Modelling the Cocaine and Heroin Markets in the Era of Globalization and Drug Reduction Policies Claudia Costa Storti and Paul De Grauwe

Transcription

1 Modellng the Cocane and Heron Markets n the Era of Globalzaton and Drug Reducton Polces Clauda Costa Stort and Paul De Grauwe

2 Modellng the Cocane and Heron Markets n the Era of Globalzaton and Drug Reducton Polces June 2008 Cláuda Costa Stort and Paul De Grauwe* Cláuda Costa Stort Paul De Grauwe European Montorng Centre for Katholeke Unverstet Leuven Drugs and Drug Addcton Center for Economc Studes R. Cruz de Santa Apolóna, Naamsestraat Lsboa 3000 Leuven Portugal Belgum clauda.costa-stort@emcdda.europa.eu paul.degrauwe@econ.kuleuven.be Abstract We model the markets of cocane and heron, from the producton countres to the fnal retal markets. One novelty of the analyss s to model the retal market as a market characterzed by monopolstc competton. Emprcal research n crmnology suggests that monopolstc competton s the prevalent markets structures So, we consder the upper level dealers to have some power over the retal market. Ths allows them to charge a markup and to earn extra profts. Smultaneously, extra profts attract newcomers n the busness, so that these profts tend to vansh over tme. We use ths model to analyze how supply contanment polces affect the retal market, the producer market and the export-mport busness. In general, law enforcement measures ncrease the rsk prema receved both by the lower and hgher level traffckers. As a result, ntermedaton margns n the busness of dealng and sellng drugs tend to ncrease. However, we fnd that globalzaton has the opposte effect of supply contanment polces. It lowers ntermedaton margns and, as a result, tends to lower retal prces, thereby stmulatng consumpton. The fnal mpact on consumpton depends on ts responsveness to prce changes. At the same tme, globalzaton ncreases the prces obtaned by producers, tendng to ncrease producton. In so dong, globalzaton offsets the effects of supply contanment polces. Fnally, we show that the effectveness of supply contanment polces can be enhanced by combnng them wth demand reducton polces. Keywords: llct drugs, globalzaton, drug polces * We are grateful to Rchard Hartnoll for helpful comments and crtcsm. The vews expressed n ths paper are our own and do not necessarly reflect those of the European Montorng Centre for Drugs and Drug Addcton. 2

3 1. Introducton Over the last twenty years, the use of cocane and heron n the world has remaned steady. Accordng to UNODC (2007), between 1992 and 2005, world consumpton of these drugs rose by about 3.2%. These growth rates were 7.3% and 3.4% n Europe and 1.8% and 1.1% n the US durng the same perod. Publc polces to combat the drug phenomenon,.e. those geared towards reducng drug supply have been extensve. In Europe, accordng to the exstng nformaton about sx countres publshed by the EMCDDA (2007) the share of the overall publc drug-related expendture devoted to supply reducton polces,.e. law enforcement, vared from 40% to 77% n 2005 (excludng Hungary where they only represented 24%). In the US, accordng to the Whte House natonal drug control strategy (2007), the percentage of drug control fundng allocated to supply reducton actvtes has ncreased from 53% n 2001 to 63% n A further understandng of the drug supply phenomena seems urgent. Despte the publc expendture devoted to restran drug supply, llct producton of drugs such as cocane and heron has contnued to ncrease and retal prces n Europe and the US have fallen sgnfcantly n the last twenty years. The latest avalable data for 2005 and 2006 show that retal prces of cocane and heron fell to less than half of ther levels of Emprcal research has showed that drug use s responsve to drug prces 1. Thus, the observed prce declne may be responsble for the ncreased use of cocane and heron. In ths paper we develop an economc model of demand and supply and of the prce formaton process of llct drugs (cocane and heron). The model allows us to dscuss the effcacy of law enforcement n nfluencng the prce formaton mechansm and drug supply. It also makes t possble to study the dfferent ways n whch globalzaton nfluences the prce formaton process and the demand and supply of cocane and heron, and how globalzaton nterferes wth the objectves pursued by the supply contanment polces set up by the authortes of the drug consumng countres. 1 Dfferent studes pont to a prce elastcty faced by aggregate demand for cocane relatvely small but dfferent from zero. See Caulkns et al. (1995), Caulkns (2001), Brettevlle-Jensen and Born (2004), Abt Assocates (2000), Dave (2004), Grossman (2004). 3

4 We model the cocane and heron markets n three steps. Frst we concentrate on the retal markets of these drugs. Ths wll lead to the demand sde of the model. Second, we model the producton of cocane and heron n the producng countres. Ths wll lead to the supply sde of the model. Thrd, we lnk the demand and supply sdes by modellng the export-mport busness of cocane and heron. We wll then use ths model to analyze how globalzaton has nfluenced the busness of producng, traffckng and consumng drugs. Our man argument wll be that the dfferent ways globalzaton affects the phenomena contrbute to explanng these emprcal puzzles. Furthermore, we wll analyze the effects of law enforcement polces at dfferent levels of the producton and traffckng of drugs. We wll suggest that these law enforcement polces rsk loosng the battle aganst the forces of globalzaton. The paper s organzed as follows. Secton 2 presents the dfferent emprcal puzzles n the cocane and heron markets. Secton 3 develops the retal sde of the model, secton 4 the supply sde and secton 5 lnks the two by modellng the export-mport of the drugs. In secton 6 we brng together the dfferent effects of globalzaton on the markets for cocane and heron and n secton 7 we present a case study about the emergence of the West Afrca cocane route. 4

5 2. Recent developments n the cocane and heron markets Durng the last twenty fve years mportant emprcal phenomena have occurred n the cocane and heron markets. Frst, retal prces of these drugs have declned sgnfcantly. We show the evoluton of these prces n the US and European retal markets snce 1990 n fgure 1. We observe that both n the US and n Europe cocane and heron prce trends fell to less than half of ther levels of (Note that snce the early 2000s a stablzaton of these prces seems to have occurred and even a surge of heron prces n the US retal market). Second, the producer prces of cocane and heron have ncreased or remaned stable over the same perod. These are the prces pad out at the farms gate n the producng countres. We show the evdence for cocane n fgure 2. We observe that the farmgate prces of coca leafs have more than doubled snce In Colomba, both the coca paste and the cocane HC1 have shown upward prce trends. (The prce data for heron are less comprehensve but the evdence suggests that these trends have been smlar for heron, see Unted Natons, World Drug Report 2007). Thrd, and related to the prevous observatons, the ntermedaton margns n the cocane and heron busness have declned dramatcally over the same perod. We show the evdence n fgures 3 and 4. Fgure 3 shows the nternatonal ntermedaton margn,.e. the margn between the wholesale prce n the drug mportng country and the prce pad to the producers n the exportng countres. Ths can also be called the export-mport margn. Fgure 4 shows the ntermedaton margn between the retal prce and the wholesale prce n the drug consumng countres. We see that both these margns have collapsed snce 1990 for both cocane and heron. Fourth, the world producton of cocane and heron has contnued to ncrease. We show the evdence n fgure 5. Ffth, the evdence suggests that the worldwde consumpton of cocane and heron has remaned steady. Accordng to the Offce on Drugs and Crme of the UN, consumpton of both cocane and heron was 3% hgher n 2005 as compared to These growth rates were 7.3% and 3.4% n Europe and 1.8% and 1.1% n the US durng the same perod. 5

6 Fgure 1 Fgure Cocane and heron retal prces, (US dollar, per gram) US - cocane Europe - cocane US - heron Europe - heron Farm-gate prces for sun-dred coca leafs, (US dollar, per klo) Peru Bolva trend trend Source: Unted Natons, World Drug Report 2007 Offce on Drugs and Crme, New York (pp 223, 228) Note: Prces are adjusted for nflaton Fgure 3 Fgure Cocane & heron: margn between wholesale and producer prces, (US dollar, per gram) US - cocane Europe - cocane US - heron Europe - heron Cocane & heron: margn between retal and wholesale prces (US dollar, per gram) US - cocane Europe - cocane US - heron Europe - heron Source: Costa Stort and De Grauwe(2008) Fgure Cocane and opum global producton, (metrc tones) Cocane Opum Global producton of cocane Global producton of opum Source: Unted Natons, World Drug Report 2007, Offce on Drugs and Crme, New York, (p.64). Notes: (1) Straght lnes are trend lnes estmated by OLS. The estmated equatons are: Cocane Y = X, where Y s the producton and X s tme Heron Y = X, where Y s the producton and X s tme. (2) US Department of State(2008) fnds smlar trends durng

7 Fnally, durng the same perod supply contanment polces have been ntense, and n some countres lke the US, these polces have been stepped up dramatcally. Accordng to Basov, et al. (2001), from 1980 to 2000, the DEA budget ncreased by a factor of three n real terms. Drug arrests n the US more than doubled durng the same perod. One could have expected that such an ntensfcaton of supply contanment polces would have shown up n hgher retal prces and declnng consumpton and producton. Exactly the opposte occurred n the US. These are puzzlng phenomena. In order to better understand them, ths paper proposes a model of the cocane and heron markets. We wll model these markets n three steps. Frst we concentrate on the retal markets of cocane and heron. Ths wll lead to the demand sde of the model. Second, we model the producton of cocane and heron n the producng countres. Ths wll lead to the supply sde of the model. Thrd, we lnk the demand and supply sdes by modelng the export-mport busness of cocane and heron. Fnally, we wll dscuss how globalzaton and law enforcement polces nfluence the phenomena. 7

8 3. The model for the retal drug market We assume that the retal market s characterzed by monopolstc competton,.e. there are many supplers of drugs, each of whch has some lmted local market power 2. The emergence of monopolstc compettve structures at the retal level can be seen as orgnatng from asymmetrc nformaton between the buyer and the seller of drugs,.e. the seller knows the qualty of the drug whle the buyer does not. Ths asymmetry of nformaton leads to a market falure: the hgh qualty drug tends to dsappear and only the low qualty drug s left over 3. Ths market falure, however, can be partally overcome when buyers and sellers establsh a relatonshp based on trust, whch can be acheved by repeated transactons between the same sellers and buyers. Ths n turn creates a network structure n the retal market whch allows the nformaton about the qualty of the drug and the relablty of the seller to be shared 4. Once trust s acheved, the seller can charge a qualty premum. These relatons based on trust n a network envronment have been descrbed by economsts 5 and, recently, by many crmnologst research. The Matrx Knowledge Group (2007) concluded that n the UK the level of market entry s largely determned by the level of the personal contact a dealer entered through. Most successful dealers were able to adapt to new crcumstances and explot new opportuntes. These often came about through chance meetngs, although ethnc tes, sellng to frends who were users,.e., successful dealers are those who are better n establshng personal networks. So ther success depends on the contacts they are able to establsh, the trust they are able to buld ether from ther supplers or from ther clents. A drug user wll prefer to buy from hs regular suppler, acceptng a hgher prce n order to guarantee that the drug s safe and the suppler s trustworthy. In a broader nternatonal lterature revew Desroches F. (2007) assesses the nature and structure of drug markets, focusng on upper level drug traffckng. He 2 The model that wll be presented n ths secton s an extenson of the Krugman(1979) model. See also Feenstra(2006). It has ts orgn n the work of Chamberln(1936) and Robnson(1933) on monopolstc competton. 3 The classc analyss of ths lemon problem was frst made by Akerlof (1970). 4 In other markets, ths lemon problem s often dealt wth by the use of brand names. The llct character of drugs makes ths soluton to be based on personal networks, where the trust on a seller s reputaton s crucal. 5 See Reuter and Caulkns (2004). 8

9 concludes that upper level dealers (.e., the local monopolsts) typcally operate n crews or cells made up of core and frnge members, wth a dealer who oversees all the mportant work (where sometmes there are some partnershps wth one or two upper level traffckers) wth employees for non-manageral tasks. The secrecy of ther actvtes and ther structures whch are based on personal networks, prevents these drug syndcates from growng. Furthermore, knshp, frendshp and ethnc bonds functon as a bass for the establshment of new clents, where the capacty of each of these drug traffckng syndcates to enlarge ther market share s also lmted. Desroches ponts out that there s a certan consensus about the vew that [ ] organzed crme conssts of a relatvely large number of small ndependent crmnal syndcates, each of whom competes wth another for a market share [ ]. Consequently, the drug market can be seen as entrepreneural organzatons, where dealers are ratonal actors who focus on proft, seek out economc opportuntes and attempt to mnmze rsk. Effectvely, due to ts llegal nature, drug traffckng s a hgh rsk actvty n whch traffckers manage rsk wth tools such as the sze of ther syndcate, ther structure and organzaton. All ths tends to create a market structure akn to monopolstc competton, n whch drug dealers have a certan market power and apply a hgh markup ntally. Ths markup tends to dmnshes over tme because new dealers are tempted to jon the market. Thus a characterstc of ths market structure s that there are no strong barrers deterrng newcomers (see also Reuter and Haaga(1989)). Consequently, these markets beneft from a certan degree of competton leadng to prce declnes. 3.1 The model Ths local market power of the suppler s represented n our model by the assumpton that each upper level traffcker or suppler faces a downward slopng demand curve for the drugs he sells. We assume there are n supplers of drugs n the retal market. The number of supplers s endogenously determned n the long run by mposng a long term no proft condton. The proft of suppler ( π ) s defned as follows π = p x wl p x (3.1) m 9

10 where x s the quantty of the cocane sold by ; p s the prce charged; l s the number of lower level dealers employed by suppler ; we assume that the same wage, w, s pad to all lower level dealers. Furthermore, p m s the cost of one unt of the drug at the moment of mport, so that the term p s the total cost of the x m mported drugs for frm (for the upper level traffcker). We assume a very smple lnear technology gudng the demand of lower level drug dealers or employees by frm,( the upper level drug dealer ): l = α + β (3.2) x where β s the number of dealers needed to sell one unt of drugs (the margnal 1 labour nput coeffcent). Put dfferently, s the margnal productvty of a lower β level dealer n sellng drugs. Effcency mprovements can lead to an ncrease n the margnal productvty of dealng. Conversely, strcter law enforcement can have the effect of lowerng the margnal productvty of dealng n drugs. The assumpton s that when the number of arrests ncreases, more dealers wll have to be used to traffc the same amount of drugs. We assume that law enforcement has a postve margnal productvty (more law enforcement leads to the mprsonng of more drug dealers), though at a declnng rate,.e. the effcacy of further law enforcement actvty has dmnshng returns. Substtutng (3.2) nto (3.1) yelds π = p x w( α + βx ) p x (3.3) m The upper level drug dealer or frm maxmzes hs profts. The frst order condton for a maxmum s gven by the followng expresson η p = ( βw + η 1 p m ) (3.4) where η s the prce elastcty of the demand for drugs of suppler (expressed n absolute value). 10

11 It s mportant to stress here that the prce elastcty, η, measures the reacton of drug users to a change n prce asked by suppler, assumng that other supplers do not change ther prce. In our model of monopolstc competton, η > 1. Ths prce elastcty s dfferent from the prce elastcty of the total demand for cocane. Let us call the latter the market elastcty and represent t by ε. The market elastcty, ε, measures the extent to whch drug users change ther demand for drugs when the prce of ths drug (as appled by all drug supplers) changes. The market elastcty, ε, s then lower than the elastcty, η, used here 6. It can been shown that n order for the model of monopolstc competton to have an equlbrum ε < η (Dxt and Stgltz(1977)). We recognze n equaton (3.4) the typcal markup condton of prce over margnal cost. The margnal cost s β w + p and conssts of two components, the margnal cost m of dealng drugs by the lower level traffcker (βw) and the margnal mportng cost of η the drug ( p m ). 1 η 1 > s the markup. It can be useful to express equaton (3.4) n a dfferent form,.e. m η βw = ( + 1) η 1 p m (3.5) where p m = s the ntermedaton margn n the retal market. Note that ths pm margn ncludes both the wages pad to the lower level traffckers and the profts of the upper level dealer. Equaton (3.4) allows us to gauge the mpact of exogenous changes on the retal prce of the drug. For example, an ncrease n the cost of mported drugs leads to a more than proportonal ncrease n the prce of the drug,.e. 6 Caulkns and Hao(2008), have an nterestng dscusson about the European and the US demand elastctes for cocane and heron. They put the market elastcty for the US wthn a range of 0.5 to 1 (absolute values). See Abt Assocates (2000), Brettevlle-Jensen and Born (2004), Caulkns et al. (1998), Caulkns (2001),, Dave (2004), Grossman (2004). The estmates of the prce elastcty ε obtaned n these studes typcally are below 1 (but larger than 0). 11

12 p p m η = η 1 (3.6) It should be stressed that these effects apply to the short-run. In the long run, the profts of the drug supplers are competed away by the entry of new drug supplers. Long run equlbrum s obtaned by mposng a zero proft condton π = 0. We wll also mpose the condton that the equlbrum s symmetrc,.e. that prces and quanttes are dentcal across drug supplers. Ths allows us to concentrate on the representatve drug suppler wthout subscrpt,.e. to focus on a representatve upper level drug dealer. Thus, from (3.3) and droppng the subscrpt, we obtan the long run equlbrum condton Rearrangng leads to px w( α + βx ) p x = 0 (3.7) m α p = w( + β ) + x p m (3.8) It can be seen that ths amounts to settng prce equal to average cost. We rewrte ths equaton to obtan the long term equlbrum value of the ntermedaton margn w α m = ( + β ) + 1 p x m (3.9) We can derve the long run effect of a change n p m. For example, the long term mpact of a ncrease n the mport prce of drugs, p m, on the retal prce of cocane, p, results of the dervatve of p wth respect to p m n equaton (3.8). Ths yelds: p p m = 1 (3.10) Comparng (3.10) wth (3.6) we see that the long term effect of a hgher mport prce of drugs s smaller than the short-term effect. In the short-run, the hgher mport prce leads to an overshootng of the prce,.e., short run retal prce ncreases more than proportonally to the ncrease n the mported drug prce, reflectng the fact that the upper level dealers mantan a markup n the short run. Ths result s confrmed by the 12

13 Matrx Knowledge Group (2007). In ths large scale project, where ntervews were made to ndvduals n prson convcted of serous drug-related offences, t s concluded that where market fluctuatons dd lead to ncreased purchase prces, dealers mantaned margns by passng these ncreases on to customers. Fnally, and n order to close the model we ntroduce the condton that the demand for drugs s equal to the supply. Total demand s equal to the consumpton 7 (c) of the representatve consumer tmes the sze of the populaton N (the prevalence),.e. cn. In equlbrum cn = x. We substtute ths expresson n (3.8) α p = w( + β ) + cn p m (3.11) The equlbrum of the model s fully descrbed by equatons (3.4) and (3.11). These two equatons determne the equlbrum value of the retal prce (p) and the consumpton of drugs (c), n the short and long term, respectvely. Note that we could also represent the equlbrum of the model n terms of the ntermedaton margn m, usng equatons (3.5) and (3.9). We represent the short term and long term equlbrum expressed n equatons (3.4) and (3.11) graphcally n fgure 3.1. The PP-lne s the graphcal expresson of the short term showed n equaton (3.4). We assume here that the retal demand curves are lnear. As a result, the elastcty η s declnng for ncreasng values of c,.e., the hgher the drug use the less senstve drug demand s to prce changes. Ths feature of the demand curve s consstent wth the evdence suggestng that hgh drug users become addcted (dependent) so that ther demand becomes less prce senstve (see Caulkns and Hao(2008)). Ths produces an upward slopng PP-lne. The ntuton behnd the upward slope s that wth a hgher level of drug consumpton the market power of the drug suppler s ncreased, allowng hm to apply a hgher markup. Ths leads to a hgher retal prce. The QQ-lne s the graphcal representaton of the long-run equlbrum condton (3.11). The negatve slope (whch s readly seen from equaton (3.11)) expresses the 7 Consumpton of a representatve drug user should be dentcal to the product of the amount of cocane per dose, purty and the number of doses a day, takng nto account that ths pattern vares over the year (Sngleton at al. 2006). 13

14 fact that QQ s derved from the average cost curve. Thus as consumpton ncreases, frms average costs declne. In the long run ths leads to a declnng retal prce. The equlbrum values of the prce and the consumpton of the representatve drug user are gven by the ntersecton pont of the PP- and QQ-lnes. We can use ths model to analyze mportant polcy questons. The frst queston we analyze s how drug sezures affect the retal market. The second queston s how globalzaton affects the market. Fgure 3.1: Equlbrum of the retal market p Q P p 1 P Q c 1 c 3.2 Impact of sezures The way we model sezures s as follows. We ntroduce n equaton (3.1) the probablty that a certan percentage of drugs sold n the retal market s sezed. Ths leads to a new defnton of the profts of suppler : π = p x (1 s) wl p x (3.12) m where s s the probablty that the drug suppled by wll be sezed. Note that π now has to be nterpreted as expected profts. 14

15 The suppler of drugs maxmzes hs profts. The frst order condton for a maxmum s now gven by 1 p = η ( w + η 1 1 s β p m ) (3.13) Ths equaton has the same nterpretaton as (3.4),.e. t descrbes the short-term equlbrum. We observe from (3.13) that when the probablty of sezures ncreases, the upper level traffcker wll rase retal prce. Because of the exstence of a η markup ( η 1 of sezures. ) the prce ncrease wll be a multple of the ncrease n the probablty We can rewrte equaton (3.13) so as to explan the retal margn m, as we dd n equaton (3.5). m η 1 βw = ( + 1) η 1 1 s p m (3.14) As before, long run equlbrum s obtaned by mposng a zero proft condton π = 0. Ths yelds: p 1 α w( + β + p 1 s x ) = m (3.15) or n the form of margns 1 w α m = ( + β ) s pm x (3.16) Snce n equlbrum x = cn (3.15) becomes p 1 α w( + β + p 1 s cn ) = m (3.17) We can now analyze the effect of changes n the probablty of sezures brought about by tghter law enforcement. We do ths n fgure 3.2 usng the same graphcal procedure as n fgure 3.1. An ncrease n s has the effect of shftng both the PP- and 15

16 the QQ-curves upwards. However, t can be shown that the upward shft of the PPcurve s hgher than that of the QQ-curve. Ths can be seen by takng the partal dervatve of p wth respect to s n equatons (3.13) and (3.17). We obtan From equaton (3.13): p s η = η 1 1 ( 1 s) 2 ( wβ + ) p m (3.18) From equaton (3.17): p = s 1 ( 1 s) 2 ( wβ + ) p m (3.19) It can be seen that (3.18) > (3.19) showng that the upward shft of the PP-curve s hgher than that of the QQ-curve. We conclude that an ncrease n the probablty of sezures rases the retal prce of drugs and reduces the amount of drug use. The latter effect follows from the fact that drug users are senstve to a prce ncrease. Note also that as the prce ncreases and the drug use declnes, the prce elastcty, η, ncreases. Fgure 3.2 : effect of ncrease n probablty of sezures p Q Q P P p 2 p 1 P P Q Q c 2 c 1 c Fnally, t can also be shown that an ncrease n sezures ncreases the ntermedaton margn m. Ths ncrease n the margn can be nterpreted as n ncrease n the rsk premum assocated to the busness of drug dealng. 16

17 There are other rsks that could be analyzed n our model. One s the rsk of ncarceraton. Ths rsk wll tend to ntroduce a rsk premum n the wage of the low level traffckers. In addton, t leads to an ncrease n the rsk premum that upper level dealers have to receve n order to deal the drug. Ths has the same qualtatve effect as the rsk of sezures,.e. t shfts both curves upwards leadng to a hgher retal prce. Note that n ths case the ncrease n the retal prce reflects a hgher proft margn whch s necessary to nduce agents to engage n dealng drugs. (See Caulkns and Reuter(1998) for an n-depth analyss). We wll return to ths rsk n secton The effects of globalzaton The model also allows us to analyze the effects of globalzaton. There are several ways globalzaton enters the model. The frst way s by reducng the mport cost of drugs (p m ), whch wll be analyzed n greater detal n secton 5. The second way s by ncreasng the supply of drug dealers. We focus on the latter here. The total demand for drug dealers s In equlbrum D S n L D = l = 1 L = L. An ncrease n the supply of drug dealers leads to excess supply and thus to a declne n dealers wage. We can now analyze the mplcatons of ths wage declne usng equatons (3.13) and (3.17) and ther graphcal representatons. Ths s shown n fgure 3.3. Both the PP- and the QQ-curves shft downwards producng a declne n the retal prce (and n the ntermedaton margn). The effect on consumpton however s ambguous and depends on the parameters of the model. The downward shft n the PP-curve s obtaned by takng the partal dervatve of p wth respect to w n equaton (3.13). Ths yelds p η 1 = β w ( η 1) 1 s (3.20) The downward shft of the QQ-curve s obtaned by takng the partal dervatve of p wth respect to w n equaton (11). Ths yelds 17

18 p 1 α = + β w 1 s cn (3.21) It s not a-pror clear whch expresson s bgger. We know, however, that when c s hgh the elastcty η tends to dmnsh (producng a hgh markup). Thus for suffcently hgh levels of c the downward shft n the PP-lne wll exceed the downward shft n the QQ-lne, producng an ncrease n consumpton. Ths s the case shown n fgure 3.3. Fgure 3.3: Effect of globalzaton ncreasng supply of low level drug dealers p Q P p 1 p 2 P Q c 1 c 2 c From the prevous analyss we note that globalzaton and supply contanment polces have opposte effects on the retal prce of drugs. Ths mples that, as globalzaton proceeds, supply restrctons must ncreasngly become tghter to offset the prce reducng forces of globalzaton. Thus, as globalzaton s an ongong process, t forces the authortes to contnuously ncrease the amount of resources used n supply contanment polces n order to prevent the retal prce from declnng. Takng nto account that law enforcement may be subject to dmnshng returns, t s very lkely that the effects of globalzaton may preval. 18

19 3.4 Demand and supply polces compared The retal model derved n the prevous sectons allows us to shed some lght on the relaton between demand and supply polces. Demand polces (preventon, treatment and harm reducton), f successful, reduce drug consumpton (c) of the representatve user. As prevously shown, a declne of c has the effect of ncreasng the prce elastcty (η) of the demand for drugs. Put dfferently, the success of demand polces can be gauged by ther capacty of ncreasng the prce senstvty of the demand for drugs (whch also mples that the power of the traffckers s reduced). Ths feature of successful demand polces n turn affects the effectveness of supply contanment polces. The reason s the followng. A reducton of the supply of drugs rases the retal prce. Wth a hgher prce elastcty of the demand for drugs, ths supply nduced prce ncrease has a stronger negatve effect on consumpton. As a result, supply polces become more effectve n reducng drug use. Thus, our model of the retal market has as an mplcaton that when supply polces are combned wth demand polces, the former become more effectve n reducng drug use. 19

20 4. Dervng the producers supply curve In ths secton we derve the producers supply of drugs n the source countres. We wll focus our analyss on the frst step of the processng stages, shown n Table 1, when coca leaf s produced. For the sake of smplcty we wll not take nto consderaton the trans-shpment of precursor chemcals and ntermedate products such as paste and base presented n Fgure 4.1. Table 4.1 Cocane prodcton cycle Coca leaf Coca paste Cocane base Cocane at the exportng country (wholesale market) Cocane n transt Cocane at the mportng country (wholesale market) Cocane at retal market Cocane at the drug user Labour Grower/producer Manufacturer Manufacturer Collector/transporter Exporter: upper level traffcker, arplane plot, shppng crew, mules, etc Importer: mult-klo dstrbuter, nvestor, broaker, etc dealers drug users Prces producer prce exportng prce mportng prce retal prce We assume that the supply of drugs n the producng country (e.g. Colomba) s organzed n a perfectly compettve market 8. We start from a Cobb-Douglas producton functon of an ndvdual producer : Q C = A C L α C G β C ( 1 pe ) (4.1) 8 See also Kennedy et al. (1993). 20

21 where Q C s the output of cocane, L C s the use of labour n the cocane producton, G C s the use of land n the cocane producton, p e s the probablty of eradcaton,.e. the share that each producer expects to be subject to the eradcaton polces followed by the law enforcement authorty. We assume decreasng returns so that α + β < 1. Fnally, A C measures total factor productvty. The budget constrant of the ndvdual producer s C = wl C + rg C (4.2) where C s the cost of producng cocane gven the wage rate, w, and the prce of land, r. The producer mnmzes hs cost, C, subject to the producton functon. Ths cost mnmzaton allows the producer to determne the optmal use of labour and land n the producton process,.e. G L C C β w = (4.3) α r Thus, when wage costs ncrease relatve to land costs, less labour and more land wll be used n the producton of cocane. Equatons (4.3) and (4.1) allow us to derve the optmal demand of labour and land n the cocane sector: L C = Q γ A γ C α r β w βγ 1 1 p e γ (4.4) G C = Q γ A γ C β w α r αγ 1 1 p e γ (4.5) 1 where γ = > 1 α + β We note that an ncrease n the probablty of eradcaton leads to a declne n the demand for labour and land n the same proportons. 21

22 Equaton (4.5) allows us to analyze how much the productvty of land has to ncrease to offset the effects of eradcaton on output. We show the results n fgure 4.1. Ths fgure presents the productvty ncrease needed to keep output unchanged when eradcaton ncreases by 1 percentage pont (from dfferent levels of eradcaton). We see that ths relatonshp s non-lnear. Consequently, t means that f eradcaton efforts ncrease, the producton area and/or productvty gans have to ncrease more than proportonally n order to keep cocane producton constant. For example, when eradcaton ncreases by one percentage pont (startng from zero eradcaton) the productvty ncrease needed to keep output unchanged s about 0.5%. When the level of eradcaton s already 80%, an addtonal eradcaton of 1% requres a productvty effort of more than 2%, to keep cocane producton unchanged. In ths sense eradcaton has ncreasng returns 9. The next step n the analyss s to derve the cost functon. Ths s obtaned by substtutng the labour and land demand from (4.4) and (4.5) nto the budget constrant (4.2). Ths yelds C = ΩQ γ A γ C w αγ r βγ 1 1 p e γ (4.6) α where Ω = β βγ β + α αγ The cost functon (4.6) allows us to plot the relaton between eradcaton effort and the cost of producng cocane. Ths s done n fgure 4.2. We assume that γ = 1.2. (Other values lead to smlar results). We have also normalzed cost to be 1 when eradcaton s 0%. In addton, we assume all the other varables to reman unchanged, n partcular, productvty. We know from emprcal evdence that eradcaton programs often lead to ntensfed efforts at ncreasng productvty. Ths effect s not taken nto account n fgure 4.2. We obtan a non-lnear relatonshp: as the eradcaton effort ncreases, the cost of producton cocane ncreases. At low levels of eradcaton the ncrease n cost s less 9 Several reports pont to the fact that the current eradcaton efforts mplemented n the Andean regon have been more than compensated by productvty gans UNODC (2007) (a) and (b). 22

23 than proportonal to the ncrease n eradcaton. For example, when eradcaton ncreases from 10% to 20% (a doublng) producton costs ncrease by only 14%. However, beyond a certan level of eradcaton (close to 60%), cocane producton costs ncrease exponentally. So, the level of eradcaton has to be hgh n order for the non-lnear part of the cost curve to become effectve. Fgure 4.1 2,5% productvty ncrease needed to keep output unchanged when eradcaton ncreases by 1% 2,0% productvty ncrease 1,5% 1,0% 0,5% 0,0% 0% 20% 40% 60% 80% 100% percent eradcaton Fgure 4.2 8,0 Cost of producng cocane as a functon of eradcaton effort 7,0 6,0 5,0 Cost 4,0 3,0 2,0 1,0 0,0 0% 20% 40% 60% 80% 100% percent eradcaton Fnally we derve the supply curve. Ths s obtaned by settng margnal cost equal to the producer prce and solvng for Q C. We then obtan 23

24 1 γ 1 C γ γ 1 C αγ γ 1 βγ γ 1 γ 1 γ 1 Q = ΩP A w r 1 (4.7) pe Thus producers react to a prce ncrease by rasng output. The prce elastcty of the 1 supply of output s gven by whch s larger than 1. It means that when prce γ 1 ncreases, producers ncrease cocane producton more than proportonally. The sze of the output ncrease depends on the volume of captal and labour used to produce one unt of cocane,.e. on γ. For a gven γ, the relaton between prce and quanttes suppled s shown n fgure 4.3. The relaton s log-lnear,.e. f we transform prce and quanttes suppled n logs we obtan a lnear relatonshp. Gven that the prce elastcty s hgher than 1, the supply curve s relatvely flat. Eradcaton programs reduce the supply of output. Its mpact s measured by the γ expresson whch s negatve and larger than 1 n absolute value. Graphcally an γ 1 ncrease n eradcaton shfts the supply curve upwards as shown n fgure 4.3. An ncrease n productvty has the opposte effect on the supply of output. Its mpact γ s measured by the expresson whch s the same as the effect of eradcaton γ 1 except for the sgn. Graphcally, productvty ncreases lead to a downward shft n the supply curve. There s substantal evdence that the eradcaton efforts n Latn Amercan countres have been offset by ncreased productvty leavng the supply more of less unchanged (for evdence see Costa Stort and De Grauwe(2008)). It can be argued that much of these productvty ncreases have been made possble by globalzaton. The latter has contrbuted to greater access of local drug farmers to new and mproved producton technques. In ths sense globalzaton has contrbuted to makng eradcaton efforts relatvely neffectve. 24

25 Fgure 4.3: the supply curve wth dfferent levels of eradcaton prce Supply curve (hgh eradcaton) Supply curve (low eradcaton) supply 25

26 5. Lnkng up demand and supply of drugs In ths secton we lnk up the retal market and the producer markets. It wll be remembered that the retal market determnes the retal prce (and the retal added value or margn, m r ) for a gven mport cost of the drug. The producer market n turn determnes the supply of the drug for a gven export prce. We can represent ths graphcally as follows. Fgure 5.1 presents the retal market n the mportng country, as we have developed t n secton 3. The D r curve represents the prces the representatve drug user s wllng to pay for dfferent levels of cocane suppled at the retal level, n the mportng country. The lower D m curve presents the dfferent levels of the mport prce, p m, whch the mporter s wllng to pay, gven the retal prce he receves n the retal market. Note that we assume here that the upper level drug traffcker of the retal market s also the mporter 10. The vertcal dstance between the two curves s the retal margn, as derved n secton 3 where we modeled the retal market. Fgure 5.1: Importng country: the demand sde of the model prce p r m r p m D m D r quantty 10 Ths assumpton could be relaxed wthout affectng the results. Caulkns and Hao(2008) analyze the dfferent dstrbuton layers between the mporter a d the retaler. 26

27 Fgure 5.2 presents the producer supply equaton whch was derved n secton 4. For the sake of smplcty we represent ths supply curve as a lnear one 11. We assume here that the total supply s exported. Thus the prce the producer s facng s the export prce, p x. An ncreasng export prce leads producers to ncrease ther supply. Fgure 5.2: The producer country: the supply sde of the model prce S x p x Quantty suppled We now brng together the demand and the supply sde of the model n Fgure 5.3. Wthout ntermedaton costs n the export-mport busness the equlbrum of the model would be obtaned where the supply curve S x ntersects the mport demand curve, D m, producng a retal prce p r. In ths equlbrum pont, the mport prce of cocane n the retal market, p m, equals the producer s export prce p x. Ths s, however, hghly unrealstc as the export/mport of cocane nvolves transacton costs and rsks, ntroducng a margn between the mport prce of the drug (cf) and the export prce (fob) when t leaves the producng country. The dfference between these two prces s the ntermedaton margn n the export and mport busness, whch we wll call m t. We model ths ntermedaton margn n the next secton. Ths allows us to lnk up the retal market determnng demand condtons wth the man stages of cocane supply. 11 In secton 4 ths was derved to be log-lnear 27

28 Fgure 5.3: equlbrum n the absence of mport-export margn D r D m S x p r m r p m= p x quantty 5.1 A theory of ntermedaton n the export-mport busness The components of the ntermedaton margn, m t, can now be analyzed as follows. Frst we have to take nto account that the mport prce n the EU or the US s expressed n euros (or dollars), whle the export prce pad n Andean countres s expressed n local currency. Second we have to take nto consderaton a margn pad to the mport/export actvty (m t ). Thus, we wrte the followng defnton pm = 1 + mt (5.1) p e x where, as before, p m s the mport prce n the market of the fnal drug user. Ths prce s expressed n that country s currency (e.g. euros or dollars); p x s the export prce n the producng country, expressed n that country s currency. Multplyng by the exchange rate, e, yelds the export prce expressed n the mportng country s currency. The margn, m t, ncludes all the costs ncurred n the busness of exportng and mportng the drugs. Ths margn ntroduces a dfference between the mport prce (cf) and the export prce (fob) even after translatng both prces n the same currency (the euro or the dollar). 28

29 The next step s to specfy the varables that affect the ntermedaton margn m t. We dentfy several cost factors that affect ths margn and that therefore lead to an ncrease n the prce, when traffckng cocane from the producng country to the destnaton market. The frst cost s the the plan vanlla transport cost (e.g. the cost of the martme transport from Andean countres to Europe, respectvely the US). The second cost arses from the rsk of losng the traffcked cocane due to beng sezed. The thrd one s the wage traffckers pay to ther employees (lower level traffckers and mules ) nvolved n the smugglng actvty. Fnally, the last cost we consder s the proft earned by the upper level cocane traffckers. We can formalze ths as follows pm = ( 1+ τ t )(1 + τ s)(1 + τ l )(1 + r) (5.2) p e x where τ t s the plan vanlla transport cost; τ s s the cost of sezure; τ l s the labour cost; and r s the proft margn n the export-mport busness. We now specfy the dfferent varables that affect costs. The exchange rate From equaton (5.2) we see that a deprecaton of the euro (an ncrease n the exchange rate, e) has the effect of ether ncreasng the mport prce p m or reducng the export prce p x, or a combnaton of these two changes. Ths follows from the fact that the varables on the rght hand sde of (5.2) are ndependent from the changes of the exchange rate. As a result, the rato between the two prces on the left hand sde of (5.2) must reman unchanged. In order to acheve ths, the mport prce must ncrease and/or the export prce must declne n such a way as to keep the rato unchanged. 29

30 Plan vanlla transport costs The transport cost, τ t, s a functon of the number of hours the trp from the exportng country to the mportng country last (h) and ts prce, p t (e.g. the ntroducton of low costs transatlantc flghts or faster boats nfluence transport costs). We have τ = τ h, p ) (5.3) T T ( t τ where T > 0 h τ T and > 0 p t Sezures Sezures add to mport prce n the followng way. Call ρ the probablty of a unt of cocane beng sezed. Then shppng one dollar of the drug wll lead to an expected value at arrval of 1 - ρ. Thus n order to ensure that one dollar value of drugs reaches destnaton, 1 1 ρ should be exported. As a result, the transport cost can be sad to have ncreased by a factor of 1. Thus we can wrte 1 ρ 1 1+ τ S = (5.4) 1 ρ The probablty of sezure, ρ, s a functon of the supply reducton polces of the countres nvolved and the assocated resources nvested n supply reducton polces ρ = ρ(sr), (5.5) where SR are the resources nvested n supply reducton polces. Labour costs The thrd cost component s labour cost. Let us wrte the wage cost per dollar of drug transported, w. We assume that the wage rate s determned by the reservaton wage of the drug carrers (.e. the wage they can earn n other employments) plus a rsk premum. The latter arses because drug traffckng nvolves the rsk of 30

31 ncarceraton 12. People wll only engage n a rsky actvty f they are compensated by a hgher wage. The hgher wage above the shadow wage s the rsk premum. We wrte that w = w + π (5.6) w where w s the shadow wage,.e., the wage ths worker would receve n a job he would manage to get as alternatve. Then, π w s the rsk premum component of the wage,.e., the payment the drug dealer requres for acceptng the rsk of traffckng. The latter s determned by a number of factors. Frst, the resources nvested n supply reducton polces ncrease the rsk of ncarceraton, and thus the rsk premum requred by ths traffcker. Second, globalzaton ncreases the pool of agents who are capable and wllng to enter traffckng at a lower shadow wage. Furthermore, globalzaton can also supply lower level traffckers wllng to accept hgh rsks for small reward (less rsk adverse labor force Z). Ths tends to reduce the rsk premum. Note that we mplctly assume that the newcomers n the traffckng have a lower degree of rsk averson than those already employed n traffckng (see secton 7, as an example). Formally we have π = ( SR, Z) (5.7) w π w π wth w > 0 SR π and w 0 Z Proft margns The fnal component n equaton (5.2) s the proft margn n the export-mport busness. Resources nvested n the export-mport busness should earn a rate of return whch reflects the return of alternatve actvtes plus a rsk premum. Thus we can wrte that r = r + π (5.8) r 12 See Caulkns and MaccCoun (2003) for a further dscusson on how ths rsk may affect drug dealers wage. 31

32 As n the case of the wage rate, the rsk premum π r s nfluenced by the rsk of ncarceraton (SR) and by the supply of new entrants n the exportng/mportng busness (Z). The rsk of ncarceraton has a postve nfluence on the rsk premum whle the supply of new entrants tends to reduce the rsk premum and thus the rate of return n the exportng and mportng busness. π = ( SR, Z) (5.9) r π r π wth r > 0 SR π and r < 0 Z Note that n a smlar way as n the retal market, we mplctly assume two types of agents n the traffckng busness. There are the hgher level traffckers. These are the entrepreneurs who organze the traffc and who earn the resdual profts, r. Then there are the lower level traffckers. They are hred by the hgher level traffckers and earn the wage rate, w. Both are affected by the same factors, the resources nvested n supply reducton polces and globalzaton whch affects the entry of newcomers n the busness. Smultaneous equlbrum: retal, producers and mport/export markets The equlbrum n the model s descrbed graphcally n Fgure 5.4. S x s, as before, the producer supply curve n the exportng country. S m s the supply curve at the pont of mport n the retal market. The vertcal dstance between the two lnes s gven by the ntermedaton margn of export/mport actvty, m t. These curves are nfluenced by those varables dscussed n the prevous paragraphs. Equlbrum s obtaned where supply of mported drugs (S m ) and demand for exported drugs (D m ) ntersect. Ths ntersecton pont determnes the mport prce n the retal market (p m ). The retal prce p r s then obtaned by addng the retal margn m r. (derved n secton 3). We then obtan an equlbrum n the retal market, where the upper level drug dealer operates n a monopolstc competton framework. The ntermedaton margn m r ncludes costs such as the lower level dealer wage, productvty and mark up. The 32

33 latter s a functon of the demand elastcty of the representatve drug user. The hgher the level of drug use (hgher addcton), the smaller the elastcty s. Conversely, a recreatonal drug user, n a relatvely early stage of hs drug use, to whom treatment s suppled, wll reduce hs drug use more strongly, when prces rse. Therefore, n ths framework, demand reducton polces whch successfully represent an alternatve to drug use, may dmnsh the demand elastcty. As specfed n the model, the prce elastcty of drug use wll determne the mark-up: the hgher the prce elastcty, the smaller the upper level traffcker mark-up. Fnally, the producer prce (export prce) p x s obtaned by subtractng the exportmport margn, m t, derved n ths secton. Fgure 5.4: equlbrum wth mport-export margn S m p r S x m r p m m t p x D r D m quantty 5.2 Effects of globalzaton Globalzaton affects the labour market structure and the rsk nvolved n the export and mport busness. It does ths n the followng way. Frst, t ncreases the pool of low level traffckers avalable n the mport/export smugglng. The openng up of 33

34 countres snce the 1980s has added mllons of low sklled workers who have lttle to loose and are wllng to take rsks. The ncrease n the competton n the market of low level traffckers leads to a declne n the shadow wage w. It also tends to reduceπ, the rsk premum component of the wage of the lower level traffckers n w (5.6). Second, globalzaton also leads to entry of hgher level traffckers n the export-mport busness whch n turn leads to a lower return of these actvtes (equaton (5.7)). The combned effect s to reduce the margn m t. We show the effect n fgure 5.5. The reducton of the margn, m t, shfts the mport supply curve downwards to the poston S m compared to ts ntal poston, S m. In the new equlbrum the mport prce declnes to p m and so does the retal prce (to p r ). Ths s exactly what has been observed n the prce data snce It s also nterestng to note that the reducton of the margn m t brought about by globalzaton also ncreases the producer prce. Ths shown n fgure 5.5 by the ncrease of the producer prce ncreases from p x to p x. As was shown n secton 2, producer prces have been ncreasng sgnfcantly n the last twenty years. Thus, our model s capable of explanng the opposte movements n retal and producer prces of cocane. The major drvng force s the reducton of the margns n the exportmport busness whch tself was made possble by the massve nflux of low and hgh level traffckers. 34

35 Fgure 5.5: Effects of globalzaton S m p r S m p r S x p m p m m t p x p x D r D m quantty These forces of globalzaton appear to have overwhelmed the attempts of the authortes of the dfferent countres, to dsrupt the supply of drugs. As argued earler, the resources spent n these supply polces have ncreased sgnfcantly. Our model predcts that these polces ncrease the ntermedaton margn m t manly because they ncrease the rsk of traffckng. However, ths effect has been more than compensated by the effects of globalzaton. In ths sense, supply polces have been wagng a loosng battle aganst the forces of globalzaton. 6. Globalzaton once agan In the prevous sectons we have analyzed the dfferent channels through whch globalzaton affects the markets of cocane and heron. In ths secton we put the peces together. We dstngush three broad effects of globalzaton: a market structure effect, a rsk premum effect and an effcency effect 13. We dscuss these consecutvely and ndcate where these effects enter nto the model. 13 See Costa Stort and De Grauwe(2008) 35

36 6.1 The market structure effect. In a very general way globalzaton tends to open markets, thereby changng the market structure away from monopolstc towards more compettve structures. As a result, competton s enhanced and the markup,.e. the dfference between the retal prce and the margnal cost s reduced. The drug market has been subject to the same forces of globalzaton that have changed the market structure n the drug consumng countres, ncreasng competton. As a result, the retal margns (markups) have been squeezed contrbutng to a lowerng of the retal prces of drugs. We have analyzed ths effect extensvely n secton 3 (the retal market). 6.2 The rsk premum effect Globalzaton has opened the borders of many countres wth a surplus of poor and low sklled workers. Rchard Freeman has estmated that the openng up of Chna, Inda, Russa snce the 1980s has doubled the world supply of cheap and unsklled workers (Freeman(2005)). Coupled wth the ncreased possblty of nternatonal travel, ths has ncreased the pool of ndvduals who have lttle to use and who want to proft from the large ntermedaton margns n the drug busness. We have ntroduced ths effect nto our model n several ways. In the retal market and n the export-mport busness t has led to an nflux of hgh level and low level traffckers. As a result, the rsk premum component of the wage of low level traffckers has declned and the rsk premum component of the return of the hgh level traffckers has been pushed down. The jont effect of these declnng rsk prema has been to reduce the ntermedaton margns n the cocane and heron markets. 6.3 The effcency effect Lower transport, communcaton and nformaton costs have ncreased the effcency of the ntermedaton n the drug busness. In addton, lower transport costs have ncreased nternatonal trade n general allowng to better concealng drug trade. Fnally, by openng up borders globalzaton has also made t possble to transfer scentfc and technologcal knowhow. 36