This Is Your Entrepreneurial Alertness on Drugs. Prohibition and the Market Process
Markets for prohibited goods exist, despite extensive efforts to suppress them. The intention of prohibitionist policies is to eliminate the market for a particular good(s). In order to accomplish this goal, laws and their enforcement are usually directed at the supply side, the production and distribution, of these illegal goods. When economists model the markets of illegal goods, prohibition is taken into account not through the elimination of supply (because we know that the supply of illegal goods, like drugs, still exists). Instead, economists frequently model prohibition as a tax or as an additional cost of doing business (Thornton 1991). This additional cost of doing business includes the costs required to evade law enforcement and consideration of the cost and likelihood of punishment (Thornton 1991; Becker, Murphy, and Grossman 2006). However, understanding how entrepreneurs respond and try to cope with prohibition policies is restricted under this framework. Market process theory, as it focuses on entrepreneurial action in the pursuit of profit, couples nicely with these insights to provide a more complete picture.
In order to remain in the market, prohibition entrepreneurs have the incentive to figure out ways of minimizing these costs of doing illegal business, as well as establishing and maintaining institutions that promote cooperation. Beyond these costs, entrepreneurs and firms within illegal markets are still concerned with increasing their profitability. How do these new profit opportunities emerge, and how do illegal firms innovate? Furthermore, how do these additional costs associated with doing illegal business shape the ability and the context within which these prohibition entrepreneurs come upon and implement new innovations?
In order to tease out what market process theory can tell us about markets for prohibited goods, we must unpack what “prohibition” means in practice. A key, but by no means exclusive, component of prohibition is that formal
(legal) property rights are not afforded to prohibited goods and services. Established, observable, and enforceable property rights are necessary for economic calculation (Mises  2007) and the market process (Kirzner 1992, 2000). One of the many roles assumed by governments is the formal provision of property rights. However, other methods of informal property rights protection exist. There is an extensive literature on the informal provision of property rights through nongovernmental and private governance (see “Drug Prohibition—a Market (?) without Formal Rules” below). These provisions can and do exist in the absence of, as supplements to, and as alternatives to formal property rights provided by the government. Informal governance is frequently present within illegal markets. This helps to explain why we observe order in the exchange of illegal goods, despite the absence of formal rules.
Another key feature of prohibition is that government-sanctioned law enforcement actively seeks to arrest and punish individuals involved in the production, distribution, and trade of prohibited goods and services. This feature not only raises the cost to individuals participating in illegal markets, but it also undermines the informal institutional structures that exist in the absence of formal protection. If prohibition simply meant that individuals involved in activities deemed illegal were not privy to protection, resources, and adjudication provided by the government’s property rights system, then the differences between legal and illegal markets could be explained by the differences in the formal and informal sets of rules that govern each, respectively. Therefore, in order to fully explain the differences in entrepreneurial options and outcomes between legal and illegal markets, the government’s role in significantly raising the costs of participating in illegal markets must be taken into consideration. These costs are created and raised when the actors working within illegal markets are not extended formal property rights and when prohibition policies and law enforcement initiatives are utilized by the government as tools to undermine the informal governing institutions.
This chapter suggests that because illegal goods are forced outside of the traditional property rights-based institutional arrangement and are faced with continuing efforts on the part of the government and law enforcement to stifle and eliminate these illegal markets, entrepreneurial efforts within illegal markets will be channeled toward protective innovations that allow these entrepreneurs to remain in business. Throughout this chapter, I refer to entrepreneurs engaging in these activities that create or enforce protection of informal property rights as “protective entrepreneurs.” In an effort to evade law enforcement and maintain governance in the face of government intervention, both of which are necessary in order to remain in business, illegal entrepreneurs must trade off against productive entrepreneurial endeavors when they act as protective entrepreneurs. In order to describe these ideas more clearly, I will use the market for illegal drugs as an example of a market for a prohibited good.
By using market process theory and digging deeper into the interaction between the institutional framework and the market for illegal drugs, this chapter contributes several extensions to the broader prohibition literature. Past literature, as referenced in the opening paragraphs, has offered a limited distinction between legal markets and the markets for prohibited goods, in the form of the “cost of doing illegal business.” This chapter extends our understanding of the cost of doing illegal business by differentiating between the costs of creating an informal governance structure and the costs of constantly adapting that structure to endure changes in the enforcement of prohibition. The argument in the pages that follow also emphasizes how these costs directly impact not only the incentives of illegal entrepreneurs, but also the channels within which they focus their entrepreneurial efforts. Finally, this chapter advances the literature by emphasizing how prohibition policies shape specialization opportunities for illegal entrepreneurs. These subtle, but crucial, distinctions create considerable leverage for explaining the divergence in qualities of legal and illegal markets, such as the use of violence and product safety.
In this chapter, the first section will discuss the literature on the impact of rules (formal and informal) on entrepreneurship and the market process. Next, using illegal drug markets as an illustrative example, I will show that thriving markets for prohibited goods exist and describe some examples of the entrepreneurial innovations within these illegal markets. In the third section I will outline problems that we see with illegal markets and differentiate which problems are associated with the lack of formal rights versus the presence of law enforcement. The final section will briefly explain how insights from illegal markets can inform the discussion of other markets without formal rules, specifically developing economies, and offer conclusions.