Wednesday, December 17, 2014

"Sugary Drinks" and Dead Weight Loss. Lets go to the graphs.

Many communities around the US  (and some other countries) have passed, or want to pass, a law that places a tax on "Sugary Drinks".  It is believed these types of products contribute to health problems and lost productivity within the economy.

The main argument is the production and consumption of sugary drinks does not explicitly include the tertiary costs to society in terms of treating conditions and diseases associated with these type of products. If we did include this cost, then the price would be higher and the market quantity would be lower.  I am going to use $.50 as the additional cost that is NOT considered in the private market production and consumption of these drinks.  This is known as an "external cost" that is not "internalized" in bringing this good to market.

The intent of the tax is to internalize ALL the costs of producing and consuming sugary drinks--even ones that have NO direct bearing on production and consumption.

Lets go to the graphs and see how this plays out.

Here is the market for "sugary drinks" in equilibrium where we ONLY consider the Private Market Demand (Marginl Private Benefit (MPB)) and Supply (Marginal Private Cost (MPC)) of this class of drink.  Right now the price of sugary drinks is $1.00 and the market quantity is "Qe".


The main policy goal is to DECREASE the market quantity produced and consumed in the marketplace.  Supporters of this policy believe the "Socially Optimal" amount of sugary drinks is LESS than what the market currently produces and consumes (graph below).


At the "Socially Optimal" market quantity, the cost to bring this good to market is $.75 (just go up to the Supply Curve) at Point "B".


However, if we include the $.50 not previously accounted for in production and consumption we see at the Socially Optimal market quantity, the producer would need at least $1.25 in order to supply that amount---Point "C" (look at the next TWO graphs to get this idea).



What is true between Points "B" and "C" is going to be true (certerus paribus) along all other points on Supply Curve "S* (MPC)---Points "A" to "D".


IMPORTANT POINT:  If we connect those new points we will derive a NEW market Supply Curve that now INCLUDES the external cost not previously included of producing sugary drinks.

We label this Supply Curve "S1 (MSC)"---MSC stands for Marginal Social Cost.  This curve includes the private costs of production and consumption AND the SOCIAL COSTS as well. Read that again!

Think of the original Supply Curve as "what is" and the new Supply Curve as "what should be". The difference between the two is the social cost.

The market is now in equilibrium at Point "C" where quantity demanded=quantity supplied---at a higher price ($1.25) and a lower market quantity (Q socially optimal).


The graph below is the same one only a little cleaned up.

Lets now consider Points "A", "D" and "C" and the neat triangle it forms.

Point "A" represents the market price and quantity as it "is". Point "C" represents the market as it "should be" if we internalized the exteranal cost of sugary drinks.  Point "D" represents at the private market quantity what the actual cost of producing each unit of sugary drink is---$1.50 as opposed to $1.00.


Graph below.  This triangle between "A", "B" and "D" represents the area of DEADWEIGHT LOSS (DWL) due to the under-pricing and over-production of these drinks.

In other words, when we include the external costs associated with the production and consumption of this good we can easily see that all the quanitities beween "Qe" and "Q socially optimal" now cost more to supply than consumers are willing to pay.

Prove it to yourself.  Pick any point on the horizontal axis between those to areas.   Go up staight up. You will hit the demand curve at at a lower price than you will hit the supply curve---cost to produce is greater than the price willing to be paid.

INEFFICIENT use of resources!

These units would not be produced if all costs associated with the good were included in the price paid and received!


Remember: The market IS at Point "A".  It is suggested that it SHOULD BE at Point "C". The difference is Dead Weight Loss.

Sorry for the repetition at times. I attempted to make this a step by step as possiblefor the beginning learner.  It can be a difficult concept to explain and learn in AP Microeconomics.

But is is a necessary one.  Guaranteed to be on the AP Test!

Let me know if you have any questions or can point out where I might have gone wrong.  Constructive criticism is always welcome.

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