High and dry?

Illegal drugs cause many social problems, but so does war on drugs. One radical economic theory suggests that reducing penalities for low-purity drug selllers could raise the price of drugs and effectively undermine the market.

The market for illicit drugs is seen as the cause of many social ills. The trade in illicit drugs gives rise to an underground economy that generates addiction, crime, and violence. In less affluent and minority communities, the drug economy crowds out the incentives to join the formal sector and raises incarceration rates. In an effort to counter these trends, massive amounts of resources are devoted to interfering with the drugs market – the so-called 'war on drugs'. The emphasis of the war on drugs is on tougher penalties and more law enforcement. In fact, there is little evidence that recent efforts to increase penalties and law enforcement have measurably reduced the availability of drugs. On the other hand, the prison population convicted of drug-related crimes has skyrocketed. (In the US, for example, the prices per pure gram of cocaine and heroin have declined substantially during the periods when budgets on law enforcement rose and penalties increased. At the same time, in the period 1981-2003 the prison population convicted of drug-related crimes has shot up ninefold.)

Partly in response to these twin failures, some quarters (including, prominently, the Economist magazine) have advocated liberalisation. Becker et al. (2006), for instance, state the argument in favour of liberalisation as follows. Penalties and enforcement aim to decrease consumption by raising the unit cost of producing/distributing the drugs, and thus ultimately the price faced by consumers. Whereas such interdiction is costly to enact and to evade, taxes could be levied at low administrative cost. Therefore, drugs should be regulated by taxes rather than interdiction. Of course, this argument works to the extent that the government has the power to tax 'legalised' drug sellers without driving them underground. Realistically, even in a world with legalised drugs there would be 'illegal' (i.e., tax-evading) drug sellers, thus limiting the efficacy of taxes as regulatory instruments. (The case of tobacco in Britain is instructive. In response to high duties on tobacco in the UK, a large underground market developed reaching 20 per cent of total tobacco expenditure between 1995 and 1999. See Cullum and Pissarides (2004).)

California Governor Arnold Schwarzenegger recently kicked off a debate on the legalisation of marijuana – though, admittedly, as a measure to deal with the California budget crisis. The position of the current US administration has not yet fully emerged. On the one hand, President Obama pledges 'full partnership' in Mexico’s war against the drug cartels. On the other hand, the background of the recently nominated 'drug czar' portends an emphasis on decriminalisation (Johnson and Goldstein 2009).

In a recent working paper (Galenianos et. al. 2009), we argue that the dichotomy between war on drugs and decriminalisation may be a false one – a carefully designed scheme of penalty reduction can, surprisingly, interfere with the functioning of the drugs market.

Understanding the drugs market

Currently, we think of illicit drug markets as centralised markets, in which the usual demand and supply curves meet and form a market-clearing price. But this view fails to account for some key economic forces that shape the retail drugs market. The first, and most important, is that retail transactions for illegal drugs are subject to significant moral hazard. What we mean is that the seller can covertly dilute ('cut') the product, and this dilution is largely unobservable to buyers until after they consume. The following table, which is based on data from undercover Drug Enforcement Administration (DEA) purchases, shows that moral hazard is indeed present in this market. The table documents an extreme instance of the moral hazard – the rip-off, a transaction in which the buyer is sold essentially zero-purity drugs. A significant fraction of "street-level” transactions are seen to be total rip-offs. Most important, the price paid in a rip-off is not appreciably different from that of a non-rip-off transaction, suggesting that buyers cannot observe dilution.

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