Wednesday, January 11, 2006

The Economic Theory of Illegal Goods

How elasticity affects the market for illegal goods

In an important new study, world-renowned economists--including a Nobel Prize winner and a MacArthur "genius"--argue that when demand for a good is inelastic, the cost of making consumption illegal exceeds the gain. Their forthcoming paper in the Journal of Political Economy is a definitive explanation of the economics of illegal goods and a thoughtful explication of the costs of enforcement.

The authors demonstrate how the elasticity of demand is crucial to understanding the effects of punishment on suppliers.
Enforcement raises costs for suppliers, who must respond to the risk of imprisonment and other punishments. This cost is passed on to the consumer, which induces lower consumption when demand is relatively elastic.
However, in the case of illegal goods like drugs--where demand seems inelastic--higher prices lead not to less use, but to an increase in total spending.

In the case of drugs, then, the authors argue that excise taxes and persuasive techniques –such as advertising--are far more effective uses of enforcement expenditures.

"This analysis…helps us understand why the War on Drugs has been so difficult to win…why efforts to reduce the supply of drugs leads to violence and greater power to street gangs and drug cartels," conclude the authors. "The answer lies in the basic theory of enforcement developed in this paper."

How elasticity affects the market for illegal goods


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