Drugs, Prostitution, and the Economics of

Black Markets

Overview

•Recap of Black Markets

•Drugs+Gangs

•Economics of Prostitution

•Economic Model

Drugs and Gangs

Invention of Crack Cocaine

•Technological advance – supply “shifter”

•All other things equal

•Lower equilibrium price

Conflicting Incentives: owner versus labor

•Owners seek to maximize profit

–Create stable and safe market environment

•Worker seeks to maximize pay

–Move up the rank -> higher pay

•Gang war

The Formation and Operation of a Regional Monopoly

•Monopoly distribution of crack cocaine in gang “turf”

•Downward sloping elastic demand curve

•Economic profit

Fixed and Variable Costs

•FC = Short-run costs

Bribes, Family Assistance, Weaponry

•VC = the productDrugs, Street

dealers, mercenaries

“Winner Take All”

•Common market structure (baseball players)

•Low Success, High Return

•Illegality drives competition

A Model for Labor

•Far right of origin•Workers taken

together require lower wages

•Represents low W*

CEOs of Gangs?

•Top 120 managers represented just 2.2%, > half the profit

•Investor reward of black market intact

Prostitution

History

• In the 1910s estimated to be 200,000 women prostitutes in US

• 1 of every 50 women in their twenties was a prostitute

• At the time a common prostitute working in Chicago would make $76,000 annually in today's money

• A prostitute working in an upscale brothel at the same time would make about $430,000 annually in today's terms

• Reported that one head of brothel accumulated as much as $22 million

Current Day

• Typical prostitute in Chicago works 13 hours a

week

• Performs 10 sexual acts per week

• Average hourly wage of $27, weekly pay of $350

• The wages of prostitutes have fallen dramatically over the last 100 years, why?

Supply and Demand

• Demand has noticeably fallen

Not for sex, but for paid sex

• Social trends involving sex have evolved greatly

• The arrest of many prostitutes has also caused a shift in supply, though not great

Elasticity

• The demand for prostitutes has shown to be rather inelastic

• Illustrated by two examples:o As prostitutes were arrested, supply dropped

which elevated the equilibrium price. Demand stayed the same as customers continued to pay the elevated wages

o Allie, a high end prostitute, consistently raised her prices but did not experience a decrease in demand for her services

Price Discrimination

•Prostitutes reported charging different rates based on skin color

•Named the price to African- American customers, allowed White customers to name the price

•Black customers pay on average $9 less per sexual act than White customers

Substitutes and Product Differentiation

• Prices at a certain location are the same from one prostitute to another

• Customers look at prostitutes as Perfect Substitutes that can be easily interchanged

• Firms, in this case brothels, can experiencing great benefits from providing slight different products

Incentives, Incentives, Incentives

• Like all markets, prostitution is ultimately driven by incentives.

• The bottom line is that the incentives provided by prostitution are enough to create a consistent amount of people willing to sell their bodies

• On the other hand, the incentives of paying for a prostitute continue to be enough to cultivate a demand for prostitution

Reducing Crime Rates

•Deterrent Effect: Increasing the potency or likelihood of negative consequences for a criminal

•Incapacitation Effect: Preventing a criminal from being able to perpetrate a crime

Sentence Enhancements

• Type of crime Deterrent

• Increased punishments that are added onto prison sentences that would have been served anyway

• Example:•Proposition 8 (1982) in California•10% reduction in eligible crimes after 1 year•After 3 years, had fallen roughly 20-40%

Sentence Enhancements cont.•Deterrent Effect vs. Incapacitation Effect•Threat of going to jail for a longer time vs. Being in jail for

a longer time

•Can often save government money

Levitt & Kessler’s Crime Model•Equations before introduction of Sentence

Enhancements•1. Maximization•(ri-ptJt(S))Cit

•2. Crime Level•Ct=1-(ptJt/R)-pt-1Ct-1

•Prison sentences in one period (t-1) are served in the following period (t)

Decoding

•r= Gain from committing a crime•p= probability of being caught•J= Utility loss from being jailed for a time period•S= Periods of time sentenced (initially 1 period)•C= Choice to commit a crime or not•If yes, C=1, if no, C=0

•R= distribution of ri for those who commit a crime•1/R is the density of crimes•t= current time period•i stands for the individual in the calculation

L&K’s Crime Model cont.•Equations After Introduction of Sentence

Enhancements•First Period

•Second Period

Differences

•Addition of variable d, the disutility of an additional period in prison

•Additional emphasis on pt-1Ct-1 : people arrested

from previous time period, pt-2Ct-2 : people

arrested from two periods ago

Conditions of Levitt and Kessler’s Model•Agents involved are assumed to live for infinite

time•Agents are assumed to be risk-neutral•Future Utilities are not discounted•Gains from crimes are kept, regardless of whether

caught