MAE101 Economic Principles Assignment, T2 2015.
This version is worth 41 points, reweighted to 22 marks.
Submit your assignment via Cloud Deakin in the appropriate assignment dropbox by
11:59 p.m. on Monday 21 September 2015. Hard copies will NOT be accepted. Please
note the new, later, due date.
Extensions can only be granted by the Unit Chair (Dr Randy Silvers,
This is an individual assignment; the work that you submit must be your own.
Plagiarism will incur penalties.
For most of the goods and services that we have considered, markets operate with few
restrictions – we have studied the consequences of price controls and taxes and tariffs,
but those restrictions affect the prices that consumers pay and the prices that firms
receive, not who can or cannot be a consumer or producer.
Consider the markets for drugs:
(i) Some drugs, such as aspirin, ibuprofen, and antacids, are over-thecounter
– anybody can purchase them and the only restriction on their
production is much the same as that on most other products, namely
that its contents be listed and the product not be defective.
(ii) Other drugs, such as codeine and penicillin, require a prescription.
Anybody can purchase them provided that they have a note, signed by
a professional, who has passed a series of tests to demonstrate
competency and ethical behavior as an authority. Moreover, the
quantities purchased are limited by the note. As with the first category,
any firm can produce these pharmaceuticals, subject to the similar
regulations – there may be tougher standards in first obtaining
approval, such as demonstrating that the drug be both safe and
effective, and documenting potential side effects, in order to warn.
(iii) The last category of drugs, such as heroin and cocaine, are illegal. No
consumer can legally purchase the drugs, no firm can legally produce
them, and no professional is authorized to issue a note that allows the
purchase or production of the drug.
In this version, you will study why these three categories of drugs exist and how
making a drug illegal does not eliminate the market; rather, it becomes part of the socalled
“black market.” You will also learn about some of the ramifications of different
policies, such as the restrictions that create the second and third categories.
• the article for discussion in seminar week 6 (It’s Time to End the War on
• the Aplia problem set that was due 16 August, News Analysis — Optimal
Decision Making: A Parking Dilemma;
• the following 50-minute podcast for which there is also a transcript
available at the link:
Task 1: Voluntary Exchange and the Risk of Addiction
(a) Consider the first two markets described in the Background. Suppose that the
production in both markets is perfectly competitive. For each, derive the
equilibrium price, quantity, and consumers’ surplus.
(i) In the over-the-counter market, assume for simplicity that the market
supply is Qs = 40 + P and the demand is given by Qd = 184 – 8P.
(ii) In the prescription drug market, assume for simplicity that the market
supply is Qs = 10 + P/2 and demand is given by Qd = 100 – 2P.
Unlike with the over-the-counter drugs, both prescription drugs and illicit drugs can
become addictive. A consumer does not know the probability that he will become
addicted until after he has consumed the drug.
Now, consider the third market, that for illicit drugs. We can think then of the
individual having an initial willingness to pay for an illicit drug (WTPo) and
subsequently, either an experienced willingness to pay (WTPe) or an addicted
willingness to pay (WTPa). Let the probability of becoming addicted be denoted by
padd — and thus, the probability of not becoming addicted and being able to continue
using the drug with experience is 1 – padd.
(b) Assume for simplicity that the current market price is $25. For a particular
consumer, let WTPo = 40, WTPe = 60, and WTPa = -$140 < 0.
(i) Interpret each WTP.
(ii) Show that if the probability of becoming addicted is 0.1 (padd = 0.1),
then the individual will choose to consume the drug.
(iii) Show that if the probability of becoming addicted is 0.4 (padd = 0.4),
then the individual will choose to not consume the drug.
(c) One of the core principles of economics is that voluntary transactions make
those economic agents that transact better off. Discuss this in light of what you
have just shown above.
(d) Some goods in each category have similar characteristics to goods in other
categories. In the U.S., the government has cracked down on prescription
painkillers, tightening the supply. Refer to the podcast. Show the effects of a
government crackdown on the market for heroin in a demand-and-supply
Task 2: Risk of Incarceration, Taxes, Production Costs, and Entry
(a) For those drugs in the third category, any consumer and any producer risks
being caught and incarcerated.
(i) Consider a consumer who is experienced but not addicted to such a
drug. Let his WTPe = 60. If the consumer is caught and incarcerated,
then he gets 0. Let his willingness to pay for alcohol, which is licit, be
54. Show that if the probability of being caught and incarcerated is 0.1,
then the consumer is indifferent between consuming the illicit drug
which entails the risk of being caught and incarcerated, or consuming
(ii) Consider producers. Previously, when the drugs were illicit, each
producer had certain explicit and implicit costs of production; suppose
that these are constant and equal to 20. A producer would sell six units
at a price of 28 each. Suppose that the probability that a producer is
caught and incarcerated is 0.25. Determine the amount of loss that a
producer would regard incarceration to be equivalent to, that would
make this producer indifferent between becoming a producer and not.
(iii) Each producer attempted to maintain a monopoly over its territory,
often by threatening potential entrants with physical harm — after all,
since the drug is illicit, the producer cannot avail itself of the judicial
system to enforce their monopoly or contracts/agreements. Suppose
that a local monopolist faces a demand given by Qd = 20 – P and has a
constant marginal cost equal to 4. Graph this local monopolist’s
demand, marginal revenue, and marginal cost. On your graph, identify
the monopolist’s profit-maximizing quantity and price, then shade the
areas that represent consumers’ surplus, deadweight loss, and profit.
Return to Task 1 (b) and suppose that the government decides to legalize the illicit
drugs and impose a tax of $10. Let Qd = 100 – 2P and Qs = 10 + P/2.
(b) Derive the new equilibrium — the price that consumers pay, the price that
firms receive, and the quantity. What is the share of tax burden that consumers
bear and how is that share related to the elasticity of demand versus the
elasticity of supply?
(c) Because the drug is now licit, explain why demand would change and write a
demand that is consistent with your explanation — for example, if you think
that demand would increase and become more elastic, then modify Qd = 100 –
2P to an equation that shows greater demand and is more elastic (at least at the
Repeat for supply — explain why supply would change and write a supply that
is consistent with your explanation.
Task 3: Government’s Choices
(a) Listen to the podcast, particularly the question and response by Marc Fisher
from 1:44 – 3:40 (starting at 10:07:50 in the transcript). Consider his statement
that the Mexican cartels switched from marijuana to poppy/heroin production
after marijuana became legalized in some states in the U.S.
(i) Use a supply-and-demand graph to show the effects of this crackdown
for Mexican drug cartels.
(ii) Do you agree with the statement that the legalization of marijuana in
some states impelled the Mexican drug cartels to switch to
poppy/heroin production, or do you think that they would have started
producing anyway because the demand for heroin increased? Explain.
In articles for discussion in the seminars, you have discussed policies to reduce
children’s tobacco consumption and the various benefits and costs of ending the war
on drugs. Many politicians and social scientists compare illicit drugs to alcohol and
tobacco, two products that are licit and taxed despite each being addictive and
physically harmful. Certainly, there is uncertainty about the benefits and costs that
would result if currently illicit drugs such as heroin were made licit and taxed.
(b) Suppose that as a government leader, you believe that making heroin licit
would result in either per annum net benefits of $1 million or a net loss of $3
million, with probabilities 0.9 and 0.1, respectively.
If after one year, you learn that:
• the result is good (net benefits of $1 million), then you maintain the
licit status into the future, yielding net benefits each year into the future
— suppose that this stream has a current value of $5 million; or
• the result is adverse (net loss of $3 million), then you would like to
reverse the policy and make heroin illicit again. However, reversing
this policy has become difficult and would entail a cost that has a
current value of $10 million; thereafter, heroin would be illicit,
yielding no net benefits or costs compared to the current situation.
(i) Would it be prudent to legalize heroin or maintain its illicit status?
(ii) Relate this to alcohol and tobacco.
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