Wednesday, March 30, 2011

Econ 101, Hayek, and Why We Are Losing the War against Drugs

Last week The New York Times reported that the drug cartels, after shaking the political and economic structures of Colombia and Mexico to their foundations, are moving into Central America. Just one more sign, as if we needed it, that the United States is losing its endless war on drugs.

No one who has ever taken Econ 101, or read the works of Friedrich Hayek, should be the least bit surprised. The drug cartels are strong because the US strategy in the drug wars makes them strong. Here's why.

First, what we learn from Econ 101. The key concept is price elasticity of demand—the percentage change in quantity demanded associated with a one percent increase in the price of a product. If a one percent price increase reduces the quantity people buy by more than one percent, demand is said to be elastic. If the quantity sold falls less than one percent, demand is said to be inelastic. Elasticity, in turn, determines what happens to the seller's total revenue when the price changes. If the percentage change in quantity is greater than the percentage change in price, demand is elastic, and revenue goes up when the price falls. (For example, suppose you can sell 100 widgets at $1 apiece and 120 when you cut the price to $.90. Your revenue goes up from $100 to $120.) If the percentage change in quantity is less than the percentage change in price, demand is inelastic, and revenue goes up when the price rises. (Suppose you can sell 100 gadgets at $1 and that you still sell 90 if you raise the price to $1.20. This time it is a price increase, not a decrease, that will increase your revenue.)

What is the elasticity of demand for illegal drugs? Intuition suggests that demand should be inelastic. If cocaine, heroin, and the rest are addictive, people who use them will not find it easy to kick the habit just because the price goes up a bit. Econometric studies of the question are hampered by the fact that drug lords don't post accurate price and revenue data on their web sites, but such research as has been done tends to confirm the hypothesis of inelastic demand. For example, one survey of the literature found that a 1% increase in the price of cocaine would tend to reduce consumption by only 0.51 to 0.73 percent, solidly in the inelastic range.

This gives us our first clue as to why the war on drugs isn't going so well. The main strategy is interdiction of supply. To the extent interdiction succeeds in reducing supply, it drives up the market price. With inelastic demand, a higher price means more revenue for the drug cartels.

Note that more revenue for the drug cartels does not necessarily mean more profit, because interdiction efforts also raise suppliers' expenses. However, from a public policy point of view, it is the expenses that do the damage, not the profits. If drug lords just earned profits, they would probably spend them harmlessly on fancy cars and villas. It is not so harmless to see their expenses rise. Those consist largely of salaries paid to thugs who guard shipments and shoot anyone in the way, bribes to officials on both sides of the border, and pay and equipment for more thugs who are assigned to inter-gang warfare, with innocent victims caught in the crossfire. With inelastic demand, a higher price for drugs means more revenue available to finance all of those things. To the extent that is the case, the interdiction strategy on which the war against drugs is based is self-defeating.

The inelastic-demand model of the war on drugs cannot be the whole story, however. In its simple form, it cannot explain the paradox that while drug violence is on the rise, the prices of cocaine and heroin have been falling steadily for decades. How can that be?

One possibility is that demand is elastic in the long run even though it is inelastic in the short run, a pattern that can be observed for other commodities, as well. It is a pattern that accords with the intuition that an addicted user will not forgo the drug even if the price goes up (inelastic short-run demand), but that cheap drugs might, over time, attract new users (elastic long-run demand). For example, one study found that between 1981 and 1995, the price of cocaine fell by a factor of 5 while the number of emergency room admissions mentioning cocaine increased by a factor of 15. (This interesting graph from the study shows the pattern holding for heroin as well as cocaine.)

Although long-run elastic demand could explain why drug cartel revenue has held up in the face of falling street prices, it cannot explain the price decrease itself. The price decrease suggests that some of the cartels' revenue has gone to investments in capital and technology, and that those investments, over time, have shifted the supply curve downward, more than offsetting the efforts of the drug wars to push it upward.

As one example of the willingness of the drug cartels to undertake investment and innovation, consider the development of drug-smuggling submarines. When satellite surveillance and more extensive patrolling raised the risk for surface boats, smugglers began building primitive semisubmersibles that evaded detection by riding just below the surface, but they were not a perfect solution. The next step is indicated by the recent discovery by the U.S. Drug Enforcement Administration, working together with Ecuadoran police, of a 100-foot fully submersible submarine. "The submarine’s nautical range, payload capacity and quantum leap in stealth have raised the stakes for the counterdrug forces and the national security community alike," commented the DEA's Jay Bergman.

The growing viciousness of the drug wars and their destabilizing impact both on the United States and its allies cannot be explained by economics alone, however. That is where some of Hayek's insights come into the picture. In one of his most important books, The Road to Serfdom, Hayek examines the internal dynamics of totalitarian movements. This passage from the chapter "Why the Worst Get On Top" applies to the case at hand with only minimal editing:
Yet while there is little that is likely to induce men who are good by our standards to aspire to leading positions in a [drug cartel], and much to deter them, there will be special opportunities for the ruthless and unscrupulous. There will be jobs to be done about the badness of which taken by themselves nobody has any doubt . . . and which have to be executed with the same expertness and efficiency as any others. And as there will be need for actions which are bad in themselves, and which all those still influenced by traditional morals will be reluctant to perform, the readiness to do bad things becomes a path to promotion and power. 
The point of this is that drug cartels are like normal business in some ways, but not in all ways. If cocaine and heroin were legal products like tobacco and alcohol, their producers' revenue would  still respond to changes in price as predicted by elasticity, and increases in revenue would still be devoted, in part, to innovation and capital investment aimed at expanding supply. But those businesses would not share the extreme badness of the drug cartels. It is not the nature of their products that makes drug gangsters so readily engage in murder, kidnapping, and other forms of mayhem. Rather, the conditions in which skill and enthusiasm in committing acts of violence become a path to promotion and power are created by the very fact that cocaine and heroin are prohibited substances, and those conditions are only intensified the more vigorously the prohibition is pursued.

What is the alternative? A strong case can be made for full legalization of cocaine and heroin, on a par with alcohol and tobacco. (For a sampler, see these items from the Drug Policy Alliance, the Economist, and the Guardian.) Another excellent source of material in favor of legalization is the web side of Law Enforcement Against Prohibition, where you can find the views of former undercover narcs, sheriffs, and judges, all intimately familiar with the unintended consequences of prohibition. Short of legalization, a demand-related approach that treated drug addiction as a public health problem, not a law-enforcement problem, would produce less violence abroad and fewer unintended consequences at home than present US policy. At any rate, that is the answer you come to if you look at the problem in terms of Econ 101 and Hayek.

Follow this link to view or download a short slideshow on the economics of the war on drugs.


  1. I've been a proponent of legalization of drugs since Econ 101. Better quality, lower price, less mayhem. The disease of addiction is not stopped by making drugs illegal it is exacerbated.

    The drug cartels probably have a nice lobby in washington to keep drugs illegal eh?

    What can we do to convince the government to give it up?

  2. "For example, one survey of the literature found that a 1% increase in the price of cocaine would tend to reduce consumption by only 0.51 to 0.73 percent, solidly in the inelastic range."

    Are you aware of what you've written? For comparison:

    Cigarette: -0.3 to -0.6
    Live Performing Arts: -0.4 to -0.9

    You have based your argument on a study which suggests that cocaine has roughly the same price elasticity as theatre.

    I think you need to retake ECON101.

  3. Keith-- I'm not sure I get your point. Why should I be surprised to find that cigarettes, like cocaine, also have inelastic demand? Tobacco prohibition would presumably produce the same effects as drug prohibition--a violent tobacco cartel. I had never seen elasticity estimates for live performing arts before, but the data showing inelastic demand suggests, to me, that theater has a loyal, but narrow base of fans, so that theater owners, like drug cartels, would not be able (in the short run; I assume these are all short-run estimates) to increase revenue by lowering prices.

    To produce the effects I hypothesize, it is only necessary that cocaine demand be inelastic (between -1.0 and 0), not that it be more or less inelastic than theater or cigarettes.