Survey of Early Economic Literature on Drug Laws

Economic analysis of drug laws emphasizes the concept of deterrence. Rottenberg (1968) is the first thorough treatment of the illegal drug trade from a positive economic perspective. He details the relationship between the clandestine nature of the market and the structure of the distribution networks for various types of drugs. From the standpoint of the allocation of law enforcement resources, he lists two major considerations of the heroin market. First, the heroin trade is a monopoly run by organized crime. Like other monopolies, organized crime will maximize its profit by reducing the output available and raising the price ofheroin. Second, the source of income for many heroin purchasers is theft.

Taking into account the first point, police can reduce the size of the heroin trade by allocating more resources to discouraging the entry of new suppliers, relative to apprehending the incumbent producers. This will re-enforce the market power of the existing distribution system and keep the extent of the industry small. However, the second point implies that a smaller industry with a high heroin price will result in more crime, a cost to the community which must be accounted for if the optimal law enforcement strategy is to be managed.

Eatherly (1974) also approaches the drug market from the perspective of optimal law-enforcement policy. Eatherly argues that law-enforcement strategy which emphasizes arrest and punishment of sellers, is less likely to be effective than a policy of arresting and prosecuting drug users. He points out that drug laws are similar to sales taxes, with the relative burden of the tax falling most heavily on that side of the market where price elasticity is lowest. Presumably in the drug trade, price elasticity of demand is very low (potentially perfectly inelastic) and that of supply is very high. This would mean that placing penalties on producers would yield less deterrent value per dollar of law enforcement expenditure than what would be achieved by placing penalties on demanders. Furthermore, he notes that sellers are probably more adept at avoiding the law (because of lower information costs and specialization) than are the buyers.

The questions raised by these early studies lead to inquiry into the price elasticity of demand for illegal drugs. If the elasticity of demand is small, then drug law enforcement greatly increases the price of these drugs and unfortunately also increases crimes which are collateral with drug-consumption income. Works analyzing the elasticity of demand for drugs include Nisbet & Firouz (1972), Clague (1973), Moore (1973), and White & Luksetich (1983) A somewhat related literature explores the connection between drug consumption and crime (see Blair & Vogel (1973), Levine et al (1976), Silverman & Spruill (1977), and Roumasset & Hadreas (1977).

Problems with the Deterrence Model

Drug use is thought to be associated with negative externalities which consumers "spillover" onto society in general. These drug consumption:related damages may include endangering the personal safety of others through public intoxication, proliferation of demand among minors, and reduction of user productivity and social responsibility. Again, the early economic literature on drug laws emphasizes the deterrent effect of prohibitionary laws on consumption in the market. Drug prohibition is treated as an excise tax which raises the price of the item and thereby discourages consumption. These analyses are all consistent with the economics of crime as detailed by Becker 1968.

However, there is an implicit normative element to analysis which proceeds from the assumption that government policy should attempt to suppress the drug market. Such work is positive from the standpoint of the policy maker who is attempting to reduce the drug trade to a minimum subject to the constraints of budget, price elasticities, and the market power of organized crime. Yet, such an optimum policy approach ignores the voluntary nature of exchange in the drug market. Analysis which treats drug consumers as "addicts" who will pay any price for their product (including entering into criminal activities), runs the risk of neglecting to consider the reduction in welfare of the demanders and of society in general which result from prohibition itself.

The allure of the popular, medical model of addiction distracts attention away from the fact that the illegal drug trade is fundamentally a market wherein both suppliers and demanders are seeking to maximize their utility subject to the prevailing price. A positive cost/benefit analysis of drug prohibition must also include the consequences of the government's choice of prohibition over explicit excise taxes as a means of reducing trade in the drug market. There are two principal criticisms of strict prohibition suggested by economic theory, i.e. (1) prohibition itself creates social costs which may be more burdensome to society than the drug consumption-related behavior which the law attempts to discourage, and (2) the overall deterrent effect of prohibition-induced price increases in illegal drugs is dominated by the income elasticity of demand for such items.

There is a body of economic literature that recognizes the social costs of the drug laws themselves. Friedman 1972, 1989 is the best known economist who provides positive arguments that the prohibitionary cure is worse than the narcotic disease. Miller, Benjamin '& North 1990 provide a simple cost/benefit analysis suggesting that the benefits of reducing drug use in society must be compared with the costs associated from undesirable side-effects which result from outlawing such goods. Although their work suffers from their use of the assumption that drugs are inelasticly demanded, they observe that property crime will rise with the price of drugs, that the huge profits involved in the illegal trade threaten to increase police corruption, and that violent crime over market territories will result from competition that is not subject to the restrictions of civil and criminal law within which ordinary, aboveground business must operate. Zinberg & Robertson (1972) is the essential early description of the costs to society of the drug laws themselves.

Using the cocaine trade as an example, Wisotsky (1986) provides a supply and demand analysis of drug prohibition as an excise tax. Wisotsky asserts that increased efforts at interdiction of imports from foreign countries raises the price of cocaine, but because of consistent domestic demand, the result is heightened profit opportunities which create a more professional (and dangerous) response from the industry. In addition to the increased incidence of violent crime and police corruption, he argues that the erosion of civil liberties, the creation of narco-terrorist groups, and the handicapping of U.S. foreign policy should also be included in the accounting of the social costs of prohibition. Carpenter 1985 details the problems that law enforcement initiatives to decrease overseas production have caused for U.S. foreign relations.

Barnett (1987) also provides a listing of social costs which follow from prohibitionary policy. From the standpoint of the demander, prohibition not only increases the price, but also reduces the control of product quality, fosters the creation of new drugs or the invention of dangerous combinations of the traditional drugs of abuse, and causes otherwise law-abiding citizens to associate with professional, organized criminals in order to secure supplies of the preferred product. Several general histories of the campaign of drug prohibition which document the accompanying sacrifices of civil liberty made by U.S. citizens in recent times have been written by Trebach (1978, 1982, 1987). For humorous critiques of drug prohibition the reader might see Block (1976) or Hoffman & Silvers (1987).

To this extensive list of problems derived from a prohibitionary approach to drug consumption must be added several other important considerations. Prohibition of drug consumption does not end demand, but only drives it underground. The result is that the development of social norms and institutions for controlling drug-related anti-social behaviors is retarded. Alcohol consumption obviously offers society problems similar to drug use. The American experiment with the 18th Amendment ended in 1933, with a system of liquor licensing and consumption-level laws which are able to allow this trade to continue without serious harm to society. Many of the disruptive and dangerous aspects of public drug use could be minimized within an above-ground market by allowing for designated areas for drug consumption within which demanders would assume full liability for criminal behaviors. As long as many popular drugs are illegal, a system of social conventions and regulated public markets (i.e. bars) cannot evolve. The result is that consumption continues, but in a fashion that is completely hidden until actual spillover damages have occurred.

Lastly, it is important to consider what is, for this author, potentially the most serious social cost of prohibition. Prohibition of drug consumption has created a political atmosphere in which most significant social problems are blamed on the consumption of narcotics. Drug use obviously causes problems for users and the people around them, but drug abuse has become a "panopathagen" to use the phrase of Szasz (1974), that is, drugs are portrayed as the cause of every social malady. One of the fundamental negative by-products of drug prohibition is a diversion of attention away from more profound social problems. The underlying causes of drug abuse, such as poverty, illiteracy, and psychological dysfunctions, are ignored. Social policy exhibits a tendency to look for quick-fix, short-run solutions to the deepest social problems. Thus, one of the most important costs of the prohibitionary approach is that it directs government policy to treat the symptoms, but not the causes, of social problems.

Rent-Seeking Model of Prohibitionary Laws

This section details a comparative static welfare analysis of prohibition (see Figure 1). First it is assumed that there is a supply and demand for the outlawed drugs. The demand curve for drugs (DD) reflects the marginal evaluation of the consumers for different quantities of the good, which is their willingness to pay for drugs. The supply of drugs represents the willingness of the producers to accept money in exchange for various quantities of drugs. The supply curve (SS) shows the costs of production of drugs if the trade is fully legal. Therefore SS represents only the legitimate agricultural, distributional, and marketing costs necessary to induce the allocation of valuable factors of production into this industry, but does not include the resources required to evade law enforcement officials.

The point of equilibrium in the drug market in the absence of legal restriction is for the market to trade the quantity Q*, which is sold at the market-clearing price of P*. Prohibition introduces police interdiction in market transactions which has the effect of increasing the costs of production. In the face of legal restrictions, suppliers must cover additional costs of evading law enforcement authorities and securing legal council. Prohibition raises the price of drugs to PT, a price which is greater than the equilibrium price, and thus has the effect of reducing the quantity which demanders will finally purchase to QT. Effectively the supply curve becomes vertical at QT. Prohibition increases the cost of production by the amount E, which is the effective excise tax per unit that the law imposes on the market. Just how much smaller QT is than Q* depends on the relative price elasticities of demand and supply. Other things equal, if the price elasticity of demand for drugs is low (relatively inelastic), then even a large increase in the price of drugs will not result in a very large reduction in the after-tax quantity.

Popular welfare analysis largely ends at this point. Drug use is asserted to have negative external effects on society and prohibition acts as a corrective tax, enhancing the welfare of society by reducing the quantity of drugs being consumed, and hence reducing negative "spillover" effects on other persons that result from drug consumption. Economists however, also recognize that prohibition itself has social costs.

Following Tullock (1967, 1980), the monopolization of the drug trade by organized crime, which results from law enforcement, acts to create monopoly rents which are themselves an inducement to new entrants. The total economic value of these rents is shown as the shaded area of Figure 1 and is the product of the effective tax per unit which results from prohibition multiplied by the after-tax quantity. In addition, there would be the loss of value associated with foregone profit opportunities suggested by Harberger (1954), which is the deadweight loss caused by prohibition.

Careful consideration of prohibitionary policy leads to the conclusion that law enforcement efforts make possible the monopolization of the trade by organized crime. Regardless of the elasticity of demand, on the supply side of the market the incidence of prohibitionary laws falls, by definition, on the most marginal of suppliers, driving them out of the trade and raising the market-clearing price of the commodities outlawed. The rise in prices creates political rents (artificial quasi-rents or super-normal profits) to suppliers who can successfully avoid (or buy off) the law and continue to remain in the trade. The existence of monopoly rents gives rise to the incentives which make it profitable for the existing suppliers to organize themselves into a trade association to restrict new entrants into the industry.

Prohibition therefore makes possible the monopolization of the supply by organized crime. Professional criminals who already specialize in theft and extortion, and who are thus already outside the jurisdiction of the law, become the beneficiaries of prohibitionary laws. These criminal elements have already undertaken many of the organizational costs and have acquired many of the skills for avoiding the police which would give them an advantage in clandestine competition in the drug trade. Importantly, drug laws do not really reduce competition in the drug trade, but merely drive it underground. Instead of taking the form of price cutting and brand-name advertising which competition usually has in other types of markets, competition between suppliers in illegal markets becomes a matter of eliminating new entrants and discouraging potential entry by means of violence.

As noted, many economists have characterized the potential for drugs laws to increase crime and violence among demanders. This emphasis stems from an implicit assumption that the price elasticity of demand for drugs is very low. However, the crime and violence engendered by rival underground suppliers is at least as important. Turf wars and terrorism designed to discourage competition also create negative criminal externalities which impose costs on society. The potentially large monopoly profits to be earned by suppliers in the illegal drug trade gives rise to violence with which the community must live. The resources which the community expends to guard itself against this violence may be much larger than the external damages caused by drug consumption in the first instance.

These social costs could be avoided if the drug trade were legal. An excise tax equal to E would also increase the cost of production, raise the price to PT, and reduce the market-clearing quantity to QT The supply curve with an excise tax becomes TT. An excise tax therefore has the same potential to reduce the final quantity traded in the market as does prohibition. The difference would be that unlike prohibition, where the monopoly profits accrue to underground suppliers who continue to operate after the law is in place, with an excise tax the rents would accrue to the government in the form of sales tax revenue. Not only would the violent competition between suppliers be eliminated, but the tax revenue could be distributed between those persons in society who have been damaged by the behaviors of drug consumers.

The problem with prohibition is that it only benefits those third parties damaged by drug consumption indirectly, by reducing consumption. The rent-seeking model suggests that prohibition creates other types of externalities which are perhaps even more damaging than those externalities which the law proposes to eliminate. The indirect benefits created by driving the trade underground may be more than offset by the externalities created by the intensified rent-seeking competition between suppliers. With an excise tax, the revenue collected could be used to directly compensate persons harmed by drug users. With prohibition, society must hope that legal restrictions will prevent the externalities from consumption from occurring and that they will not be damaged by spillover violence from heightened supplier competition.

Finally, this analysis of the social costs which underground competitors inflict on society applies regardless of conclusions about the relative price elasticity of demand. Obviously, if demand is very inelastic then the potential profits of organized criminals and independents who are able to evade the police are greater than if demand is elastic. But the idea that law enforcement creates a windfall profit for suppliers holds unless demand is perfectly elastic. In fact, the presumed lack of available substitutes in the prefer-
ence orderings of drug demanders, itself is a positive incentive for a consumer to become part of the clandestine supply network.

Drugs as Inferior Goods

Because of its underground nature, it is difficult to collect data on the connection between income level and drug consumption. Nonetheless, the Federal Bureau of Investigation collects statistics on arrests by age, race and gender. Data on the arrest rate of blacks may provide a proxy for the relative frequency of drug consumption among the poor see (Table 1). The 1988 median income of black families is only 60 percent of that of all American families. In 1988 blacks comprised 12.3 percent of the United States population, and yet were 39.6 percent of the arrests for drug abuse violations. The proportion of blacks in the total population and their percentage representation in drug arrests from 1965 to 1989 is plotted in (Figure 2). At no time is the arrest percentage rate less than the black proportion in the population. Although not diréct evidence, it seems clear that blacks as a socio-economic group have both a low income and a high incidence of drug market involvement.

Here there seems to be an implicit normative element to prohibitionary policy. Although drug laws single out for prosecution only those who use and provide drugs, and do not explicitly target blacks, from the standpoint of a positive economic analysis, for low income blacks the result is the same. Many low income people are involved as consumers and producers in the illegal drug trade, and due to the high correlation between lower income and blacks as a demographic group, the prohibitionary drug laws which target drug market participants consequently also target blacks to a much greater degree than their proportional representation in the population. Treated as an excise tax, prohibition is doubly regressive since it not only "charges" a higher tax as a proportion of income (as do all sales taxes), but it falls on a consumer group which is already relatively lower income to begin with. Drug laws may therefore have some role in controlling the proletarian elements of society as suggested in the class welfare analysis of Fernandez (1973).

What is implied in the relationship between poverty and drug consumption is that drugs are an inferior good. The assertion of this paper is that prohibitionary drug laws have little ability to deter drug consumption because the consumers as a socioeconomic group are largely poor people. While it does make sense to treat prohibition as a type of excise tax which seeks to reduce consumption by raising the price of illegal drugs, the income effect of price changes cannot be neglected if the effectiveness of this social policy is to be evaluated. Prohibition produces perverse deterrent results in the face of a backward-bending income consumption curve. Drug laws have not produced the desired deterrent effect because the tax falls on groups which react to the reduction in their income fostered by the prohibitionary excise by actually increasing the quantity of drugs consumed!

If drugs demanded in illegal markets are strongly inferior goods, this suggests that the negative substitution effect on consumption of prohibition is outweighed by a positive income effect. It would seem relatively clear that the poorer the demographic group or area under consideration, the more likely it is that the underground drug trade offers significant attractions to persons both as consumers and producers.

From the policymaker's standpoint, prohibitionary laws will probably have little effect in deterring drug use unless such policies are also accompanied by relatively large transfers of income to those who would otherwise remain participants in the underground drug market. In other words, if drugs are inferior goods, the best anti-drug policies are those which aim to increase the incomes of potential drug users who are from low-income groups. Increasing the income-earning and consumption possibilities in poor neighborhoods would reduce the demand for drugs indirectly, but nevertheless more effectively, than direct prohibitory law enforcement.

Conclusion

The deterrent effect of laws prohibiting the marketing of a certain good is reduced if the good is an inferior good to the consumer. Drug laws have little deterrent effect because drugs are strongly inferior goods. Analyzed as an excise tax, a prohibition increases drug prices which, in terms of only the substitution effect, does reduce the quantity demanded. In the case of drugs, this effect is offset by the inferior income effect. The difficulty which prohibition has in reducing drug use is usually attributed to low price elasticity of demand, but is actually the result of a low or even negative income elasticity of demand. Prohibitionary laws do little to reduce drug use in society overall and probably have the opposite effect in low-income communities.

The strict prohibition of drugs is sub-optimal from the standpoint of social welfare. Prohibition is rationalized as enhancing the welfare of society by acting as a corrective tax, to reduce the damages which drug users cause to other parties. This fails to account for the external damages caused by the drug laws themselves. Prohibition creates a barrier to entry, increasing price, and creating huge profits for producers who can meet consumer demand. Rent-seeking behavior ensues which, because it is outside the normal jurisdiction of the civil law, often involves violent criminal actions with negative "spillovers" to third parties in society that are far more damaging than the negative externalities of drug use. Social welfare is also reduced because the value of the resources devoted both to enforcing the laws and in evading the enforcement, is greater than the economic value of the rents created by prohibition. A Pareto-superior position for legal agencies, beyond prohibition, would be as reducers of transactions costs where, in a Coasian (1960) fashion, drug users could merely pay third parties for spillover damages from their consumption behavior.

In summary, the economic approach to drug law largely focuses on the use of prohibition to deter consumption. While there may be benefits to reducing drug consumption, a complete analysis must also account for the social costs which arise from prohibition. One important caveat to the government's anti-drug policy is that prohibition probably backfires in poor neighborhoods and may actually increase the amount of drugs being used by youths and minorities. Finally, prohibition has nothing to recommend itself over a sales tax from a positive economic perspective.

Frederick J. Oerther is an assistant professor of economics at Greensboro College.

815 W. Market St., Greensboro, N.C. 27401.

References

Bibliography furnished by author upon request.