The Economics of Drug Prohibition

Steve Finlay

MBA ’91 (SFU)Dean’s Medal Winner

The Economics of Drug Prohibition

• Principles of economics

• What “prohibition” means

• The predictions of economics

The black market

What suppliers will do

What customers will do

What law enforcers will do

What others will do

• Quantifying the impacts

Principles of Economics

• Economics is not about what people should do; it is about what they probably will do

• People will voluntarily trade with each other if, and only if, at least one party believes itself to be better off as a result of the trade, and no party believes itself to be worse off (Pareto optimality)

• Given a stable currency, voluntary trading and full information, prices reflect (a) how much something is wanted by how many buyers; and (b) how difficult, costly and risky it is for sellers to produce it

• If there is an opportunity to make a profit, some people will take it. If the profits are greater, more people will take the opportunity.

Principles of Economics

• Risky profits are less attractive. Therefore, a risky business must offer higher profits in order to attract suppliers into it.

• “Economic profits” or “rents” are profits that are higher than the level of profit that is needed to keep suppliers in a given business which has a given level of risk.

• Economic profits generally cannot exist unless there are significant and lasting barriers to entry

• The desire to obtain not just profits, but economic profits, may be the most fundamental driver of all business strategies, marketing plans, product innovations – and lobbying efforts

What “Prohibition” Means

• For economic purposes, the most useful definition of prohibition is

The outlawing of a transaction which both the buyerand the seller voluntarily want to execute

• Prohibition is therefore an attempt to stop Pareto-optimal trades (malum prohibitum)

• Laws against such crimes as murder and theft (malum per se) are not “prohibitions”, because the victim of the murder or theft does not voluntarily participate in the transaction

The Predictions of Economics

• When did economists start to suspect that prohibition is not a good idea? Try 1776:

“In the reign of Edward VI, religious zeal prohibited all interest. This prohibition, however, like all others of the same kind, is said to have produced no effect, and probably rather increased than diminished the evil of usury.”

“When the law prohibits interest altogether, it does not prevent it. Many people must borrow, and nobody will lend without such a consideration for the use of their money as is suitable, not only to what can be made by the use of it, but to the difficulty and danger of evading the law. The high rate of interest among all Mahometannations is accounted for by M. Montesquieu, not from their poverty, but partly from this, and partly from the difficulty of recovering the money.”

from An Inquiry Into the Nature and Causes of the Wealth of Nations, by Adam Smith

The Black Market

• Because buyers and sellers still want to conduct the transaction that is prohibited, some of them will still do so, regardless of prohibition. This trade is called a “black market”.

• All black markets have three characteristics that are very important economically:– Because the transaction itself is punishable by criminal sanctions,

participation in the market is highly risky

– Legal structures, procedures, or systems cannot be used to resolve disputes

– There is a significant barrier to entry: Only those who are prepared to break the law can become suppliers.

Suppliers in a Black Market

• Profits will be extremely high

– The high level of risk demands high profits; otherwise, suppliers would avoid the business

– Because of the barrier to entry, suppliers will obtain economic profits, over and above the (already high) profit level that is needed to compensate for the risk

• Disputes will be frequent, and will be settled by force

• Suppliers will do whatever it takes to retain and increase their market power

The Black Market for Drugs

• The worldwide black market for drugs generates revenues of about $500 billion per year

• How much money is $500 billion?

Well, I can show you $255 million, in $100 bills

OK, it looks like they have a few Euros as well.

Do you think that people will fight about that much money?

Fighting over $255 million in a legalized market

(Sleeman bought Unibroue. Then who

bought Sleeman?)

Fighting over $255 million in a prohibited market

What is the difference between this picture and the other three?

That is the entire differencebetween legalization and prohibition:

How people fight over the money

Market Danger vs. Product Danger

• The dangers and damage created by the black market far exceed the dangers and damage created by whatever product is prohibited– Which would be more dangerous in Chicago in the 1920s:

Getting between a drunk and his booze, or getting between Al Capone and his money?

– What will happen if enforcement removes a supplier from a black market?

Customers in a Black Market

• Customers are disadvantaged

– Information asymmetry: What are they getting?

– Suppliers have oligopoly or monopoly power

– Suppliers willing to use violence

– No legal recourse

– In the drug market, demand is inelastic

• Low income customers resort to crime

• In the drug market, customers cannot safely seek help from governments or public agencies

Law Enforcers in a Black Market

• Buyers and sellers never “report a crime” to the police. In order to make an arrest, police must spy, entrap, and go undercover.

• If performance and productivity are measured by number of arrests, arresting street users and low level dealers pays off much better than arresting those who commit burglary, assault, rape or murder

• The violence of the black market kills police officers

• Black market suppliers have a motive to try to corrupt the police, and a lot of money to use for this:

Imagine you are a team of Mexican police officers, and you just made the arrest and found this room.

Your salaries are not very high, and are paid in pesos.

What others will do

• Where the black market takes over, law-abiding businesses and citizens will abandon the area

• Predators other than the black market suppliers may take advantage of vulnerable customers

• Where government spends money in order to maintain prohibition, opportunists will pursue these profits regardlessof whether there is any social economic benefit– Private prison operators

– Prison guards’ unions

– Drug testing companies

– Drug “treatment” providers

Quantifying the Impacts

• Total spent by the U.S. since creating the phrase “War On Drugs”: $1 trillion

• U.S. drug enforcement budget, federal ONLY: $20 billion

• Estimated net savings for the U.S. if drug prohibition were ended: $88 billion

• Estimated annual goverment spending in Canada: $2.2 billion (2002)

• Estimated cost to Australian taxpayers and business: $6.7 billion

• Estimated cost to Canadian business: $4.3 billion