Tuesday, July 29, 2014

Discouraging drug use: prohibition or taxes?

Marijuana has been legalized in several states in the U.S. recently, including Colorado and Washington. So fare there have been no major problems with drug use and Colorado officials project to take in $30.6 million in revenue for the first fiscal year. This is not as much as previously projected, however, and one possible reason mentioned in the article is that medical marijuana is a cheaper alternative due to the insurance subsidies and thus people who should be buying retail are getting prescriptions instead. But that is a separate issue that does not change the fact that the Colorado government is making money taxing marijuana.

In my opinion the result in Colorado from legalizing marijuana would hold for harder drugs as well, and I will explain why. Let's take heroin for example. Many heroin uses are addicted to the drug or at the very least really enjoy the effects the drug has on them. If that is true, this means that their demand for the drug is price inelastic, meaning that if the price rises they will not drastically reduce their consumption of the good. Below is a diagram portraying a market for a drug like heroin. Price is on the vertical axis, quantity is on the horizontal axis.

The demand curve is relatively vertical, which portrays the inelastic demand for a drug like heroin. The point Q1*, P1*, where supply curve S1 intersects demand curve D, is the initial equilibrium quantity and price for heroin. The U.S.'s current method for decreasing drug use is largely based on attacking the supply side; the DEA goes after large drug dealers and tries to prevent drugs from crossing the border. They also raid poppy fields in places like Afghanistan to reduce the supply. This can be shown in the graph by shifting supply from S1 back to S2. When this happens the equilibrium quantity decreases from Q1* to Q2* and the price rises from P1* to P2*.

What the diagram shows is that the equilibrium price for heroin increases by more than the equilibrium quantity for heroin decreases. If that is the case, total revenue from selling heroin will actually increase when the supply is reduced from S1 to S2. This is because the increase in the price more than offsets the decrease in the quantity, and since total revenue is price times quantity the total revenue will increase. Depending on a dealers cost structure, their risk aversion, and the penalties for being caught, it is possible that the higher price makes dealing heroin even more lucrative than before the reduction in supply. A relatively high price would induce more dealers to enter the heroin market. In fact, there is evidence that drugs like heroin are more available than ever. The article also claims the drugs are cheaper too, which could happen if the government is unable to reduce supply (shift back to S2) as fast as the dealers increase it (shift S1 to the right), either by expanding existing capacity or from new dealers entering the market.

So if the war on drugs isn't working, what is an alternative? One option is to treat drugs such as heroin like cigarettes and marijuana; legalize them, tax them and regulate them. Below is a graph similar to the one above, only it portrays what an excise tax on heroin would look like.

In this scenario, instead of targeting the supply side governments would tax the demand side. An excise tax would be placed on heroin, like the tax on cigarettes or marijuana. This would shift the demand curve left from D1 to D2. Consumers would pay the high price labeled Pc* and producers of heroin would receive the low price Ps*. The gap between them, the tax, would go to the government.

This policy has some advantages over the first scenario. First, it lowers the price producers receive instead of raising it. Second, governments take in tax revenue equal to the TAX times Q2*. This revenue can be used to fund rehabilitation and education programs for heroin users. Third, the money used to fund the DEA and to care for prisoners convicted of non-violent drug offenses could be used on other things society values, such as infrastructure, education, etc.

The analysis presented here is certainly not complete; some details and dynamics were omitted. But as a first approximation I think it makes a case for legalizing, regulating, and taxing drugs instead of criminalizing them.

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