The economics of drug prices or why the War on Drugs is failing

Redlogarythm Borderland Beat

One of the most common mistakes that can be found when talking about the current war on drugs is the increasingly common tendency to speak about the drug market and the strategies used to combat its functioning from an economic point of view, comparing it to the normal development of other markets and products. Thus, the theories, methods and characteristics applied to other innocuous and commercialized products are used to evaluate the commercialization of drugs and to design a combat policy in an effort to reduce the ability of producers, smugglers and dealers to produce, transport and sell these substances to the public.

Thus, since the never-ending war on drugs began in the 1970s its general strategy has been focused almost exclusively on multiple and ineffective efforts against the producers and distributors of the drugs being offered to the final consumers. And what is even worse, these strategies have been designed and applied as if they were aiming a normal product which behaves in the same way other products do when the forces of the market that rule their prices suffer different types of blows. In other words, the strategy in the war on drugs is not only focused in just half of the market (the producers) but has been designed as if drugs were a normal product and not a very complex range of different products which are almost immune to the current doses of governmental combat efforts.

What I´ll try to do with this article is to explain two things. First of all, how the classical theory of the most important market forces (Demand and Supply) works and how the example of the drug market can be analyzed in this way. Secondly, I´ll try to explain why in my opinion this theories cannot be applied as they are to the drug markets. For doing so I´ll use graphs and a bit of math. They aren´t complex, just the basic info that people which are not used to the economic analysis of the drug market might need to fully understand the context and conclusions. I´ll try to explain concepts schematically without making them boring or difficult to understand. I know that lately I´ve been posting about mathematic issues and related topics that aren´t as interesting as other topics, but I honestly think that a practical analysis about this complex issue is always useful. I really hope you find this worth it.

SUPPLY AND DEMAND, THE BASIC FORCES OF THE MARKET:

When we talk about a certain market (the place or atmosphere where a certain product or service is commercialized) we can always appreciate two forces interacting: the supply and the demand. These two forces interact in order to determine the quantity of the product/service being sold as well as the price at which it is sold. While the demand represents the quantity of a certain product/service that consumers are willing to buy the supply represents the quantity of the product/service that the producers are willing to offer.

In order to fully understand these two market forces and their values we must represent them in a graph. Don´t worry, although it might seem complicated it is not and I´ll try to explain all the concepts.

In economics (and al almost everywhere) the interaction between demand and supply is represented with graphs. A graph is composed by two axis: vertical and horizontal. The horizontal axis represents the Quantity (Q) of a certain product while the vertical axis represents the Price (P) of the product. The Demand and the Supply are both represented with lines that normally adopt the form of curves (although they can also be represented with a straight line as we´ll see in a few moments)

In order to provide a real example of both the demand and supply let´s imagine a real and illicit market such as the one taking place in a street of Chicago were a dealer sells little doses of cocaine to his habitual clients.

As we have said, the demand represents the amount of the product (cocaine) that the drug consumers will buy from the dealer at a certain price. We will represent the Demand of cocaine of this little drug market as a downward sloping curve. It is important to understand the form of the curve. It´s downward sloping because as the price gets smaller, the bigger are the quantities demanded by the consumers. Thus at a certain Price (P1) for each cocaine dose there is a certain Quantity (Q1) demanded to the dealer. If the Price is reduced from P1 to P2 it is obvious that the new Quantity that the consumers are going to demand is going to be higher (Q2)

In the case of the Supply curve, it´s upward sloping. The reason is simple; the higher the price of the product, the more of it that the supplier (drug dealer) will be able to sell. These can be understood as a simple price increase. If a gram of cocaine goes from $90 to $100, then the dealer will be able to sell more than before when the price of each product unit was lower.

Now, as in any other sphere, these two forces (supply and demand) tend to an equilibrium. This is, a point were both the consumers and the producers reach an agreement for the purchase of a certain Quantity of the product (Q) at a certain Price (P) The point were both curves converge indicates this Market Equilibrium. It is important to stress the point that this Market Equilibrium doesn´t have to exist. In fact, most real markets don´t ever reach the equilibrium point because the Prices and Quantities are always fluctuating. The Market Equilibrium is only a tendency but not a fact in every single market.

As we have said the Market Equilibrium is only a tendency and this means that the Prices and Quantities are normally over or below the Equilibrium rates. In order to provide an example of the Market Equilibrium applied to the drug economy imagine a simple market such as the one conformed by a local marihuana grower and dealer and his clients. This market has a natural equilibrium of let´s say $5 per gram. At his price, the grower is able to sell his product and the consumer is able to purchase it. Nevertheless, the Covid crisis strikes and the grower realizes that since he is under a virtual lockdown by local authorities he isn´t able to reach the plantations he has in the outskirts of the city. Thus, he is stuck in his street with a certain amount of stock (in other words, the Supply is reduced due to the lockdown) and consequently he raises the prices to $7. What happens in this new situation? 

The following graph reflects it:

At the new prices the dealer is able to provide a certain Quantity of marihuana (Q2) larger than the Quantity that the consumers are able to purchase (Q1) When this happens we say that there´s an excess of Supply (since the real price is over the Equilibrium price the demanded quantity will be below the quantity offered by the Supplier)

We can find just the opposite situation, Excess of Demand. In this case the real price is below the Equilibrium price so the demanded quantity is over the supplied one) This could happen if there is a sudden boom of marihuana plantations all over the region. When the harvests begin there´s a flood of product in the area. Naturally the excess of product causes a fall in prices below the initial Equilibrium price which means that consumers will want to purchase more than what the suppliers would be able to sell at that certain lower price.

It is also important to mention that since most markets tend to their natural Market Equilibrium sooner or later the Supply tends to equilibrate with the Demand. In our example this could happen when the lockdown is removed and the dealer is able to harvest his plants or when law enforcement destroys the new marihuana plantations reaching the old production levels. Thus, the real price is reduced or increases until the point where it reaches the Equilibrium level.

ELASTICITY OF DEMAND, THE DRUG WAR´S ACHILLES HEEL:

One of the most vital concepts in the fields of economics is the term Elasticity. In order to explain what Elasticity is and how it works we should provide an example of a legal market.

Imagine the market for oranges. The unit of measurement for this product is $/kg. According to the index mundi database the price of a kilo of oranges on January 2020 was of $0,51/kg. Oranges, as most consumer goods, do have a very fluctuating price which means that the price is constantly changes due to different causes and parameters. Thus, when the Covid crisis hit hard on April oranges started costing $0,58 and when things escalated in May the price reached $0,65. What happened with the demand of oranges? 

Obviously, since oranges became more expensive a lot of people ceased buying them. This behavior is extremely common. When a product becomes more expensive it´s natural that consumers stop buying it or at least they buy smaller quantities. This consumer behavior is common and can be seen in almost every single market.

What Elasticity measures is precisely the percentage variation of a product´s demanded quantity depending on the variation of this product´s price. In other words, what Elasticity reveals is what happens with the quantity demanded when the price changes.

If the quantity demanded varies a lot when the price changes, we say that the product´s demand is elastic. But when a price change isn´t translated into a significant demand variation the demand is inelastic.

Every product, legal or illegal has a certain Elasticity coefficient which measures how the demand reacts to a change in the price. The higher the Elasticity coefficient the bigger the demand´s reaction is going to be.

The Elasticity coefficient can be expressed as:

  

Although this might seem complex it´s very simple. Q is a variable representing Quantity and P is another variable representing Price. The triangle sign ∆ is called Delta a measures a variation between a gap of time. The sub-indexes 1 and 2 represent points in time. P1 means Price in moment 1 and P2 price in moment 2. Q1 represents Quantity at moment 1 while Q2 represents Quantity at moment 2.

Let´s provide a plausible example of how the Elasticity coefficient can be used. Take into account that this example if purely fictional and doesn´t represent how things work with drugs as we´ll see in a moment. Its only aim is to explain how the Elasticity coefficient is calculated.

Imagine a US city where the crystal meth market is controlled by a unique organization (although this never happens let´s make things simple and assume there´s only 1 distributor) This group sells each gram of meth for $100 and each month they are able to sell 10 kgs of meth. Nevertheless, suddenly law enforcement locates and conducts a raid in the organization´s main hub where they seize a great amount of the group´s crystal meth stock. The most obvious answer by the group would be to raise the meth price in order to cover losses and minimize the costs that its structure means. Thus, the meth gram rises to $115 and since the drug is now more expensive it´s logical to suppose that the Quantity being sold after the price increase will be smaller. Let´s say 9 kgs per month. How do we calculate the Elasticity coefficient of the cocaine being sold in this city?

All we need to do is substituting the data into the equation and we obtain the result of – 0,6666 which in absolute terms is 0,6666. Translated to words this number means that for each unit of Price (for each dollar) increase the quantity demanded will decrease by 0,6666 units (grams)

What does Elasticity depend on? There are certain factors which determine the elasticity/inelasticity of the demand.

First of all it is important to determine if the good is necessary or if it´s a luxury one. The demand of necessary goods (such as bread, milk, clothes, electricity or gas) tends to be inelastic since everyone needs to consume them regardless of their prices. In the case of luxury goods (the ones that are not necessary and are bought for purely recreational purposes) their demand tends to be elastic since apparently, people stop buying them when their prices increase.

Another important factor is the existence of substitute products. Imagine that in the US the price of Michoacanese limes skyrockets for some reason. The consumers of limes might start buying lemons instead since they are similar products (substitute products) and the lemon´s price hasn´t been altered. If there are substitute products available, the demand is elastic and if there are not the demands tend to be more inelastic.

One vital Elasticity factor is the time horizon. The demand tends to be elastic in the long run. For example, a sharp and sudden price increase means that consumers will stop buying the product almost immediately. Nevertheless, as time goes by and the price starts fluctuating again some of the initial costumers might return to buy it again.

Now let´s say this crystal clear. The terms and formulas we have been explaining are mere theories. As they are pure theoretical speculations accepted by most economists they are confirmed by most of the world´s markets and tend to work right and to be true most of the time. Since they have been accepted as a universal truth they have been applied to every single area of economics, to every product and service offered for a price. And this is where the War on Drugs has failed to apply economic logic to its general strategy. How has this happened?

HOW ARE THE DRUG PRICES SETTLED?

The current Anti Drug strategies of fiercely combatting the Supply side of the drug markets has failed to achieve any decent results by reducing the final product consumption because under the official logic drugs can be compared with other goods whose behaviors can be predicted through the tools we have explained.

We can all agree that almost all the Governmental effort in the War on Drugs is focused on the Supply-side. This means that most of the resources destined by authorities to combat drug commercialization are centered on discovering and dismantling the producers and the dealers (all along with their plantations, routes, logistics, resources, etc) Of course, every single Government, from the US to Myanmar, acknowledges that the elimination of the producers is almost impossible. The continuous efforts of the Italian authorities against the Ndrangheta´s cocaine trafficking have failed miserably since the 80s, the US (the world´s most powerful country) isn´t even able to control its borders which are penetrated by loads of drugs that achieve new records year by year, the Colombian Government has been spreading chemical defoliators since the 90s in order to reduce the size of the coca plantations and nearly after 30 years of continuous fumigation cocaine production has reached the biggest levels in all Colombia´s history, etc.

Authorities worldwide acknowledge that it is impossible to eliminate the Supply side of the chain. And their efforts aren´t focused on bringing the production of meth, cocaine, marihuana or heroin to an end. 

Instead, their anti-drug campaigns and operations are aimed at making the drug production unaffordable to suppliers. How? Very simple, by increasing the production costs until a point where consumers can´t afford to purchase and consume more product.

Although this might seem crazy it is not. In fact, it is a logical reasoning based on a basic economic argument. As we have said product prices are subjected to continuous movements that increase or decrease the cost of purchasing a product. The main goal of the current War on Drugs is to make the drug production costs so high that in order not to lose money drug producers have to add them to the final product price thus making the purchase of the product unaffordable. In other words, they pretend that by attacking the suppliers they are going to charge extra ``fees´´ at street level which will make the purchasing of drugs impossible for addicts or buyers.

Although this might seem as an oversimplification of the complex and international antidrug efforts it is not. It has been acknowledged both by Government officials and acclaimed academics that it is not possible to eliminate the supply of drugs and that the ultimate goal of all anti-drug efforts (from the chemical defoliations on the Colombian rainforest to the seizure of chemical precursors in the ports of Mexico) is to hinder the drug production chain so producers and suppliers have to make the drugs more expensive in order not to lose money.

As we´ll see now, this objective is not only difficult to reach but sometimes it´s just a mere chimera.

To demonstrate that this fee-generating strategy is useless we must understand how the drug prices are generated. When we buy a gram of cocaine, heroin or meth at the street, the price of the gram (or ounce or whatever unit of measurement we buy) indicates the final value at which the final consumer gets the product. We must understand that this final price is not the original one of the materials used for the producing the drug being sold. As with any other product there is a difference between the cost of producing the drug and the price at which it is sold. This difference constitutes the benefit. It is difficult to establish how the final price of a certain drug is stablished, mainly because the drug market is fragmented and we can see how the same product is sold at different prices in places which are not very far away one from the other. Perhaps the best way of explaining how the prices of illicit drugs are established is the following one:

There is an initial cost of producing each drug. We will label this cost with the term C. Now, this cost includes the raw materials (such as coca leaves, gasoline, pseudoephedrine, etc), the salaries of the people intervening in the process (chemists, harvesters, peasants, etc) and any other cost related to the production process. Nevertheless, all these production costs (C) depend directly on the resources used by the Government for combating the drug supply chain. Now, it is important to understand that the final production costs (C) will depend on these Governmental resources combatting the drug trade (E) Thus we can express the total production cost of a certain drug as the following simple function: C(E)

This equation means only that the cost (C) of producing a certain drug is directly linked to the resources (E) destined by the Government to tackle its production. For example, let´s say that there is a certain criminal group in Michoacan which is centered on producing methamphetamine. For doing so they need only three things: labs, chemists and chemical precursors. The value of these three items indicate the cost (C) of producing the meth. Now, these costs are going to depend on the resources deployed by the Mexican Government to combat the meth trade. Until now it has been easy to build labs in the mountains, to hire chemists from urban areas and to smuggle Asian chemical precursors through the port of Lazaro Cardenas. Then the Mexican Government suddenly takes control of the ports militarizing the facilities and the smuggling of chemical precursors which are vital for the production of meth becomes more difficult since now the group has to bribe not only the port authorities but also the army officials in charge of the port. As we can see the resources (E) employed by the Government have increased due to the militarization of the port and thus the productions costs (C) of meth increased since C depends on E.

Although we have used the example of meth, we could form similar equations for cocaine, heroin, fentanyl or marihuana. Each drug will have its own production resources, but all of them inevitably depend on the resources (E) deployed by the Government to tackle the drug.

Now, these total costs expressed by the function C(E) reflect the production cost of a drug. In other words, C(E) is the cost of the drug just after being produced. If the producer sells the drug at this price he will obtain 0 profit. In other words, he won´t gain or loose not even a single cent since he would be selling the product at the same price he has paid to produce it. What the supplier does is to sell the drug over C(E) in order to obtain benefits. It is difficult to determine how this final price is formed. Sometimes it depends on the distance between the producing hub and the selling location, other it depends on the popularity of the drug at the moment as well as the prices set by other producers, etc. This final price is represented by the function C(E) + T.

What is T? T represents the value that the dealer adds to the Costs in order to obtain a benefit. In other words, it represents the benefit that the seller is going to obtain from selling the drug to the client.

Let´s represent this with a graph (take into account that the initial Supply and Demand curves are lines now in order to make all the figure more easily understandable):

The first intersection (P0 , Q0) represents the Price and Quantity perceived and sold by the producer/seller when there´s no War against Drugs and consequently no Governmental efforts nor resources to combat drug trafficking so C = 0. Since this only happens in legalized markets we cannot portray a real example.

The second intersection (P1 , Q1) represents the Price and Quantity perceived and sold if the transactions takes place at the Price determined by the Governmental repressive resources. In this case the benefit would be 0.

The third intersection (P2 , Q2) represents the Price and Quantity perceived and sold when the producer/seller charges T, this is, the value at which he obtains a profit when selling the drug. The difference between P1 and P2 is equal to this profit value T.

As we can see the bigger the Price (P) is the smaller the purchased Quantity (Q) gets. Logically, when a product price increases the consumption of this product decreases.

What does the War on Drugs try to do? In a few words: increase T until a point that the Quantity (Q) is reduced if not to 0 at least to a point that can be considered minimal or anecdotic. A graphical representation of this phenomenon would be this:

In other words, the more resources (E) deployed by authorities in their War on Drugs the higher T should be in order to obtain benefits. So in the end the producers and distributors have to increase T so much that the demanded Quantity (Q) of the drug plummets.

This is the theory, and it is a mere chimera because the drug market is extremely flexible and can adapt to almost any circumstance.

Contrary to other products cocaine, heroin, fentanyl or methamphetamine have considerably low elasticity. In other words, the demand for drugs is inelastic. This means that increases in the drug price do not cause big distortions in the demand of the product. Instead of entering a long and boring debate about why the demand for drugs is inelastic, we'll use a simple reason: drugs are addictive per se.

Returning to our initial example of the market for oranges. We explained that when the price of a kilo of oranges increases the quantity of demanded oranges decreases. This doesn´t apply to the drug markets simply because the final consumers usually are addicts which are in constant need of consuming more products. Oranges, apples, pens, TVs, CDs or books can´t be compared with drugs because they don´t create a never-ending addiction, their consumers don´t need to consume them to palliate a physical need. This is one of the biggest mistakes of the current War on Drugs, to assume that drugs are like any other commercialized product and that an economic strategy designed for normal markets will succeed when applied to the drug markets.

Although we could discuss for months about the elasticity ratios of different drugs the only truth is that it is impossible to calculate them since this market is totally opaque and that the studies and investigations conducted until now have revealed low elasticity ratios.

There are even further reasons that explain why the current policy of increasing T is failing. It is very difficult to find the example of a product that is produced for so few and sold for so much. When cocaine or heroin are produced in Colombia or Mexico the price of the drug is very small. The price of the drugs starts increasing when they are travelling to the north (the US) or to the final distribution locations. In the middle of these logistical routes another fatal mistake is to suppose that the whole chain is controlled by a unique organization. This is totally false, and evidence suggests that several (perhaps dozens) of organizations are involved in the production, packaging, transportation, smuggling and distribution of drugs. From the Colombian peasant who cultivates coca leave to the American street gang which distributes cocaine in Chicago we can find a Colombian far right paramilitary group which buys the leaves, a Colombian based group which elaborates the basics coca paste, a Cali criminal group which packages and exports the drugs to Central America, a Honduran shipping syndicate which smuggles the cocaine to Mexico through light planes, a Sinaloan group which receives the load in the Sierra Maestra, an organization from Sonora which provides free access to the border, an American based wholesaler from New Mexico who buys the cocaine and finally the Chicago based gang (the ultimate distributor) We must take into account that at each step of this Supply chain the T is constantly incrementing and that it reaches Chicago at a considerable rate. Obviously, the T charged by the Colombian peasant to the guerrilla group which buys the first coca leave load is much smaller than the T charged by the Chicago gang to the street addicts.

It is absolutely foolish to pretend that local anti-drug efforts deployed at the US, Mexico or Colombia are going to make T increase until a point that makes it impossible to buy drugs because they have become very expensive. Firstly, subdivisions and parceling of the market make it impossible to pretend that local or even regional anti-drug efforts are going to increase the overall T. And secondly, this simplistic strategy apparently forgets that the deep differences between each supply step makes it impossible to achieve a global effect since the upper group is always able to pressure the weaker node of the chain to absorb losses. For example, the insurgent groups in Colombia can force the peasants to assimilate the higher costs of the coca leaf caused by chemical eradication campaigns by the Colombian Government.

This would be a plausible cocaine supply chain from the initial growers to the final street vendors. Take into the account that each producer/seller sells the cocaine to the next individual in the chain so each transaction makes the value of T increase (not too much during the first transactions but heavily as the chain gets more sophisticated) The idea that the deployment of local anti-drug resources is going to modify definitely, the value of the last Ts is just a chimera.

This little article has tried to show the basics of the current economic theories and why their enforcement in the context of the War on Drugs is nothing more than a futile, useless and the disastrous excuse used to hide the main fact: until we realize that the drug producers and suppliers cannot be eradicated and that the problem should be addressed in relation to the consumers we won´t stop funneling hundreds of thousands of millions to fund a supposed war that is on the path of becoming one of the longest ones on our history: the War on Drugs.