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Tuesday, January 11, 2005

Cocaine cheaper than Coffee?

In Britain, this is evidently the case (Story here). Now, in class we preach that prices send very important and clear signals to both consumers and suppliers. If the price of drugs is falling over time, what can be the cause?

First might be a decline in demand. If demand is well behaved (in an economic sense) than a decline in demand, everything else equal, will cause a drop in price. If supply doesn't change and demand drops then we see less quantity sold in the market. Second might be an increase in supply. If supply is well behaved (in an economic sense), then an increase in supply, everything else equal, will cause a drop in price. If supply increases and demand does not change then we see more quantity sold in the market. The third possibility is an increase in supply coupled with a decrease in demand, which would cause a decline in price but an ambiguous change in quantity sold/consumed.

Unfortunately, the story doesn't indicate how the quantity of drugs sold in the market has been changing over time, although the story hints that more people are using drugs today than in the past. If this is the case, then it must be the case that the supply of drugs is increasing faster than demand. Even if demand for drugs is increasing, a sufficiently large increase in supply will cause a drop in price. On the other hand, if the demand for drugs is falling, a sufficiently large increase in supply could actually increase the quantity of drugs sold.

On the demand side, dropping prices tend to increase the quantity of the product consumed, everything else the same. What about the supply side? In a principles of economics class, we preach that as prices fall, everything else equal, the quantity supplied will fall. We also preach that as the price of one good falls the supply of substitutes in production should increase as producers switch production to higher priced products.

As coffee is a substitute in production to cocoa, wouldn't cocoa farmers switch production to coffee? We would expect this to happen if the farmers actually sold cocaine and coffee to the end consumer, but they don't. Coffee farmers sell their beans to coffee processors, who have formed a fairly good cartel in recent years and have pushed down the price that coffee farmers receive for their product, even as the price of coffee increases for the end consumer (here is an MSNBC story, although I remember a story in the Wall Street Journal discussing the same issue).

The cocoa farmer does not receive the full value of cocoa converted to cocaine - the drug cartel and drug dealer take the majority of the profit - they bear risk and are able to bid farmer-prices down. Similarly, the coffee farmer does not receive the full value of her coffee beans - the cartel bears some risk and is also able to bid prices down. Evidently, the coffee cartel has been more successful in driving its price down than the drug cartel.

Thus, for an increasing number of coffee farmers it is more profitable to produce cocoa. Therefore, contrary to what the simple demand-supply model would predict, as long as the drug and coffee markets are structured as they are (especially the coffee market), the price of drugs to the end user will continue to fall and the price of coffee to the end user will continue to increase.

This is a lesson for students of economics. It is important to recognize the power and the limitations of the supply-demand model. Supply and demand, as we teach in principles courses, assumes perfect competition on both sides of the market. While consumers are likely competitive agents (that is "price takers") in both the market for coffee and the market for drugs, the supply-side of each market is not perfectly competitive. Therefore, while the model helps conceptualize some aspects of both the coffee and drug markets, it is not completely appropriate and requires a bit of "tweaking."

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