Alchian–Allen effect

{{Short description|Per-unit costs favor high-grade goods}}

The Alchian–Allen effect was described in 1964 by Armen Alchian and William R Allen in the book University Economics (now called Exchange and Production{{cite book |author=Alchian, Armen Albert |title=Exchange & production: competition, coordination & control |publisher=Wadsworth Pub. Co |location=Belmont, CA |year=1983 |isbn=0-534-01320-1 |url-access=registration |url=https://archive.org/details/exchangeproducti00alch }}). It states that when the prices of two substitute goods, such as high and low grades of the same product, are both increased by a fixed per-unit amount such as a transportation cost or a lump-sum tax, consumption will shift toward the higher-grade product. This is because the added per-unit amount decreases the relative price of the higher-grade product.

Suppose, for example, that high-grade coffee beans are $3/pound and low-grade beans $1.50/pound; in this example, high-grade beans cost twice as much as low-grade beans. If a per-pound international shipping cost of $1 is added, the effective prices are now $4 and $2.50: High-grade beans now cost only 1.6 times as much as low-grade beans. This reduced ratio of difference will induce distant coffee-buyers to now choose a higher ratio of high-to-low grade beans than local coffee-buyers.

Another example is that the effect would predict that Australians drink higher-quality Californian wine than Californians, and vice versa, because it is only worth the transportation costs for the most expensive wine.{{cite web|url=https://www.ft.com/content/87b47d38-79f8-11db-8d70-0000779e2340|title=Dear Economist - Financial Times|date=24 November 2006}}

The effect has been studied as it applies to illegal drugs and it has been shown that the potency of marijuana increased in response to higher enforcement budgets,{{cite journal |first=Mark |last=Thornton |title=The Potency of Illegal Drugs |journal=Journal of Drug Issues |volume=28 |issue=3 |year=1998 |pages=725–740 |doi=10.1177/002204269802800309 |issn=0022-0426 }} and there was a similar effect for alcohol in the U.S. during Prohibition.{{cite book |first=Mark |last=Thornton |url=http://mises.org/books/prohibition.pdf |title=The Economics of Prohibition |location=Salt Lake City, UT |publisher=University of Utah Press |year=1991 }} This effect is called iron law of prohibition.

Colloquially, the Alchian–Allen theorem is also known as the “shipping the good apples out” theorem (Thomas Borcherding),{{cite journal |title=Shipping the Good Apples Out: The Alchian and Allen Theorem Reconsidered |first1=Thomas E. |last1=Borcherding |first2=Eugene |last2=Silberberg |journal=Journal of Political Economy |volume=86 |issue=1 |year=1978 |pages=131–138 |jstor=1828763 |doi=10.1086/260651}} or as the “third law of demand.”{{cite journal |doi=10.1093/ei/cbg008 |title=On the Third Law of Demand |first1=Laura |last1=Razzolini |first2=William F. II |last2=Shughart |first3=Robert D. |last3=Tollison |journal=Economic Inquiry |volume=41 |issue=2 |pages=292–298 |year=2003 }}