Supply and demand

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TEAM GDL

Chapter 5

Question 9
An interesting application of supply and demand to addictive substances compares alternative techniques for supply restriction. For this problem, assume that thedemand for addictive substances is inelastic.
a) P
One approach (use today for heroin and cocaine and for alcohol during Prohibition) is to reduce supply at the nation’s borders. Show how thisraises price and increases the total income of the suppliers in the drug industry.
S0

Y1
P1

P0
S1

Y0

D

0
Q0
Q1
Q

In this example we had a decrement in Supply, and because thedemand is inelastic, the quantity decreased but only a few, and in the other side the price raising a lot, so the supplier’s income increase.
So: 0P1Y1Q1 > 0P0Y0Q0

b) S0
P
Q
Analternative 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 drugindustry.
Tax
Y0
0
Q0
Q1
Y1

P1

S1

P0

PS

D

In this case the Tax increment shifts the Supply curve up, creating a new supply curve, parallel to the original curve. This new supplycurve intersects the demand at the new equilibrium Y1, where price to consumers has risen for P0 to P1 and suppliers’ price has fallen for P0 to Ps. We can see that the quantity has decrease and alsothe price, so the Suppliers will produce more in a lower price.

c) Comment on the difference between the two approaches.
The difference between the two approaches is that in the first one, theprice increasing affects directly to the Suppliers income, although the quantities demanded decrease, the price increment is higher to support the lower quantities.
In the second approach taxing thegood heavily, the consumer bears most of the burden, but the suppliers also receive less money because the price income goes to the government. This is because the supply is relatively price-elastic...
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