David R. Henderson  

The Economics of Illegal Drugs

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WSJ article gets a lot right and a little wrong.

A recent article by David Luhnow in the Wall Street Journal, "Saving Mexico," contains a lot of good economic analysis of the market for illegal drugs, as well as a few statements that a completely economically literate writer would not have made. Dealing with the whole article in depth would take an article in itself, so I'll just hit some highlights.

First, what journalists call the dec (sp?) line, the line after the title that tells the gist of the article, doesn't do justice to the article. The dec line is:

To weaken the cartels, some argue the U.S. should legalize marijuana, let cocaine pass through the Caribbean and take the profit motive out of the drug trade.
It's that last part, "take the profit motive out of the drug trade," that is incorrect and, fortunately, the author doesn't make that mistake, although he comes close.

The gist of the article is that if the U.S. were to legalize not only possession, but production and sale, of marijuana, the demand for drugs from Mexico would fall, assuming that all the currently-illegal drugs from Mexico remain illegal to produce and sell in Mexico.

At first, I thought, that can't be right. Making a drug illegal is like imposing a high tax, most of whose proceeds are eaten up in avoiding the tax. Reduce the huge tax wedge in the U.S. by legalizing it here, and the net demand for drugs increases, which means the net demand for drugs from Mexico increases. Luhnow even quotes Mexican officials saying something similar, writing:

While this strategy may make sense domestically for the U.S., Mexican officials say it is the worst possible outcome for Mexico, because it guarantees demand for the drug by eliminating the risk that if you buy you go to jail. But it keeps the supply chain illegal, ensuring that organized crime will be the drug's supplier.
But as I thought about it, I realized that my one-sentence statement of the argument above is correct: the demand for illegal drugs from Mexico would decline. The reason is simple: the implicit tax in the U.S. would fall to zero. The implicit tax imposed by the Mexican government would stay high. It's as if the U.S. government was imposing both a tariff on imports, a tax on domestic production, and a tax on domestic consumption, and then suddenly ended the tax on domestic production and the tax on domestic consumption. The amount demanded would rise because of the lower tax, but domestic production, suddenly facing a much lighter tax burden, would be advantaged relative to imports. Therefore domestic production would rise, crowding out imports. The net effect on imports is likely to be negative. So, yes, the supply chain in Mexico would be illegal and organized crime would be the supplier, but they would supply less to the United States, the main area of consumption.

What else do I like about the article? A few things. Take this statement:

Because governments make drugs illegal, the risk associated with transporting them translates to high rewards for those willing to take that risk.
That's a nice statement of the idea that the apparent high profits are a return to risk-bearing. David Luhnow, the author, even gives the mark-ups at each level. Unfortunately, he falls into a trap after giving the mark-ups, writing:
With markups like that, the business is bound to keep attracting new entrants, no matter what governments do to stop it.
There's no "bound" about it at all. Whether it attracts new entrants depends on the mark-ups relative to the risk. I think the main reason it attracts new entrants is that the existing producers die, are imprisoned, or make their bundle and retire.

Another thing I like throughout this piece is the author's feel for how markets adjust to new laws. For example:

Governments also have a hard time stopping the drugs trade because, like any good business, trafficking organizations innovate and adapt. Mexican customs has stumbled upon a long list of ingenious methods to transport cocaine, including one shipment of liquefied cocaine smuggled in red wine bottles. Another recent bust yielded 800 kilos of cocaine--worth an estimated $40 million--stuffed inside a batch of frozen sharks.

After Mexico restricted the importation of pseudoephedrine to slow the manufacture of methamphetamines, drug gangs found another way to make the drug using different, unrestricted chemicals widely used in the perfume industry. "I've always thought these guys had a good research and development arm," says one exasperated Mexican official.


This reminds me of some of the best business reporting I've read in the 37 years I've been reading the Journal regularly.

Two final highlights:

Marijuana is also less risky to a drug gang's balance sheet. If a cocaine shipment is seized, the Mexican gang has to write off the expected profits from the shipment and the cost of paying Colombian suppliers, meaning they lose twice. But because gangs here grow their own marijuana, it's easier to absorb the losses from a seizure. Cartels also own the land where the marijuana is grown, meaning they can cheaply grow more supply rather than have to fork over more money to the Colombians for the next shipment of cocaine.
This is what I call the "I wish I owned a candy store because then I could eat all the candy I want" fallacy. I believed in this fallacy when I was six. I don't now. There is one possible little bit of truth here. One could argue that a particularly risky part of the business is transacting and that, therefore, vertical integration is cheaper. But there must be limits to this argument: otherwise, the whole industry would be vertically integrated.

Finally and disturbingly:

A new 2% tax on cash deposits greater than $1,250 in bank accounts gives tax authorities a better picture of Mexico's cash economy--the currency of the drugs trade.
Wow, talk about seigniorage!

Comments and Sharing


CATEGORIES: Regulation , Taxation



COMMENTS (25 to date)
Alex J. writes:

Taxing bank deposits would make people take their money out of banks. This would give authorities a worse picture of Mexico's economy.

Robert Speirs writes:

Legalizing marijuana and other drugs may not increase demand. Demand doesn't increase steadily upward. It levels off somewhere. It's possible everybody who wants drugs has as much as they want right now. So legalizing wouldn't raise demand at all. It's even possible that the illegality of drugs makes using them more attractive and legalization would lead to a drop in demand. OK, maybe that's not likely, but it is possible.

Mr. Econotarian writes:

Prohibited drug violence comes from the lack of legal means of signaling for competition, combined with an inability of its participants to obtain the public good of law enforcement.

The lack of signaling is what drives competition by territory, rather than having competing multiple modes through advertising.

Then the lack of law enforcement access allows the territory to be decided by violence, rather than traditional means.

TomB writes:

The effect on total demand is largely irrelevant(or quantity demanded). Even if you legalized production in both countries, the undesirable components of the cartels will lose. If production is legal, cartels have less need for huge armies, smugglers, and street gangs. Those functions will be taken up by contracts/courts, the shipping industry, and retailers and sales distributors. Maybe the people running the cartels are just ruthless, but I suspect that they are mostly just avaricious and ambitious.

If you just legalized production in the U.S., I would guess that most companies would use reputable sources. Especially if it was still a crime to import drugs made in a country where production remained illegal. You may still be able to buy some Mexican drugs on the street, but as long as some low priced, legal drugs were available people will likely buy those.

Steve Sailer writes:

If we legalized cocaine, what would Costco charge for a quarter kilo of 100% pure cocaine?

$99.99?

How much more business would emergency rooms get if everybody with a Ben Franklin could party like Tony Montana?

Josh Weil writes:

Robert Speirs,

It's best to think about demand for a good as a downward sloping relationship between price and quantity. If drugs are legalized, prices will fall, and quantity consumed will almost assuredly increase. The vast majority of drugs users don't use drugs because they are illegal and cool.

David,

Could you explain the seigniorage line at the end? I know what seigniorage is (printing money to pay for things) but I can't decipher how it applies here.

Steve writes:

I don't think total legalization is what the article refers to as Mexico's "worst possible outcome." They are referring to the US legalizing consumption but not production. The reasoning then would be that demand is increased in the US by a greater margin than would be supply, thus making the drug trade through Mexico even more lucrative.


From the article:

"Several U.S. states like California and Oregon have decriminalized marijuana, making possession of small quantities a misdemeanor, like a parking ticket. Decriminalization falls short of legalization because the sale and distribution remain a serious felony. One of the big reasons for the move is to reduce the problem of overcrowded and costly prisons.

While this strategy may make sense domestically for the U.S., Mexican officials say it is the worst possible outcome for Mexico, because it guarantees demand for the drug by eliminating the risk that if you buy you go to jail. But it keeps the supply chain illegal, ensuring that organized crime will be the drug's supplier."

aaron writes:

Why would mexico keep drugs illegal if we legalized them?

Brandon Reinhart writes:

Somewhat related:

http://io9.com/5440883/putting-mutated-enzymes-in-the-water-could-prevent-cocaine-addiction


Douglass Holmes writes:

I believe that marijuana is effectively decriminalized already. Although it is technically illegal to use it, hardly anyone goes to jail for possession. So, Americans keep bidding up the price of drugs, and various players in United States and Mexico supply them. The profits are real because the suppliers develop a work force with the skills to avoid law enforcement.
If we really wanted to make war on drugs, we would have to punish the users as much as we punnish the suppiers. That would make the war on drugs a civil war, with the opposing sides being the millions of users against the law enforcement and non-using community. I don't think that is politically possible. We have effectively shipped the civil war into Mexico.

Jon writes:

Response to Robert Speirs, quoted as follows:

"It's best to think about demand for a good as a downward sloping relationship between price and quantity. If drugs are legalized, prices will fall, and quantity consumed will almost assuredly increase. The vast majority of drugs users don't use drugs because they are illegal and cool."

Depends on how sensitive consumption is to changes in price. In fact, it could be argued that crack cocaine would have an upward sloping demand cuve; that is to say, a Giffen good.

Isn't it true that prices could actually increase? Taxes? Fewer suppliers to pay taxes, etc.?

David R. Henderson writes:

To Josh Weil,
Re seigniorage, you're right. But printing money really amounts to to a tax on money. A tax on bank accounts is just like seigniorage--the main difference being that the treasury, instead of the central bank, collects the tax.
BTW, I looked at your web site and loved the tone and content of your bio.
Best,
David

David R. Henderson writes:

Steve Sailer asks:

How much more business would emergency rooms get if everybody with a Ben Franklin could party like Tony Montana?

I'm guessing that you're asking this rhetorically, Steve. If so, then I think your mistake, which most people who discuss illegal drugs make, is to take examples of what happens when drugs are illegal as if the fact that drugs are illegal has nothing to do with those examples. A better way to get an idea is to look at the evidence from Lester Grinspoon et al on what the U.S. looked like when all those drugs were completely legal.

Best,

David

Richard Works writes:

If all goes as the article states, wouldn't we run into the same problem that we have for other goods with domestic production requiring higher wages than foreign production? If so, imports would increase. What about the product life cycle... domestic production could rule for a while, but would it eventually be that the United States would prefer to import at a cheap rate rather than producing?

wm13 writes:

Alcohol is legal, but, although its legal status has eliminated the gangland violence associated with Prohibition, it has by no means eliminated the medical and legal problems associated with consumption, in terms of emergency room admissions, trafffic fatalities, barroom violence, drunken date rape episodes etc. A legalization of drugs on both the supply and demand side would mean that the production, distribution, and sale would be dominated by cautious, law-abiding businessmen, and the demand side would be populated by a significant number of people with major substance abuse problems.

RL writes:

Wm13: "the demand side would be populated by a significant number of people with major substance abuse problems."

I guess it depends on what you mean by "a significant number". Do you mean a very very small percentage of 330 million people? Then you're right. Do you mean the kind of result "Reefer Madness" warns us about? Then you're wrong.

Jeremy, Alabama writes:

There was an excellent The Economist survey on this, about a decade ago. I was unable to google it up, but you might remember it and be able to find a link.

From memory:
- drug cartels lobby to keep drugs illegal
- profits are so vast they can load up light aircraft and lose 2 out of 3 planes
- they can afford to buy submarines
- each crackdown increases, not decreases, the profits of the cartels
- cartels seek alternative supply routes e.g. if Mexico gets cut off, they go through Carribean, Canada, or wherever necessary
- The Economist came down narrowly in favor of legalization, as they could not imagine any enforcement strategy that did not increase cartel profits.

azmyth writes:

There's an easier way to say what you said in the first paragraph. Trade is founded on comparative advantage. Legalization would give the U.S. a comparative advantage over Mexico in marijuana production, thus we would not import it.

David R. Henderson writes:

Dear azmyth,
Good point about comparative advantage and correct. The reason I didn't do it that way is that there's a third element that doesn't get captured that way, namely the decline of the tax on consumption that, therefore, causes an increase in overall drug consumption. But in future renditions of this argument, your way of saying it will be part of my approach.
Thanks.
David

Josh Weil writes:

David,

Thanks for the compliment. I'm a big fan of your writing so it was very warmly received.

-Josh

wm13 writes:

"I guess it depends on what you mean by "a significant number". Do you mean a very very small percentage of 330 million people? Then you're right. Do you mean the kind of result "Reefer Madness" warns us about? Then you're wrong."

I don't know about "very very small," but I mean small. I would guess around 1%, so there might only be 3.3 million Americans spending the children's food money on cocaine, something like that. Although, since, in my experience, cocaine is significantly more addictive and more debilitating than alcohol, it might be more like 3 or 4%.

Josh Weil writes:

Wm,

if cocaine was legal, prices would be significantly lower and poorer people would spend a smaller percentage of their income on drugs. Illegality is a regressive tax. Moreover, I think it's kind of unfair to assume poor people will make the choices you assume they will make. Some might, but no more than do already.

David R. Henderson writes:

wm13,
I think Josh Weil nicely handled the part about expenditures, but I don't understand your point about how based on your experience, the percent would be more like 3 or 4. I'm not trying to be catty and probe and try to catch you admitting that you break a law. Rather, I'm making the point I made in response to Steve Sailer: it's very hard to use directly, without adjustments for illegality, evidence from an era of illegality to predict what would happen in an era of legality.
Best,
David

wm13 writes:

Well, Mr. Henderson, there's always the statute of limitations to consider.

In any case, I'm not talking about my personal experience in the sense of personal substance abuse: I graduated from college and law school more or less in due course, and I have never lost a job. But not all my preppie/Ivy/yuppie friends could say the same. Cocaine is highly addictive, more addictive and more psychologically destructive than alcohol, and a significant number of people can't handle it.

As to expenditure, if the cost were one-tenth as much, wouldn't people use it ten times as much? And I don't think we should discount the effect of social stigma and the threat of legal punishment in deterring some number of current potential users.

Steve in San Jose, CA writes:

One component left out of this discussion is the US domestic production of Marijuana by Mexican drug cartel employees (most of them here in the US illegally). If domestic production is legalized, I would expect more cartel money and employees coming over the border and being used to produce drugs here in the US. Thus the cartels continue to profit, regardless of the new geographic tariff structure.

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