as footnote 2 on page 173)

These facts combine to suggest that when smokers buy cigarettes, the full cost of their smoking not only is not paid at the cash register, but it is not even fully incurred by the smoker. Most estimates of the external expenses that are paid by the general public come to around a dollar per pack of cigarettes.

This is not to say that economists hold unanimous opinions in these matters. Some suggest that there is a benefit to nonsmokers when other people smoke. These benefits come from two separate but related aspects of smoking. First, as mentioned previously, people who smoke for long periods of time die several years earlier than comparable people who never smoked. Smokers and nonsmokers pay more into Social Security and other pension plans, but nonsmokers have some of their retirement essentially subsidized by smokers, because the smokers died before they had collected the benefits to which they were entitled.

A second form of subsidy that smokers grant nonsmokers is that they not only die early, but they die more suddenly than nonsmokers. When smokers over the age of 60 become ill, their lifetime of smoking has so depressed their immune systems that they die of illnesses that nonsmokers are more likely to survive. They also succumb to those illnesses much faster and less is spent attempting to save them. Even though the money is spent sooner, it is much less. It is grimly ironic then that by dying more quickly than nonsmokers, smokers sometimes cost the health system less than do nonsmokers. By dying early and quickly, smokers avoid expenses that nonsmokers eventually need to pay. Because more than half of Medicare expenses are incurred during the last year of elderly people’s lives, hastening their deaths saves money. If this gruesome fact is taken into account, the net external costs of smoking become negligible in the eyes of some economists. [this whole section is just fine.]

Though there is a morbid economic upside to smoking, there no such benefit to drunk driving. There are more than 1 million arrests a year for driving under the influence of alcohol. While that number has come down substantially over the last decade, it is still more than high enough to represent a significant problem. Of the roughly 37,000 accidents that result in 42,000 traffic fatalities each year, thirty percent involve at least one person whose blood alcohol level is over the legal limit. Another ten percent involves someone who has a legal, but still measurable, blood alcohol content. Even when someone does not die, alcohol is a contributing factor in nearly a half million automobile accidents a year.

Despite these troubling statistics, it is time to try to look at the issue from a dispassionate viewpoint. To model the problem of the externalities that are associated with people who drive under the influence of alcohol, we need to alter our supply and demand diagram to account for the extra costs for which their behavior is responsible. To understand Figure 17.2, you need to recall that under perfect competition the supply curve is the marginal cost curve to the firms in the business. Any costs that are borne by neither the seller nor the buyer must be added to these costs to create the social cost of the good. On the assumption that the only people who benefit from the consumption of the good are the consumers themselves, the demand curve is the social benefit curve. So instead of coming to the market solution of a price–quantity combination P*–Q*, the socially optimal combination is P’–Q’. That is, if there is a market for a good where some of the costs spill over to others, then the market will produce too much of the good and charge too little for it.

Insert 17.2 from 164

Morality Issues

We have looked now at the first two circumstances under which economists consider it acceptable for government to intervene in the market. Besides lack of information and externalities in which innocent people may be harmed, a final reason why government might regulate a free market is that the market may be for a good or service that is considered to be immoral. For believers in certain major world religions, alcohol, tobacco, drugs, and prostitution are accorded this status. While appeals to righteousness are not particularly meaningful to economists on an academic level, they are certainly important to many other people. Many religions consider drinking a sin and a few feel the same way about smoking.

TAXES ON TOBACCO AND ALCOHOL

MODELING TAXES

To correct an externality, we can tax the offending good, we can limit its use, and we can forbid its use. Of these options, taxes are the most appealing to economists, as they allow people who are willing to pay all of the costs of their consumption to go ahead and consume. Using taxes in this way has the positive effect of discouraging those people who are not willing to pay the costs from becoming consumers of the undesirable or unhealthy good.

The taxes that the United States imposes on tobacco and alcohol are a 39-cent per pack tax on cigarettes and a 32-cent per six-pack tax on beer. The federal taxes on tobacco raise approximately $8 billion dollars a year, while the taxes on alcohol raise $7.6 billion. States also tax these goods, finding them to be a significant source of revenue, as they are for the federal government.

Figure 17.3 shows that the effect of the federal taxation on cigarettes and alcohol is to raise the price from P* to P’ and to lower consumption from Q* to Q’. An important thing to notice about this effect is that smoking and drinking do not stop. This means that the deleterious effects of secondhand smoke and drunk driving do not stop either. They are simply reduced. If the tax is set equal to the dollar value of such externalities, then in theory the tax revenue raised is sufficient to cover the costs of the externalities. One problem, though, is that the tax hits the considerate and rude alike. Smokers who light up alone do not cause secondhand smoke, whereas smokers who blow it in your face do. A per-pack tax hits both equally.

[insert figure 18.3 from page 172]

In any event, a policy short of prohibition implies that there is an economically acceptable number of expected drunk driving deaths and of childhood secondhand- smoke–induced illnesses. The idea is that as long as we have an adequate sum of money available to compensate the people who are affected, it is acceptable for smokers to smoke, for drinkers to drink, and for people to be influenced in negative ways by their behavior.

People who are not economists have a very difficult time with the “acceptability” of deaths and illnesses. The basic idea is that people drink and smoke because they enjoy doing so. If we take taxing and regulating too far, the reduction in enjoyment by users would outweigh the effect of the reduction on innocent victims.

The notion of acceptable deaths is a difficult one for many to accept. Consider this though: the Brain Injury Association reports that approximately 15 children die each year on playgrounds as a result of falls and other injuries. We continue to send our children out on recess because we weigh what is to be gained with what is to be lost and judge the risk of injury or even death to be tolerable. We drive to work because we see that what is gained--income--is greater than what is lost--a small risk of injury or death.

The Tobacco Settlement and Why Elasticity Matters

For quite some time legislators have given particular consideration to raising the taxes on tobacco. The settlement between several states and the big tobacco companies that was reached in 1998 requires that the companies pay the states more than $250 billion dollars over 20 years to compensate them for Medicaid expenses the states paid that were created by smoking. The companies will then pass on those taxes to the smokers who buy their products. To see how a sequence like this works, we need to look at the supply and demand curve for tobacco.

First, it should be remembered that when someone is addicted to a product, as smokers are to cigarettes, the demand curve for the good is highly inelastic. If you look at Figure 17.4 you see that a tax will again raise the price from P* to P’. If you compare the size of the tax (P’’ to P’) to the amount of the price increase, you see that smokers will be paying for most of this tax increase and that tobacco companies will pay comparatively less (P* to P’ versus P* to P’’). Since smokers are far poorer than the average of the general population, this tax is as regressive as any tax we can imagine. Since consumption falls only from Q* to Q’, it is also disturbing that the tax will not have a significant influence on how much people smoke either.

[insert fig 18.4 on page 173]

When you look at teen smoking, the picture is not quite so bleak. Because the habit of smoking takes up a much larger portion of teenagers’ than adults’ incomes, the elasticity of demand for cigarettes by young people is much greater. That is, demand is more elastic and the demand curve is flatter. If you were to draw such a demand curve, you would see that the burden of the tax would still fall mainly on consumers. You would also see that tobacco companies would be paying a greater proportion of the amount of compensation. Further smoking, at least teen smoking, would be reduced by more. Still economists’ best estimates are that elasticities for cigarettes are as low as 2.2 for adults and as high as 2.5 for children. This means that an increase of a dollar in cigarette prices would diminish adult smoking by 10 percent, and it would diminish smoking by children by 25 percent. A study of the elasticity of demand for beer put it at 2.53, which suggests a tax which adds 10 percent to the price of a six-pack would reduce consumption by 5.3 percent.

WHY ARE DRUGS AND PROSTITUTION ILLEGAL

THE DEBATE OVER WHETHER DRUGS AND PROSTITUTION SHOULD BE LEGAL USUALLY COMES DOWN TO A COMPARISON OF THE NEGATIVE CONSEQUENCES OF WHAT IS CURRENTLY LEGAL, TOBACCO AND ALCOHOL, WITH WHAT IS CURRENTLY ILLEGAL. CLEARLY A CASE CAN BE MADE THAT THE AGGREGATE IMPACT OF TOBACCO AND ALCOHOL IS MUCH GREATER THAN THE AGGREGATE IMPACT OF ILLEGAL DRUGS AND PROSTITUTION. AS YOU CAN TELL BY NOW, ECONOMISTS ARE LESS INTERESTED IN “AGGREGATE” IMPACTS THAN “MARGINAL” ONES. HERE, THE CASE CAN BE MADE THAT THE NEGATIVE EXTERNALITIES ASSOCIATED WITH ONE PERSON PURCHASING ONE MORE UNIT OF THE ILLEGAL GOODS IS GREATER THAN THE NEGATIVE EXTERNALITIES ASSOCIATED WITH ONE PERSON PURCHASING ONE UNIT OF A LEGAL GOOD. THE OTHER ARGUMENT THAT COULD BE MADE TO JUSTIFY THE CURRENT STATE OF THE LAW IS THAT THE UNKNOWN OR UNDERESTIMATED CONSEQUENCES TO THE CONSUMER OF USING DRUGS OR ENGAGING IN PROSTITUTION ARE SUBSTANTIALLY GREATER THAN THOSE WITH REGARD TO ALCOHOL. OF COURSE THE OPPOSITE CASE COULD BE MADE AS WELL.

THE IMPACT OF DECRIMINALIZATION ON THE MARKET FOR THE GOODS

Given the previous discussion, suppose a good or service is currently illegal. What would result from making it legal? The first thing that would likely happen as a result of making a good legal is that the concerns of both consumers and producers about getting caught would evaporate. Because getting caught would not be a problem any longer, any shift to the left of supply that resulted from clandestine operation would cease to exist. Similarly, any shift to the left in the demand curve by those who might have wanted to partake of the illicit good but did not because it was illegal would cease to exist. The net result of legalizing a previously illegal activity would be a movement in the demand curve to the right and a movement in the supply curve to the right.

Another impact of decriminalization would occur on the elasticity of demand and, to a lesser degree, supply. When a good is illegal, it is often the case that the consumers of the good are addicted to it in some sense. The demand curve for a good for which a consumer is addicted is likely to be very inelastic. Similarly, once people have made the decision to become a seller of an illicit good, the price they sell it for is not usually a stimulus to sell it in great quantities. This is because the risks of getting caught may prevent sellers from expanding their operation quickly as prices rise. Therefore, from either side, the supply and demand curves are less elastic when the good or service is illegal than when it is legal. The net result here is that both curves flatten out when the good is made legal.

Figure 17.5 depicts the effect of legalizing a previously illegal good. The demand curve flattens and moves right and the supply curve flattens and moves right. If the supply curve movement is more than the demand curve movement, as it is in Figure 17.5, the net result is a lowering of price. Not shown, but equally plausible, is the case where the demand curve movement is greater than the supply curve movement and the price rises.

[Insert fig 17.3 on page 166]

Thus the direction of a price change as a result of decriminalization depends on whether the reduction in risk to dealers or prostitutes is greater than the increase in interest by consumers. Because the conventional wisdom is that legalization would lower the price, conventional wisdom is just that: the supply curve shift will be greater than the demand curve shift.

The External Costs of Decriminalization

Ultimately, whether legalization makes sense to you depends on whether you believe the external costs of these activities are significant enough to pay the significant costs of punishing users and dealers. One potential solution that many pro-legalizers suggest is that we tax and regulate drug sales and prostitution in order to take into account and pay for the externalities.

Looking back to Figure 17.3 you see that we simply added a tax equal to the external cost that was examined in Figure 17.2 to get the P’, Q’ result. That is, a proper taxation scheme can make up for the problems of an externality. There is money to educate against the use of the illicit good or to compensate victims of users of the questionable good.

The problem is that if the external costs are very great, the tax will have to be very high. If the tax is very high, there will be a motivation to have a black market in untaxed goods. As evidence of this, consider that in Canada a prohibitively high tax created a black market for cigarettes. In this case people drove to the United States, bought cigarettes, took them back to Canada, and sold them. In another similar case, while prostitution is legal in Nevada, it is highly regulated. That regulation leads to prostitutes’ avoiding regulation by working on their own outside of the regulated brothels. Whenever a tax is too high or regulation too severe, a black market will exist beside a legal market.

Summary

You now understand how we can apply a supply and demand model and the concepts of consumer and producer surplus to tobacco, alcohol ,drugs, and prostitution. You understand that there are reasons that economists endorse interference in a market, reasons that have to do with the information and costs to innocent third parties. You have seen how the question of who gets hurt by taxes on tobacco and alcohol is dependent on the elasticity of demand for these goods. Finally, you have seen the argument for the current state of the law with regard to the treatment of these goods and the economic consequences of decriminalization.

1. Economists believe that the best reason(s) to regulate a market is (are)

a. A good has no moral value.

b. A good produces an external cost.

c. People are uninformed about the damaging nature of the good.

d. (b) and (c).

2. An example of an external cost of tobacco is

a. Cigarettes burns on the furniture of smokers.

b. Matches.

c. Increased life insurance premiums of smokers.

d. Secondhand-smoke–induced deaths.

3. An example of the external cost of alcohol is

a. Drunk driving.

b. The cost to alcoholics of going to rehabilitation clinics.

c. The cost of producing whiskey.

d. The cost to bars of hiring janitors to clean up after their customers.

4. Because of different elasticities, a tax on cigarettes will affect the smoking patterns of children

a. The same as those of adults.

b. More than those of adults.

c. Less than those of adults.

5. The elasticity of demand for cigarettes among teenagers is

a. Less than that among adults.

b. More than that among adults.

c. The same as that among adults.

6. The elasticity of demand for a particular brand of beer is likely to be

a. Greater than the elasticity of demand for beer in general.

b. Less than the elasticity of demand for beer in general.

c. The same as the elasticity of demand for beer in general.

7. Draw two supply and demand diagrams, one with the demand for cigarettes by children and the other with the demand for cigarettes by adults. Show the effect of the tax on decreasing smoking among these two populations.

8. If there are innocent victims and a market is not regulated to combat this, then the market equilibrium is such that the price is too ______ and the output is too ______.

a. Low, low

b. Low, high

c. High, low

d. High, high

9.. If a good is made illegal or is heavily taxed because of the damage the good creates to innocent third parties,

a. Everybody will stop wanting the good.

b. Everybody will stop producing the good.

c. There will be a black market and costs associated with enforcement.

d. Nobody will change their behavior.

10. Show that making a previously illegal good legal may raise or lower price depending on whether the supply shift is bigger than the demand shift.

Think about This

Compare marijuana and alcohol with regard to legality. Does the distinction make sense with regard to externalities? Does it make sense in any other regard?

When we consider the impact of smoking-related costs on the taxpayer we often ignore the smoking-related benefits described in this chapter (the early and rapid deaths of smokers diminishing Medicare and Social Security costs). It’s not good economics to ignore this aspect. In deciding the issue of cigarette taxes for yourself, will you consider this aspect? Why? Why not?

Talk about This

Talk about This

List the costs and benefits of legalizing marijuana. Which, in your opinion, is greater? What does this tell you about the possibility of legalization? Do the same for cocaine, methamphetamine, and prostitution.

What is the most important function of cigarette taxes in your mind: raising revenue to pay the external costs or reducing smoking? Why?

For More Insight See

Thorton, Mark. The Economics of Prohibition. Salt Lake City: University of Utah Press, 1991

For More Insight See

Grossman, Michael, Jody Sindelar, John Mullahy, and Richard Anderson. “Alcohol and Cigarette Taxes.” Journal of Economic Perspectives 7, no. 4 (1993), pp. 211–222.

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Insert as Text box (like p165)

examining the externalities

THERE ARE A FEW FACTS ON CRIME THAT WE OUGHT TO CONSIDER WHEN DEALING WITH DRUGS IN PARTICULAR. FIRST, 28 PERCENT OF ALL VIOLENT CRIMES (44 PERCENT FOR RAPES) ARE COMMITTED WHILE THE PERPETRATOR IS ON DRUGS. SECOND, 55 PERCENT OF INMATES IN JAIL, DETENTION, OR PRISON USED DRUGS DURING THE MONTH LEADING UP TO THEIR ARREST. LAST, WE SPEND $1.9 BILLION ON DRUG INTERDICTION AND $49 BILLION ON INCARCERATION IN THIS COUNTRY EVERY YEAR. MORE THAN HALF OF THOSE INCARCERATED NOW ARE THERE FOR DRUG-RELATED OFFENSES.

What effect would legalization have on these statistics? We would save a lot of money—half of the incarceration costs and all of the interdiction costs. If overall use increased, as it probably would, violent crime would increase as those who were not addicts before legalization became addicts after legalization and once addicted became violent. [But doesn't much of the violence come from the fact that the drug they're on is illegal?]

Battling Negative externalities while creating other problems

SOLVING THE EXTERNALITIES ASSOCIATED WITH A GOOD BY ENFORCING A PROHIBITION STRATEGY CREATES A PROBLEM. SOMETIMES THE SOLUTION CAN BE WORSE THAN THE PROBLEM IT WAS INTENDED TO SOLVE. MUCH DRUG VIOLENCE EXISTS ONLY BECAUSE OF LAWS CRIMINALIZING DRUG USE. [OK] 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. THERE WOULD BE NO NEED FOR THE HUNDREDS OF THOUSANDS OF PRISON BEDS DEVOTED TO DRUG OFFENDERS. IT IS FOR THIS REASON THAT YOU FIND A SIGNIFICANT NUMBER OF ECONOMISTS, EVEN VERY CONSERVATIVE ECONOMISTS, FAVORING DRUG LEGALIZATION. THEY APPRECIATE THAT DRUGS CARRY WITH THEM EXTERNALITIES BUT SEE THE SOLUTION AS WORSE THAN THE PROBLEM.

Insert as Text box (like p165)

examining the externalities

THERE ARE A FEW FACTS ON CRIME THAT WE OUGHT TO CONSIDER WHEN DEALING WITH DRUGS IN PARTICULAR. FIRST, 28 PERCENT OF ALL VIOLENT CRIMES (44 PERCENT FOR RAPES) ARE COMMITTED WHILE THE PERPETRATOR IS ON DRUGS. SECOND, 55 PERCENT OF INMATES IN JAIL, DETENTION, OR PRISON USED DRUGS DURING THE MONTH LEADING UP TO THEIR ARREST. LAST, WE SPEND $1.9 BILLION ON DRUG INTERDICTION AND $49 BILLION ON INCARCERATION IN THIS COUNTRY EVERY YEAR. MORE THAN HALF OF THOSE INCARCERATED NOW ARE THERE FOR DRUG-RELATED OFFENSES.

What effect would legalization have on these statistics? We would save a lot of money—half of the incarceration costs and all of the interdiction costs. If overall use increased, as it probably would, violent crime would increase as those who were not addicts before legalization became addicts after legalization and once addicted became violent. [But doesn't much of the violence come from the fact that the drug they're on is illegal?]

Battling Negative externalities while creating other problems

SOLVING THE EXTERNALITIES ASSOCIATED WITH A GOOD BY ENFORCING A PROHIBITION STRATEGY CREATES A PROBLEM. SOMETIMES THE SOLUTION CAN BE WORSE THAN THE PROBLEM IT WAS INTENDED TO SOLVE. MUCH DRUG VIOLENCE EXISTS ONLY BECAUSE OF LAWS CRIMINALIZING DRUG USE. [OK] 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. THERE WOULD BE NO NEED FOR THE HUNDREDS OF THOUSANDS OF PRISON BEDS DEVOTED TO DRUG OFFENDERS. IT IS FOR THIS REASON THAT YOU FIND A SIGNIFICANT NUMBER OF ECONOMISTS, EVEN VERY CONSERVATIVE ECONOMISTS, FAVORING DRUG LEGALIZATION. THEY APPRECIATE THAT DRUGS CARRY WITH THEM EXTERNALITIES BUT SEE THE SOLUTION AS WORSE THAN THE PROBLEM.

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