Theory of Illegal Goods

I expect that a lot of attention will be given to the recent paper by Becker, Murphy and Grossman, titled The Economic Theory of Illegal Goods: The Case of Drugs. An early draft can be found here [courtesy of Marginal Revolution].

Their claims are striking:

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."

The actual accomplishments are far more modest, and fall short of the grandiose excerpt above in two major ways. First, on p. 20, we see the disclaimer:

An optimal monetary tax on a legal good is still always better than optimal enforcement against an illegal good. The proof assumes that the government can choose optimal punishments for producers who sell in the underground economy, and that demand for the good is not reduced by making the good illegal.

[All emphasis mine.] The second assumption, together with the authors' implicit assumption that the punishments for illegal drug trafficking can be reduced to an equivalent monetary value, renders their much-hyped conclusion little better than a tautology.

This assumption also underlies their second major conclusion. On p. 23:

Indeed, the optimal monetary tax would exceed the optimal price due to a war on drugs if the demand for drugs is inelastic -- as it appears to be -- and if the demand function is unaffected by whether drugs are legal or not -- the evidence on this is not clear.

One of the costs of the war on drugs is the cheapening of what it means for an activity to be "illegal". If, and only if, this degradation has already progressed to utter completion, then Becker et al. are justified in their conclusion that drug interdiction should be replaced with a tax regime.

It would be more socially productive to avoid this cheapening by setting a truly enforceable boundary of legality, so that the social stigma against illegal actions could be enlisted to reduce drug use without being wasted in an unwinnable battle. I suspect that this might be accomplished by legalizing (with heavy taxes) the less damaging drugs, drawing a defensible line against the worst ones. The bright line between legal and illegal is one of the government's chief assets, and to date its deployment has been absymal.

We now turn to the second conclusion, that the socially optimal level of consumption could be lower under legalization and taxation than it is presently. Here the authors have pursued their mathematics outside the realm of reason.

To see this, first suppose that the penalties for underground production and distribution in their new regime are equal to those in the current regime, and that the taxes are such that neither legal nor illegal producers have an advantage. This leads to the same price, and thus [accepting for the moment the highly questionable assumption above] to the same demand, in the old regime as in the new. Raising the taxes further without harsher enforcement would drive legal producers away, recovering the present equilibrium; only the name of the crime would have changed. To increase prices above today's equilibrium would require both higher taxes and more stringent enforcement.

Translating that back to the language of policy, an overall reduction in drug use would stem from legalization only if the penalties for illegal production and distribution of a legal drug [in the new regime] exceeded those for illegal production and distribution of an illegal drug [in the present regime]. Only if we are to penalize tax evasion more harshly than cocaine trafficking will we see this drop in demand.

[Since tax revenue is, ceteris paribus, a social good, it is indeed economically optimal to penalize tax evasion more harshly than other crimes. But society does not seek this optimum.]

Of the suggested benefits of legalization, then, one is contingent on the war on drugs being already lost, and the other on an implausible and morally dubious style of enforcement. This paper hints at the questions which should drive policy, but its own offerings do not appear valuable.