Markets in Action: Economics of Opium Production

Ed Maris writes on the incentives to supply opium in the turbulent country of Afghanistan

The Opium trade has existed for hundreds of years; it was the cause of the Anglo-Chinese wars of the nineteenth century and has been a resilient market despite increasing pressure from law enforcement agencies and governments worldwide. It is a part of most country’s shadow economy - it is an illegal good and a factor of the world narcotic trade. Opium is an example of a good exhibiting derived demand; whilst it may be consumed in its raw state, it is usually processed into Heroin, a powerful and damaging drug. Afghanistan’s opium production is estimated to account for 52% of the country’s legal GDP and 87% of the world’s total supply.

One of the principal factors affecting the change of supply of opium in Afghanistan is weather conditions; the crop from which it is derived, the opium poppy, is durable, drought resistant and resilient to pests. This means that it may be cultivated where other cash crops would not. The prevailing weather conditions in Afghanistan in the last decade have meant that cultivators have seen a significant increase in harvests; between 2004 and 2005 the average yield per acre increased from 34 to 39 kilograms per hectare, a 22% increase.

New firms entering the market have also increased market supply; opium attracts a much higher price at source than any other licit alternative; this incentive is enhanced by a decrease in entry barriers, such as the Taliban’s ban on its cultivation, which has been removed since the US invasion in 2001 (in the year 2000, the Taliban’s condemnation of opium production reduced harvests by 91%). This arises from a scarcity of other revenue sources for many families. Interestingly, before the instigation of this ban, the Taliban levied a 10% tax on opium production, which increased production costs, thereby reducing market supply of opium.

There are few goods which are in competition with opium as a cash crop. However, the recent soar in wheat prices meant that production of opium in Afghanistan in 2008 fell by 500 tons to 7700, from 8200 in 2007. This results from the profitability of wheat cultivation increasing (yet still remaning twenty seven times less profitable that opium!), coupled with localized subsidies which encourage licit farming, reducing market supply and thus increasing market price.

Traditionally, Afghan opium traffickers relied on foreign organizations to convert opium into heroin. However, a decrease in heroin production costs such as labour and a fall in the price of raw materials (chemicals) required for the process means that heroin production in Afghanistan increasing. All of these factors reduce the unit cost of production, increasing profitability for those involved every facet of the market, from cultivation to transportation; this in turn increases market supply of opium.

Whilst such a large increase in market supply clearly exceeds demand, with Afghanistan’s production in 2007 standing at 8200 tons, and global demand estimated to be around 4500 tons, it is not apparent why market price has not fallen due to supply exceeding demand (market saturation), and indeed why prices have increased. This may be due to producers stockpiling their product to artificially raise market prices (see article link at end), or due to emerging global markets which are not yet accounted for. The supply of opium is highly volatile, due to its illicit nature, and fairly elastic - producers can easily respond to changes in price as the required factors of production are limited, require little capital investment and are in abundance.

Opium is a highly ‘versatile’ good; it exhibits composite demand - it is used both raw and in various purified forms. This means that a rise in the market price of one of its derivatives (Eg Heroin) leads to a rise in market price of others (Codeine & Morphine - both licit pharmaceuticals). Owing to its addictive properties, demand for opium is highly inelastic; a change in price has little effect on demand, as consumers are willing to pay hugely elevated market prices to obtain the product. The price of heroin has risen to an average of $67 per gram in Europe - this rise in price has led to an increase in supply (due to the law of supply), as producers attempt to increase their profits.

Demand is also affected by the opportunity cost of illegal consumption; some countries, such as Singapore, hold the death penalty for trafficking or possession of narcotics; demand for opium there is proportionally much lower than in the United Kingdom, where the O.C. of being caught supplying or consuming the drug is not as high. Furthermore, the prevalence of regional law enforcement has a huge effect on regional market prices; when importation of opium and its derivatives is reduced owing to the seizure of consignments, the price of the drug increases as the total supply is lower than the total demand, increasing scarcity of the good; this gives exporting countries an incentive to increase production.

Unless the market price of other cash crops can match that of opium or suitable subsidies can be implemented in all opium exporting countries, it will be difficult for governments to reduce market supply, as farmers have little incentive to change the nature of their cultivation. As market price steadily increases, production is only set to increase, and the damaging effects of opium will spread over the global population. Although regional control of opium at the consumption end of the market has some effect on supply, it can only be reduced effectively if targeted at source.