The Economics of Prohibition

by Mark Thornton

  Progressive interventionism is a recurring theme in the literature of political economy. It is a theme in which the policy of prohibition is often cited as a critical illustration. F. A. Hayek, Ludwig von Mises, and James M. Buchanan have pointed out the pernicious effects of using political institutions to intervene in economic activity and personal liberty.

  Hayek’s classic Road to Serfdom ([1944] 1977) was a warning that government planning of the economy was a threat to basic freedoms and that the acceptance of planning would result in socialism and totalitarianism. He noted: “Because of the growing impatience with the slow advance of liberal policy, the just irritation with those who used liberal phraseology in defense of antisocial privileges, and the boundless ambition seemingly justified by the material improvements already achieved, it came to pass that toward the turn of the century the belief in the basic tenets of liberalism was more and more relinquished” (19). Prohibition was just one part of the acceptance of planning by the people, “because they have been convinced that it will produce great prosperity” (61). According to Hayek, the acceptance of planning and interventionism is a break with the rule of law, a primary condition for a well-functioning economy. Hayek (72–87 and elsewhere) has written that this same rule of law is the basis for maintaining other freedoms. He quotes Max Eastman, a one-time Socialist, concerning the connection between economic planning and “democratic freedoms”: “He (Marx) is the one who informed us, looking backwards, that the evolution of private capitalism with its free market had been a precondition for the evolution of all our democratic freedoms. It never occurred to him, looking forward, that if this was so, these other freedoms might disappear with the abolition of the free market” (104–5).

  In discussing the economic results of planning, interventionism, and “the close interdependence of all economic phenomena,” Hayek raises an issue for which planners cannot supply an easy answer: how can planning be controlled or limited? He notes that the results of economic planning “make it difficult to stop planning just where we wish and that, once the free working of the market is impeded beyond a certain degree, the planner will be forced to extend his controls until they become all-comprehensive” (Hayek [1944] 1977, 105).

  Another economist who stressed this important aspect of intervention was Ludwig von Mises. In dealing with the issue of interventionism, Mises stressed the important political consequences of direct interference with consumption as it relates to the prohibition of drugs:

  Opium and morphine are certainly dangerous, habit-forming drugs. But once the principle is admitted that it is the duty of government to protect the individual against his own foolishness, no serious objections can be advanced against further encroachments. A good case could be made out in favor of the prohibition of alcohol and nicotine. And why limit the government’s benevolent providence to the protection of the individual’s body only? Is not the harm a man can inflict on his mind and soul even more disastrous than any bodily evils? Why not prevent him from reading bad books and seeing bad plays, from looking at bad paintings and statues and from hearing bad music? The mischief done by bad ideologies, surely, is much more pernicious, both for the individual and for the whole society, than that done by narcotic drugs.

  These fears are not merely imaginary specters terrifying secluded doctrinaires. It is a fact that no paternal government, whether ancient or modern, ever shrank from regimenting its subjects’ minds, beliefs, and opinions. If one abolishes man’s freedom to determine his own consumption, one takes all freedoms away. The naive advocates of government interference with consumption delude themselves when they neglect what they disdainfully call the philosophical aspect of the problem. They unwittingly support the case of censorship, inquisition, religious intolerance, and the persecution of dissenters. (Mises [1949] 1977, 733–34)

  Therefore, the consequences of prohibition include its direct effects, the unintended consequences, and the tendency for intervention to influence the philosophy, size, and scope of government.

  This aspect of political economy has received attention recently by the Nobel laureate James M. Buchanan. He showed that individuals can restrict the behavior of others at low cost by using the democratic process. This method of resolving conflicts is, however, deceptive and dangerous. “The majoritarian institutions of modern democratic politics are exceedingly dangerous weapons to call upon in any attempts to reduce conflicts in areas of social interdependence. They are dangerous precisely because the institutions are democratic and open to all citizens on equal terms . . . [and] preferences are as likely to be imposed upon as imposed” (Buchanan 1986, 339). Buchanan goes on to discuss the economics of partitioning issues that involve the prohibition of various activities. He notes that whereas the majority may benefit from a prohibition, the minority may suffer greatly. The democratic system as a method of conflict resolution allows issues to be partitioned and freedom of consumption to be taken away. Nothing exists in the purely democratic system to stop this process once the Pandora’s box has been opened. Buchanan states: “Let those who would use the political process to impose their preferences on the behavior of others be wary of the threat to their own liberties, as described in the possible components of their own behavior that may also be subjected to control and regulation. The apparent costlessness of restricting the liberties of others through politics is deceptive. The liberties of some cannot readily be restricted without limiting the liberties of all” (340).

  Before turning to specific results of prohibition, it is worth noting that its implications are much wider than basic economic analysis reveals. It is not mere speculation or chance that the macropolitical implications described above go hand in hand with prohibition and that these consequences are greater than those generated within a prohibited market.

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  1For example, point 3 offers the concern that consumption of certain products causes harm to the health of the consumer. According to a survey by the National Institute on Drug Abuse, however, the majority have considered only the consumption of heroin and the daily consumption of LSD, cocaine, amphetamines, barbiturates, or five alcoholic drinks to be harmful. In no case did more than 90 percent of those surveyed find the consumption of these drug products of great risk for harm to the user.

  2When the losses to consumers and producers are disregarded this is a reasonably accurate description. Prohibitionists, such as Irving Fisher, often claim, however, that the marginal benefits of enforcing prohibition actually increase. This inconsistency of stated (rather than demonstrated) preferences is also revealed in an ABC News public-opinion poll, which indicates that most Americans favor spending “as much money as necessary to stop the flow of drugs into this country” and that most realize that “drug abuse will never be stopped because a large number of Americans will continue to want drugs” (ABC News, New York, May 8–13, 1985).

  3Advertising is also a good example of the distinction between the Austrian-subjectivist approach to the market process and the neoclassical approach to markets. Austrian economists view advertising as an important, beneficial, indeed, crucial element in the market process. From a neoclassical viewpoint, however, advertising is inherently redundant, wasteful, and a tool to manipulate the consumer. The modern orthodoxy seems to have sided with the Austrian approach. On some of these issues see Hayek 1961 and Robert B. Ekelund and David S. Saurman 1988.

  4Even “deceptive” advertising can convey knowledge of products and enhance consumer awareness. See Ekelund and Saurman 1988.

  5Lancaster’s analysis does not completely close the gap between process-oriented and orthodox neoclassical economists. His framework is static in nature, and value is objectively determined.

  6Policymakers may be unconcerned with unintended consequences, unaware of their possibility, or unaware of the connection between interventionist policies and the resulting unintended consequences. Economists may know of the existence of these results, but they often fail to incorporate these conseq
uences into policy analysis and recommendations.

  7I will apply this theory primarily to the prohibitions against drugs and the prohibition of alcohol during the 1920s. These results are, however, equally applicable to the prohibition of other goods, such as books, pornography, prostitution, gambling, etc.

  4

  The Potency of Illegal Drugs

  Another factor contributing to increased health consequences of marijuana use is the increase in potency over the past several years.

  —The White House Drug Abuse Policy Office, 1984 National Strategy for Prevention of Drug Abuse and Drug Trafficking

  Drug prohibition establishes a wholly superfluous discovery process with respect to the potency of illegal drugs. Black-market entrepreneurs are spurred on by artificial, prohibition-created profit opportunities in a similar fashion to entrepreneurs in a legal market responding to profit opportunities. At one level, the entrepreneur supplies a profit-maximizing quantity of the product, in both legal and illegal markets. On another level, the profit motive prompts entrepreneurs to alter production techniques, product quality, and the product itself.

  Market forces lead to certain industry standards, such as twelve ounces in a can of soda and four rolls of toilet paper per package. Each product line in the market, whether breakfast cereals or light bulbs, moves toward an efficient level of product diversification (heterogeneity), the lowest cost of production, and optimal quality levels for the product. In the black market similar tendencies exist. In prohibited markets, however, consumers face fewer choices at any time, but severe product variability over time.

  The potency of narcotics, cocaine, alcohol, and marijuana increased significantly after the enactment of prohibition. In the United States during the past century, opium was virtually replaced by morphine and, later, morphine by heroin. The original Coca-Cola contained small concentrations of cocaine. Today cocaine is sold in the form of a high-potency powder or as concentrated nuggets called crack. During Prohibition consumption of beer plummeted, and consumption of distilled spirits and moonshine increased. The potency of marijuana increased several hundred percent after a “prohibitive” tax was enacted in 1937. Synthetic narcotics and combinations of drugs, such as “speedball” (heroin and cocaine) or “moon-shot” (crack cocaine and PCP), have been introduced.

  Since 1968 when Simon Rottenberg published his germinal article, “The Clandestine Distribution of Heroin: Its Discovery and Suppression,” economists have investigated many aspects of illegal drug markets, including alcohol prohibition, the problem of addiction, and public policy toward addiction and black markets.1 Rottenberg examined several hypotheses for changing potency but concluded that his analysis did not answer the question of changing potency. “It is like explaining why Falcon automobiles will be manufactured, as well as Continentals, but would not explain why the fraction of Falcons rises and the fraction of Continentals falls” (Rottenberg 1968, 83).

  The question of potency remains unanswered and largely uninvestigated despite its implications for public policy, the effectiveness of law enforcement and addiction, and the health of illegal drug users. The questions of potency and product quality also have important implications for basic theoretical and empirical investigations of prohibition and other public policy. Crawford et al. (1988) and Reuter, Crawford, and Cave (1988) found (indirectly) that entrepreneurs switched to smuggling higher-potency drugs when faced with increased enforcement.

  Higher potency reduces the overall effectiveness of law enforcement because it means that smaller quantities represent greater effective amounts of the product. Higher-potency drugs are thought to be more dangerous and produce a greater risk to the health of the user, but actually great variance in the potency of a product poses a greater risk to the user. Higher-potency drugs are also thought to be more addictive. In the black market the potency of a product is not fixed, consumers have less information about potency and added ingredients, and the producers are not legally liable in the same sense as pharmaceutical companies. In a recent study on the relegalization of drugs, James Ostrowski (1989, 47) claims that 80 percent of the 3,000 deaths per year associated with heroin and cocaine are the result of the illegal nature of the market, not drug use per se. (See also National Institute on Drug Abuse 1981–84.)

  What caused the tremendous increases in drug potency after prohibition? Exogenous technological changes and shifting consumer tastes might provide explanations. For example, in figure 4 the market for drugs has been divided into high-potency and low-potency submarkets. If a technological change occurs that decreases the costs of high-potency drugs, shifting the supply curve to the right, this shift would cause a decrease in price and an increase in the quantity demanded. The changes in the market for high potency would lead to a decrease in the demand for low potency. These events would explain also the type of result observed under prohibition.

  Technological changes are typical after prohibitions are instituted, but the type of technological change that occurs is not new technology but a different implementation of existing technology (see A. D. Little 1967).

  The experience of prohibition, particularly of National Alcohol Prohibition, seems to rule out changes in consumer tastes as a cause for the increased potency of drugs. Once Prohibition was repealed, the pre-Prohibition expenditure patterns for both high- and low-potency alcohol reemerged. It appears that the dramatic change in potency of prohibited drugs is directly related to prohibition itself. The decrease in average potency over time of legal drugs, such as caffeine, nicotine, and alcohol, reinforces this proposition (Ippolitio, Murphy, and Sant 1979).

  The explanation of higher potency offered here depends crucially on the effect prohibition has on relative prices of the same drug of different potency, the relative prices of different drugs, and the incentive for innovation in new drug products. The penalty structure, the level of enforcement, and the incentives of law-enforcement officials will be examined as causes for higher-potency and more dangerous drugs.

  Figure 4. Effect of Improved Technology for High-Potency Drug Production.

  THE ECONOMICS OF POTENCY

  Lancaster’s approach to consumer behavior (1966) provides a convenient structure for analyzing the economics of potency. This approach has helped solve many problems in neoclassical economics and has allowed economists to undertake the study of many new problems. The approach is based on the simple idea that goods are valued for their attributes, characteristics, or properties and are not the direct objects of utility. Economists have begun to investigate the composition of a good with the same zeal as physical scientists investigate the components of the atom.

  Goods contain a variety of attributes that can be combined in a large number of finished products. Potency is but one attribute of drugs, representing the strength or concentration of the drug in its final form. Even a pure drug product would have additional attributes, such as coloring, taste, and freshness.

  Each characteristic of a good represents an independent opportunity cost for the producer. Likewise, consumers evaluate each characteristic to determine the product’s value and how much to buy. Therefore, for each attribute, supply and demand conditions exist; they may or may not be independent of other characteristics. While an enormous variety of products is possible, it would be inefficient for all possible products to exist at one time. The entrepreneur’s job is to assemble attributes into a final product that maximizes profit.

  Lancaster’s approach helps answer two related questions in the realm of illegal drugs. First, what causes the tremendous increases in potency, and second, when all attributes are taken into account, what happens to overall quality?

  Drugs have a number of characteristics that can be altered, and new characteristics can be added. Consumers demand the final products according to the value they place on the combination of attributes provided. The supply of products is based on the costs of producing a product with a particular combination of attributes, with each attribute having its particula
r cost. The products that survive in the market are those which provide the most efficient combination of attributes in relation to the costs of production.

  PROHIBITION AS A TAX

  Economists have drawn the analogy of taxation to represent the effects of prohibition. The enforcement of prohibition creates risk for suppliers of illegal products. This risk acts as a tax, thus increasing price and reducing output.

  The theorem developed by Armen A. Alchian and William R. Allen (1964) provides a good example of how prohibition can affect the attributes of illegal drugs. In the original application of the theorem, constant transportation cost was applied to apples of various prices, resulting in a change in relative prices favoring the apples of higher price. More higher-priced apples are thus shipped out (table 3).2 A similar change in relative prices should occur with prohibition if the prohibition “tax” is similar to a transportation charge or unit tax.

  Yoram Barzel (1976) examined the effect of per-unit and ad valorem taxes on product attributes, after-tax price, and overall quality. His analysis indicated that depending on the type, taxation does affect the attribute composition of the product and therefore may be useful for understanding prohibition’s influence on potency. A tax, depending on the type, results in a price and an output that differ from those predicted by the constant-quality model. According to Barzel, “Commodities as transacted in the market are complex, and the margins with respect to which optimization takes place are numerous. Because commodity tax statutes will not generally cover all these margins, any tax will induce multiple changes not only in resource allocation away from the taxed commodity and into others but also in the ‘quality’ of the commodity and how it is transacted, a substitution away from the taxed attributes and into the others” (1195). A per-unit tax imposed on commodity X containing n characteristics will induce inclusion of more of the untaxed characteristics. The commodity is defined by statute as containing a minimum amount of characteristics 1, . . ., e. The remaining characteristics, e + 1, . . . n, are unconstrained by the tax. The imposition of the tax results in relatively more of the unconstrained-untaxed characteristics being included in commodity X. Quality upgrading and a higher-than-predicted price are the results (Barzel 1976, 1181). The per-unit tax, like the transportation cost for fresh food, induces quality upgrading.