The Economics of Prohibition

by Mark Thornton

  Figure 2. The Traditional Approach for Determining the Optimal Level Prohibition Enforcement.

  The policymaker must find the optimal level of enforcement by determining the benefits provided by enforcement (in deterring production and consumption of the prohibited product) and the costs of this effort (which at present are limited to the direct costs of enforcement). By using the “traditional approach” described above to make these determinations, one can clarify the relationship between the cost of law enforcement and the price and quantity of the prohibited product. The results explain why prohibitions are never fully enforced in democratic nations—the costs of total enforcement far outweigh the benefits.

  The traditional approach to policy based on the preceding analysis focuses attention on setting optimal levels of enforcement and determining the proper type and administration of enforcement. The approach also balances expenditures between enforcement and demand-reduction policies, such as drug education.

  Much more has become known about prohibition through decades of painful and costly experience. For example, one notable observation is that drug addicts will sometimes resort to criminal activity to pay the high prices of prohibited products. The traditional approach is a static analysis that retains assumptions of neoclassical analysis, such as a homogeneous product of a given quality. This oversimplification places important limitations on the analysis. A more detailed theoretical knowledge of prohibition is provided by the Austrian, or market-process, approach to economics.

  Market-Process Approach

  The Austrian, or market-process, approach to economic analysis is best exemplified in the works of Mises ([1929] 1977, [1936] 1951, 1922, [1949] 1977), F. A. Hayek (1937, 1945), and Israel M. Kirzner (1973, 1985). It begins with the truism that human action is purposeful and aimed at enhancing individual utility amid uncertainty and imperfect knowledge. Economic development occurs through exchange, learning, entrepreneurship, innovation, and the evolution of institutions. The market economy generates solutions to social problems; for example, the introduction (or evolution) of money reduces the transaction costs of exchange. The generation of such solutions is a discovery process because it requires alertness to opportunities and interaction between numerous individuals over time.

  The market-process approach employs a multidimensional view of competition, whereas orthodox economists often rely on simplifying assumptions, such as homogeneous products. The market-process approach reminds us that goods are subjectively evaluated by individuals, who base their evaluations on many features of products. For example, a car is evaluated on the basis of age, design, style, color, size, power, materials used, fuel efficiency, and reliability, and many of these categories have multiple dimensions. The market produces a variety of products—determined largely by subjective choices from among the available technological possibilities.

  This elaboration of the capitalist process indicates that entrepreneurs do more than drive prices to equilibrium levels. The entrepreneurial search for profits results in a competition based not only on price but also on alterations of the product and the development of new products. The market-process approach views disturbances of equilibrium as entrepreneurial moves to create new products and markets, to enhance products or information about the product, or to reduce cost. For example, one key element of the market process and economic development is advertising.3 Advertising increases knowledge of a product, allowing the consumer to make better decisions while reducing search costs.4 Advertising also assists in the development and introduction of new products and products with new characteristics.

  Elements of the market-process approach have been integrated into modern economic orthodoxy. An important aspect of this integration is the “modern microeconomic synthesis,” in which market-process elements have been synthesized with the neoclassical paradigm. A notable contribution in this area was by Lancaster (1966). His “new approach to consumer behavior” improved the understanding of product differentiation, complements and substitutes, advertising, and many other aspects of economic analysis that had become the “black holes” of the neoclassical paradigm.5

  This new approach begins with the notion that economic goods consist of attributes and that these attributes (not the goods themselves) are what provide utility to users. Attributes of goods can be altered so as to enhance the utility derived from goods. The supply and demand for attributes follow the normal economic laws, and over time provide utility enhancement for the consumer (given free entry).

  Interventionism and the Market Process

  Interventionism is an alternative form of economic organization to capitalism or socialism, a form that involves governmental control or direction of resources that were private property. This popular form of organization includes price controls and regulations that are known to impose heavy direct costs on the economy, such as shortages and surpluses, inefficiency, and waste. Prohibition is an extreme form of government intervention that has important implications on the entrepreneurial discovery process.

  In addition to the direct effects of interventionism, economists have discovered important “unintended consequences” of interventions, such as the racial discrimination that results from minimum-wage laws. The costs of these unintended consequences have often been found to be greater than either the direct costs of interventionism or the perceived benefits derived from the intervention. Policymakers and orthodox economists do not anticipate (theoretically) these unintended and undesirable consequences because they are unaware of the causal relationship between interventionism and these effects, or simply deny the existence of such relationships.6

  These consequences are predictable when the market-process approach is used to model interventionism. While all unintended consequences cannot be predicted in detail, they can be categorized in a way suggested by Kirzner (1985). Kirzner’s four categories of results can be profitably applied to the policy of prohibition. As an extreme form of interventionism, prohibition can be expected to have more pronounced effects than other forms of intervention, such as regulation or price controls.

  The Undiscovered Discovery Process

  The undiscovered discovery process refers to the market’s ignorance or impatience with the progress toward solutions. It is difficult to imagine political solutions, however, without market discovery. Car safety features and nonsmoking sections in restaurants, for example, could not be mandated unless the market had first discovered them.

  The demand for interventionist policies such as prohibition arises from the perception that the market process has caused an inefficient outcome or that the market will not correct inefficiencies. It may also be the result of the perception that the market should correct inefficiencies in a “perfect,” instantaneous, and complete fashion.

  The market’s tendency for correction takes place under conditions of imperfect knowledge. Corrections take time, may not be immediately recognized, and are never complete in a world where equilibrium is never actually achieved. In other words, the market corrects for inefficiencies in an efficient manner, that is, resources are directed away from the least-valued uses toward the most highly valued applications. As Hayek (1945) has demonstrated, information in the market is dispersed and the policymaker can hope to gather only a small fraction of the vast amount of relevant information that exists. In contrast, the market uses all this information.

  As shown earlier, prohibitions were often preceded by long periods of government intervention, rather than a pure market process. Prohibition was imposed because the harms of the prior intervention and the benefits of voluntary, market-based measures were not understood.

  The market’s discovery process results in less expensive, higher quality, and safer products. Prohibition terminates the discovery process and replaces it with a black market and a bureaucratic process, each with its own evils.

  The Unsimulated Discovery Process

  Prohibition establishes bureaucracy not to intervene in the market but to repl
ace it. Government direction of economic activity is inherently different from the market process. Whereas market activity (production) takes place in a competitive, profit-directed environment, government direction (prohibition enforcement) is carried out in a bureaucratic, rule-guided environment. Entrepreneurs are motivated and directed by profits; bureaucrats are directed by rules and are precluded from receiving profits.

  The general inefficiency of bureaucracy is well known and unavoidable. Because they lack incentives to do so, bureaucrats do not minimize the costs of production. William Niskanen (1971) found that bureaucracies could behave like monopolies because of their informational advantage over politicians. Bureaucracies themselves provide most of the information on which elected representatives base their votes on budgetary requests. Stigler (1977) found that bureaucracies were captured by the interests of regulated industries. C. M. Lindsey (1976) found that bureaucracies moved production out of desired activities and into observable activities. Bureaucrats find it to their (budgetary) advantage to allocate resources to produce “noticeable” results rather than uncountable, but more valuable, services. Even in the unlikely event that none of these incentive problems were present, bureaucracies would still face the information problems described by Mises ([1944] 1969).

  Businesses are spurred on to implement new production methods, cost-cutting techniques, product enhancements, and new services in order to avoid losses and achieve profits. The discovery process is made easier because the market consists of many entrepreneurs who develop innovations that are generally recognizable and readily copied.

  The bureaucrat has no such luxury. Bureaus are centrally directed and guided by rules; they have little access to innovations from outside sources. There is no systematic process that would result in less efficient bureaucrats being replaced or efficient bureaucrats being promoted, even if bureaucrats are assumed to be well intentioned. In fact, the Peter Principle suggests the opposite—bureaucrats rise to the highest level of their incompetence. Further, there is little scope for encouraging discovery by bureaucrats or for rewarding bureaucrats for discovery.

  Thus bureaucracies cannot simulate the discovery, or successes, of the market. They have no way of knowing what the market would do in given circumstances and little incentive to find out. The lack of incentives results in less discovery of cost-cutting techniques and production techniques. In fact, successful bureaucracies often find their budgets cut, and innovative bureaucrats are often chastised, demoted, or dismissed. For example, two of the most successful Prohibition agents, Izzy Einstein and Moe Smith, were dismissed for doing their jobs in an honest and effective manner. “The two of them had raided three thousand speakeasies and arrested 4,900 people. They had confiscated five million bottles of bootleg liquor and smashed hundreds of stills. In every household from coast to coast Izzy and Moe were living proof that prohibition agents could be honest and incorruptible. But to be famous for honesty might seem an empty accomplishment when it was rewarded by dismissal” (Coffey, 1975).

  The Stifled Discovery Process

  Not only are bureaucracies incapable of discovery, they also stifle the discovery process of the market. Prohibition completely ends the discovery process of the market with respect to the outlawed good.

  Some direct effects of government intervention are well known. Rent controls lead to housing shortages; minimum-wage laws cause unemployment. These results can be viewed on supply-and-demand diagrams, but these basic effects are not the only costs of government intervention.

  In addition, intervention also discourages the development of new techniques, products, product characteristics, safety features, and sources of supply. These are the very types of discoveries that, given time, would make the call for intervention unnecessary, but which cannot take place because of the intervention.

  Although we cannot know the magnitude of these stifled opportunities, they are costs of the intervention. In the case of prohibition, this cost is significant because the discovery process of the market is not merely stifled but destroyed altogether for the good in question and is severely curtailed or distorted for related goods.

  The Wholly Superfluous Discovery Process

  The elimination or control of a particular economic activity produces profit opportunities that previously did not exist. These profit opportunities will likely disrupt the plans of bureaus and undercut the pursuits of regulators and government policymakers. The severity of the intervention will determine the extent of these new (black-market) profit opportunities. Therefore, the wholly superfluous discovery process is particularly relevant to prohibition.

  The profit opportunities created by prohibition will result in new methods of production, transportation, inventory, distribution, and marketing. The product, its quality, and attributes will experience tremendous change moving from a competitive market environment to one dominated by prohibition. These changes should of course be attributed to intervention, not to the market. Cave and Reuter (1988) found that entrepreneurs (smugglers) learn from experience; such increased knowledge can result in lower prices even during periods of increased enforcement efforts.

  Bureaucrats are also subject to this wholly superfluous discovery process. Bureaucrats are normally unable legally to reap profit opportunities as residual claimants of their bureaucracies. Profit opportunities created by prohibitions, however, can be extended to bureaucrats by black marketeers in return for protection or selective enforcement. Bribery and corruption are unintended but nonetheless expected results of government intervention. Again, because prohibition is an extreme form of government intervention, corruption due to prohibition will occur to a greater extent than corruption associated with a price control or regulation.

  In order to compare the severity of prohibition with other interventions, imagine a milk-price support established at $150 per gallon. Even at current levels, the milk price support program entices new suppliers of milk into the market. It encourages the development of special dairy cows, the use of special hormones and chemicals, and expensive feeding techniques. Even small amounts of smuggling and corruption can be detected. At a support level of $150 per gallon, one can imagine that missiles containing dried milk might be shot into the United States, that artificial forms of milk would be produced in basement chemistry laboratories, and that economists would become dairy farmers.

  In summary, prohibition is advocated on the basis of misconceptions of the market’s ability to solve social problems (although rent seeking is typically required for prohibitions to be enacted, as shown in chapter 2). Bureaucracies established by prohibition are inherently inefficient and unable to discover the knowledge required to solve social problems. Prohibition also suppresses the market’s ability to solve social problems, so that little or no progress is made while prohibitions are in effect. And finally, prohibitions create profit opportunities which add to the problems prohibition is intended to solve.7

  Figure 3. The Process of Progressive Interventionism (and exit).

  THE POLITICAL ECONOMY AND PROHIBITION

  The general tendency for one act of government intervention to lead to further acts of intervention has been modeled by James M. Buchanan and Gordon Tullock (1965). More recently, Bruce L. Benson (1984) has pointed out that each change in property rights establishes a new set of rent-seeking (and defending) possibilities. The process of this “progressive” interventionism is described in figure 3. Here, the expansion of intervention occurs for three reasons. Bureaucracy is inherently inefficient at achieving the sought-after results of policy, and initial failure leads to the call for more resources and powers for the bureaucracy to carry out its mission (1). The market has been stifled and therefore is unable to address social problems (2). And the activities of the bureaucracy create distortions and new problems in the market which “necessitate” (in the minds of bureaucrats and policymakers) further intervention (3).

  The connection between the perceived need for policy response and more interventi
onism (4) is based on the institutional-based incentives of bureaucrats, politicians, and voters. Bureaucrats seek to expand their influence and power in order better to accomplish their original duties. This tendency for bureaucracies to grow is not dependent on the bureaucrats’ being either selfish or public spirited. In any case, the bureaucrats do not perceive “failure” as the result of their own inefficiency. They are also unlikely to blame their own bureaucracy for problems generated from the wholly superfluous discovery process. Politicians who are ultimately responsible for bureaus receive benefits from them, and they are unlikely to admit failure or engage in the costly and uncertain procedure of dismantling a bureaucracy. Voters will perceive easily recognizable gains from the application of bureaucratic solutions, but they will not see the total cost. Bureaucracies tend to set the price of their outputs below cost (usually zero), resulting in a gain to the voter and a loss to the taxpayer. One result of this pricing policy is long lines for government services and the perception that more government is required. In the case of prohibitions, there never are enough enforcement agents to stop the problem.

  The process of progressive intervention can only be reversed (5) by the electorate’s discovery of both the true cause of the problem (intervention) and an alternative solution (the market). Because of the extensive transition and realignment costs, it is unlikely that elected representatives will act to dismantle a prohibition without extensive public support. In the event of the repeal of an intervention, bureaucracies must be quickly and thoroughly disbanded; else they will likely “discover” some new rationale for their existence.