FORMAL VS. INFORMAL RULES AND THE MARKET PROCESS
Market process theory and the study of entrepreneurial activity in response to economic and institutional conditions can enhance our understanding of how markets evolve. Israel Kirzner, in “The Market: Its Structure and Operation,” rather simply defines the market process as “what goes on when potential buyers and potential sellers are in mutual contact” (2011, 24). At first glance, this seems applicable to almost any circumstance. Kirzner is clear in other places, however, that what can be considered a market process is far more attenuated. Elsewhere, Kirzner states, “We have emphasized the importance of entrepreneurial entry as the driving force in the market process. But, more generally, this process depends on individual freedom to pursue perceived opportunities, within the limits of property rights, without arbitrary obstacles being placed in one’s path” (1992, 53). Property rights, as it turns out, are crucial to the market process. In “The Limits of the Market: The Real and Imagined,” Kirzner expands this emphasis on property rights when he states, “[The] limits on the market are imposed by its institutional prerequisites. Without these institutional prerequisites—primarily, private property rights and freedom and enforceability of contract—the market cannot operate” (2000, 83).
Formal property rights, upheld by the government, are frequently taken as a starting point for the market process to function. As Mises notes in Human Action, “The state creates and preserves the environment in which the market economy can safely operate” (Mises  2007, 257). In describing Kirzner’s approach to analyzing the market process, Boettke writes, “The economist first assumes the moral norms, ethical rules, and the legal institutions that define and enforce private property and ensure the freedom of contract are in place; he then examines the processes of exchange and production that emerge within the market economy that exhibit the strong tendency to realize all the gains from trade and technological innovation” (2014, 235). However, it is unclear from this literature if formal property rights are necessary or just sufficient for the market process to take place.
Yoram Barzel ( 1997) provides us with an important distinction between economic (property) rights and legal (property) rights in the analysis of property rights. Economic rights refer to “the individual’s ability, in expected terms, to consume the good (or the services of the asset) directly or to consume it indirectly through exchange” ( 1997, 3). It is important to note that there is nothing given about the protection of economic rights in this definition. Legal rights, by contrast, “are the rights recognized and enforced, in part, by the government” (Barzel  1997, 4). Barzel continues by saying, “These [legal] rights, as a rule, enhance economic rights, but the former are neither necessary nor sufficient for the existence of the latter” (4). The literature on the role and success of private governance suggests that other options beyond legal protection are available for the enforcement of property rights.
There is a significant literature on the role of informal institutions and private governance in overcoming collective action problems as well as establishing, maintaining, and enforcing property rights in the absence of the state (see Benson 1989, 1990; Ostrom 1990; Greif 1993; Greif, Milgrom, and Weingast 1994; Dixit 2009; Leeson 2014; Stringham 2015). In many of these situations, government has been unsuccessful in enforcing property rights to the satisfaction of market participants and these participants establish alternative rules to facilitate exchange and solve problems. Informal governance structures apply a variety of methods, such as social norms, contractual agreements, and written constitutions, to achieve order such that trade and cooperation can take place. There is evidence, in fact, that informal institutions are what really matter for securing private property. Williamson and Kerekes (2011) find that after controlling for informal institutions, formal institutions have no impact on securing property. In their introduction, they state, “Our paper challenges conventional beliefs that formal institutions are the driving force establishing property rights. Instead, we contend that informal mechanisms are crucially important but are often underestimated . . . while the benefits of codification are typically overstated” (2011, 538-39). Given such evidence, it is unclear why activity within markets whose property rights are enforced by exclusively informal mechanisms would be considered any less of a market process that those markets whose disciplinary mechanisms are both formally codified and informal.
Markets for illegal goods present an additional puzzle for the application of market process theory. In describing prohibition in Man, Economy, and State, Rothbard states, “In many cases of product prohibition, of course, inevitable pressure develops . . . for the re-establishment of the market illegally, i.e., a ‘black market.’ A black market is always in difficulties because of its illegality” ( 2009, 901). Consequently, as Boettke and Coyne (2004), in summarizing Rothbard’s discussion of prohibition and property rights under socialism, note, “Individuals within this prohibition environment still pursue their plans, but they are forced to do so in a manner that is different from what would take place in an unhampered market environment” (83). “Illegal underground markets arise,” as Benson and Baden (1985) describe, “when the institutional structure precludes private owners from allocating their resources in a competitive market” (393). It is an empirical reality that markets (or at least things that look an awful lot like markets) for illegal goods exist despite policies enacted to eradicate them. In these environments, as Boettke, Coyne, and Leeson (2004) state, “there is a strong disconnect between de jure rules and de facto realities” (74). They argue further that “[d] ue to the fact that the de facto realities were not recognized by the legal and political system, market participants [were] forced to undertake transactions outside the formal legal system” (2004, 75).
The literature on extralegal governance suggests that not only do markets for illegal goods not shut down in the face of prohibition, but that governance is actually sought out in order to better facilitate trade, even among criminals (see Leeson 2009, 2014; Skarbek 2011, 2014). Similar to legal markets with insufficient formal property rights protection, informal institutional entrepreneurs step in to create a system of governance to establish and maintain order. This is the role that organized crime syndicates, drug trafficking organizations, drug gangs, and prison gangs play within the illegal goods trade when they establish and protect property rights (Gambetta 1993, Fiorentini and Peltzman 1995, Skaperdas 2001, Sobel and Osoba 2009, Leeson and Skarbek 2010). Anderson (1995, 33-34) explains that when organized crime groups engage in illegal activity, they act like mafias, and she describes one of the key characteristics of mafias as “performing governmental functions—law enforcement and criminal justice—in that sphere were the legal judicial system refuses to exercise power.”
Illegal governance structures use a variety of methods to maintain order. David Skarbek, in his book, The Social Order of the Underworld: How Prison Gangs Govern the American Penal System, provides a detailed account of how prison gangs provide a governance structure such that the trade of contraband, including illicit drugs, can take place even in an environment where such activity is strictly forbidden. Gangs facilitate trade by establishing and protecting private property rights to contraband. They also establish order to incentivize cooperation, thus allowing prisoners to trade and evade detection by prison guards. In similar fashion to Leeson (2007a, 2007b, 2009), Skarbek presents a “hard case” for informal governance by showing how individuals who have previously proven that they have little regard for formal rules (as they have been incarcerated for breaking the law), are confined to small proximities living among enemies, and are constantly under the supervision of law enforcement are able to find a set of rules by which they can live in order to facilitate cooperation and commerce. Additionally, Leeson and Skarbek (2010) and Skarbek (2011) emphasize how criminal organizations utilize constitutions because they generate information and methods of punishment that can align private behavior with group incentives. Leeson and Rogers (2012) highlight the importance of organizational structure for illegal governance in aligning incentives based on the contestability of the industry. Skarbek (2012) describes how norms and the creation of organizations or groups can both be used to establish governance over prison populations. As the size and heterogeneity of the population increases, norms are less desirable and the role of organizations increases. These smaller groups are better able to transmit information, delineate insiders and outsiders, and enforce rules among one another.
Governance is not the only hurdle for the application of market process theory in illegal markets. Unlike in legal markets governed by informal institutions, the government is actively enforcing laws and policies that undermine the property rights of illegal goods in prohibition markets. In legal markets, as Barzel ( 1997) describes it, “Assuming that ownership is not attenuated, the legal owners of commodities are free to exercise their rights over their commodities in any (legal) way they choose” (92). This is not the case when the good in question is illegal. Thus, problems of governance within illegal markets arise when the informal rules are insufficient in protecting property rights against the government. Individuals working within these markets must, therefore, participate in entrepreneurial innovations that make them more successful in evading law enforcement, protecting their informal rights against law enforcement, and reestablishing order after the government has undermined the governance structure. Put differently, in the absence of legal rights, entrepreneurs will have to alter the methods by which they informally provide protection for the economic rights, to use Barzel’s term, of individuals involved in illegal markets. It is the task of this chapter to use market process theory to analyze how illegal entrepreneurs cope with law enforcement that seeks to undermine their rights.
Kirzner, as documented above, makes it clear, in no uncertain terms, that the institutional framework of the market must be taken as given. Furthermore, he is cautious about social scientists explaining the emergence of the framework within which the market process takes place. He states, “It follows that those institutions cannot be created by the market itself. The institutions upon which the market must depend must have been created or have evolved through processes different from those spontaneous coordinative processes which we have seen to constitute the essence of the market’s operation” (Kirzner 2000, 83). Boettke (2014) reemphasizes Kirzner’s apprehension toward the application of market process theory to explain the evolution of institutional frameworks. Boettke writes, “But [Kirzner] raises a caution to those who indiscriminately want to stretch spontaneous order explanations from the market within a given institutional framework to the explanation of that evolution of that framework itself” (2014, 241). Boettke, commenting on Kirzner’s explanation of language as a spontaneous order, states that “Kirzner is making the very sensible point that in social evolution, without recourse to the mechanisms provided by property rights, freely adjusting prices, and the lure of profit and the discipline of loss, all we can say is that practices that evolve serve as focal points of action” (2014, 241).
Barzel ( 1997), too, approaches the emergence of property rights with caution. He states, “It might be tempting to trace the pattern of currently existing property rights holding to its point of origin to determine how and why it came out, yet such an effort would be futile. The ability to consume commodities, including those necessary to sustain life, implies the possession of rights over them. Once this is understood, it becomes clear that one cannot expect to discover any evidence of a pre-property rights state, since it is not possible to endow a pre-property rights state of affairs with meaning” (85). A few sentences later, he continues, “Once some rights are already in existence, it is possible to explore their evolution with respect to changes in economic conditions and legal constraints” (Barzel  1997, 85). This is why he is very clear in differentiating economic rights from legal rights.
It is clear from this discussion that the institutional framework is of utmost importance in explaining how market outcomes manifest. Boettke also states that “[w]hile the entrepreneurial element of human action is ever present, the entrepreneurial market process and the efficiency properties it exhibits are institutionally contingent. Against the appropriate institutional backdrop, entrepreneurial action will tend to realize the gains from trade and the gains from innovation. Absent that framework, however, entrepreneurial action can run in a variety of directions, and without any guarantee of social desirability” (2014, 243).
We can reconcile Kirzner’s warning against using market process theory as a method to explain the emergence of property rights by saying that the informal institutional entrepreneurs working within illegal markets take the economic property rights of illegal goods as given (where the government does not). However, they have the additional task of acting as protective entrepreneurs in how they choose to enforce and protect those rights. Thus market process theory can help to explain how these entrepreneurs alter their methods of property rights protection and tactics of law enforcement evasion in response to changes in economic conditions as well as changes in law enforcement.
In the sections that follow, I will use the market for illegal drugs as a test case for this application. To do so, I will provide examples of changes in evasion and protection tactics within illegal drug markets in response to changes in drug policy to illustrate how these entrepreneurs adapt. I will then explain how government enforcement of such drug policies exacerbates negative outcomes and violence associated with the drug war by limiting the number of illegal drug market participants which decreases specialization, limits entrepreneurial alertness to other methods of protection, and reinforces the criminal presence and violence associated with drug markets.