Monday, July 11, 2005

L&S: Prohibition Economics

At another event in a couple of weeks, I’ll be doing a presentation on the economics of prohibition. Researching the topic has caused me to doubt one of the traditional arguments for legalization, at least as it’s usually presented. (Just to be clear, I don’t doubt the wisdom of legalization in general. I have doubts about one specific argument.)

Stossel and others often make the following claim: drug prohibition restricts supply, drives up profits in the drug industry, and there high profits encourage violence. Now, a restriction in supply should drive up prices, but it doesn’t follow that profits will also rise. The supply curve represents costs of production, including costs associated with the risk of legal punishment and eradication of one’s product. To the extent that prohibition reduces supply, the reduction occurs because of a rise in (expected) costs, which means profits need not rise at all.

Indeed, if there are low barriers to entry into the drug industry – as appears to be the case – producers should continue to enter until they drive (expected) profits down to near-zero.

I suspect the reality is that ex ante profits in the drug industry are not very high. But many of the costs are actually expected costs, which result from the risk of punishment or product eradication. As a result, ex post profits exhibit high variance. The luckier, or perhaps cleverer, producers reap large profits because they haven’t gotten caught (much). The unluckier producers actually make losses, especially once you factor in lost life and liberty. Overall, the industry is not high profit, but high-risk high-return.

The connection to violence is also tenuous. Even if you buy the argument that prohibition inflates profits, high profits don’t generally breed violence in other markets. To explain the violence of drug markets, we must appeal to a different (and much stronger) pro-legalization argument: that illicit markets have to provide their own contract enforcement because they cannot rely on courts of law. Or, to put it simply, they have to hire thugs to beat up people who break their promises or fail to pay their bills.

6 comments:

Anonymous said...

I would think, though, that the dangerous nature of drug dealership would require some pretty hefty incentive, such as high profits, or all those drug dealers would move to safer and more legal alternatives, like selling shoes or vacuum cleaners.

Getting shot isn't really the kind of cost that can be amortized over a length of time.

Also, dealers are highly (and often violently) monopolistic, and their customers are physically addicted to their product, both suggesting that prices could raise as high as a typical customer could regularly pay.

While the wholesale price of an ounce of cocaine might go up because of the difficulty of growing, refining, and smuggling it, the retail price of that bag can be raised virtually without limit.

(Note: I'm neither a drug dealer or a drug user, so what I've just said may be completely and totally crap)

Gil said...

But doesn't the fact that the trade is illegal encourage current producers to violently prevent others from entering the market? Living victims are unlikely to go to the police, and dead ones aren't considered as high a priority as innocent victims outside of the illicit market.

Seems like a high barrier to entry to me.

And of course there are the many other costs like corruption, pressure to reduce civil liberties, users driven to crime (often violent) to support a habit made more expensive because of prohibition, resources allocated to prohibition that could be used to capture and incarcerate more violent criminals, etc.

Anonymous said...

It's a difficult question because the costs associated with illegal activity (violence and prison) are extremely subjective and vary from person to person. I would suggest that profits in the illegal drug trade are effectively high because the individuals who engage in it are of a small minority of the population that place low values on those costs.

-XLM

Glen Whitman said...

"I would think, though, that the dangerous nature of drug dealership would require some pretty hefty incentive, such as high profits, or all those drug dealers would move to safer and more legal alternatives, like selling shoes or vacuum cleaners."

The danger associated with the drug trade is part of the *cost* of that trade. So higher *revenues* are needed to justify those higher costs. But when both revenues and costs are high, profits can still be low.

However, XLM is right that these high costs of illicit business -- i.e., possible loss of life and liberty -- are highly subjective and don't usually get stated in monetary form. As a result, the *accounting* profits associated with the drug trade are probably large indeed, because accounting profits don't take into account such subjective costs. However, I still contend the *economic* profit (which accounts for all implicit costs) is probably not that high.

Gil -- yes, it's true that in an illicit business the marginal cost of using violence against your competitors is low (because you're already working outside the law anyway). However, the evidence seems to indicate that any reduction in competition tends to be ephemeral. When Pablo Escobar gets killed, a new drug operation springs up to fill his shoes. Any especially high profits are a temporary phenomenon.

Ken said...

"Gil -- yes, it's true that in an illicit business the marginal cost of using violence against your competitors is low (because you're already working outside the law anyway). However, the evidence seems to indicate that any reduction in competition tends to be ephemeral. When Pablo Escobar gets killed, a new drug operation springs up to fill his shoes. Any especially high profits are a temporary phenomenon."

But the marginal cost of your competitors using violence against you is also low, which means that all competitors in the field are (a) selected for being unusually willing to employ violence and (b) operating in an environment where all his competitors are unusually willing to employ violence against him. Both of these factors tend to encourage lots of violence.

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