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2005-2006 Essay Contest - What economic lessons can be drawn from an illegal drug deal?

In the United States, as in most other countries, markets for drugs are heavily regulated. Drugs intended for medicinal purposes must be approved by the Food and Drug Administration, and psychotropic drugs with questionable medical benefit are often banned. Drugs like methamphetamine, cocaine, heroin, marijuana and LSD are deemed by the government so dangerous to users and society that their possession, use or sale is a criminal offense.

Making a product illegal does not eliminate the market for it. The Office of National Drug Control Policy estimates that Americans spent about $65 billion on illegal drugs in 2000, more than the amount spent on cigarettes. Worldwide, the drug business is worth about $400 billion. Drugs are also a big concern to politicians, with government spending an estimated $40 billion to $60 billion annually to fight the "war on drugs."

Potential profits from selling drugs have led to violent crime in America's inner cities and elsewhere, causing some to ask whether there is a better way to address the problem.

Some have proposed tougher enforcement. Others have suggested moving away from a criminal law strategy toward a public health approach, and still others have proposed legalizing drugs altogether.

These are emotionally charged and controversial issues, but perhaps by taking the cool view of an economist we can gain some perspective. Fundamental concepts, such as externalities, cost-benefit analysis and black market economics, can shed light on policies and individual behavior related to illegal drugs. For this reason, the Federal Reserve Bank of Minneapolis has decided to ask the following question for its 2005–2006 Student Essay Contest: "What economic lessons can be drawn from an illegal drug deal?"

The Economics of Illegal Drugs: A Primer

Economists have a number of tools and concepts to analyze the economics of the drug trade. Economics can help us understand individual incentives regarding drug use, the black market in which drugs are sold, and the most cost-effective policies to curb the sale of drugs. You may find it helpful to review a summary of Economic Principles to Keep in Mind as you prepare your essay. Essays that use economic concepts effectively will tend to score higher.

Below we mention a few economic tools that relate to drug use and the drug trade. As you decide what aspect of the essay contest topic to write about, consider how these tools apply.

Externalities from drug abuse

Activities of drug users and dealers often have harmful effects on other parties outside those involved in the transactions. Examples include an intoxicated employee who causes an accident, children of a drug addict who live in an unstable home, or a bystander who is shot by a gang member trading drugs. More broadly, society as a whole picks up the tab for increased costs to the health care system due to drug abuse.

These examples illustrate what economists call "externalities," which are classified as market failures. Economists generally believe that markets allocate resources efficiently or that at least their performance cannot be improved upon by other institutions. However, in the case of market failures such as externalities, there may be a case for government intervention.

Other examples of negative externalities include air pollution and traffic jams. There are also positive externalities to activities like education. Typical policies intended to reduce harm from negative externalities include taxes, fine and lump-sum redistribution. In the case of many drugs, the government has decided that the best policy is to ban these substances.

Students choosing to examine this aspect of drug markets might review research on the external effects of drug consumption and explore how to quantify the externality.

Property rights and black markets

As we have seen, banning a product does not eliminate its supply or demand, it simply drives the market underground. A black market is much like a traditional market in some ways, but very different in others. One of the key differences is property rights.

Economists usually argue that markets require some form of property rights. In capitalist economies property rights are typically secured by the state, through the police and the courts. However, drug dealers cannot go to the police when they are robbed, since their business is illegal.

Does this mean that there are no property rights in drug markets? Not necessarily. Alternative institutions often form to create property protection, such as the Mafia or street gangs. Protection rackets run by the Mafia are similar to police: Petty criminals pay tribute to the Mafia, and if outsiders try to interfere with business the Mafia uses force to intimidate them. Street gangs band together to secure valuable turf (usually areas where drugs are sold) from rivals who may wish to take control of it.

Such activity is, or course, extraordinarily violent. What is interesting to an economist is the way that driving markets for a commodity underground also creates underground markets for the provision of property rights. From a policy standpoint, it is worth asking whether the policies intended to reduce externalities from drug abuse end up creating greater externalities in the form of such violence.

Students writing on this topic will find that the analysis of property rights often provides a powerful way to understand economic forces.

Cost-benefit analysis and efficiency

Some readers will conclude that drugs are simply too harmful to be legal; others may feel that the effects of criminalization make the cure worse than the disease. This debate could descend to a matter of opinion without the help of one of economists' primary tools: cost-benefit analysis.

When considering an important choice like what college to attend or what policies to pursue, economists advise decision makers to add up all the costs associated with the decision and then tabulate the benefits on the other side. Cost-benefit analysis allows us to see if the costs of a particular action outweigh the benefits. If benefits outweigh costs, the action will more than pay for itself. This analysis also allows us to compare the consequences of different actions, that is which choice will provide the most benefit relative to the cost.

The cost-benefit analysis also allows us to compare the consequences of different actions. This leads directly to an issue of utmost importance to economists: efficiency. One policy will be more efficient than another if it provides a greater benefit at the same cost, the same benefit at a lower cost, or a greater benefit at a lower cost.

This is often easier in principle than in practice—it's difficult to make a full accounting of benefits and costs. Remember that economists count as costs not only the financial toll of a choice, but also the other options that were forgone in making that decision. Accounting for such opportunity costs can be tricky. Often a decision will also have indirect or unanticipated costs, and unforeseen benefits may arise as well.

Students could apply cost-benefit analysis to the current drug policy regime. They could also explore the relative differences in costs and benefits for alternative policy proposals.

Current policy offers an emphasis on reducing the supply of drugs through eradication programs, border patrols and penalizing traffickers and users with jail time and fines. In addition, government and nonprofit organizations provide drug education programs and rehabilitation programs to reduce demand for drugs. However, government spends much more on reducing supply than demand.

Students might write about how policy could change in order to reduce supply and/or demand for drugs more effectively. For example, government could ramp up the jail time for trafficking or possessing drugs or increase police presence in areas where drugs are often sold. These policies might discourage drug sales and make it more difficult for traffickers to sell drugs.

Some economists argue that these policies do not solve the problem, since demand for drugs remains. Limiting the supply only makes selling drugs more profitable since prices for drugs increase when supply is reduced and demand stays the same. A better approach, from this perspective, would be to reduce demand by increasing emphasis on education, early intervention and treatment.

Another alternative is to treat drugs as a public health problem rather than a criminal problem. Advocates of such policies argue that drug abusers are not criminals but victims of their own bad choices. The proper approach, they say, is to put resources into treating addiction and other harmful consequences of drug abuse by offering counseling and medical treatment, rather than locking users up in jail. An example is methadone substitution that is effective in reducing demand for heroin.

Some argue that it would be better to reduce penalties for drug users and traffickers, or even legalize drugs altogether. They argue that the costs of incarcerating drug users and policing traffickers are greater than the effects of those practices in reducing drug use and drug trafficking. One approach would be to decriminalize drugs—drugs remain technically illegal, but criminal penalties are removed for minor possession, use, or perhaps sales of small quantities, while trafficking remains a criminal offense. Thus, there wouldn't be drugs for sale at a grocery store, but there would likely be informal decentralized markets for drugs. This course has been pursued by the Netherlands and some other countries that have liberalized their drug laws.

Legalizing drugs would go further and remove penalties on selling of drugs; however, the market for drugs would likely be highly regulated. The trade-off of decriminalization policies and legalizing drugs would include increases in drug use since prices would decrease as penalties are lifted. After prohibition on alcohol was repealed in 1933, there was an increase in alcohol consumption, and we could expect the same effect with legalizing drugs.

These policies are not the only possibilities, and they are not exclusive of one another. A student writing such an essay could describe his or her favored policy and argue why it is better than the current situation.

Final thoughts

Again, these are not the only possibilities for essay topics, but rather
a list intended to highlight some of the tools available to you. Students are encouraged to review the Judging Criteria that are used to rate essays and the Writing Guide that shows what students should consider when researching and writing their essays. Judges award points for creativity, so a unique approach could confer an advantage.

But aside from the competition, this should be a learning experience and, more important, fun. Good luck!