Black markets and smuggling: An unintended consequence of government intervention

(This policy bulletin is extracted from FMF Occasional Paper Black markets and smuggling: An unintended consequence of government intervention, published by the FMF in 2000.)

This Occasional Paper can be downloaded here


The cause of smuggling

The high duties which have been imposed upon the importation of many different sorts of foreign goods, in order to discourage their consumption, have only served to encourage smuggling.

Adam Smith,The wealth of nations

Smuggling is an important catalyst in stimulating the underground economy. It encourages existing criminal gangs and helps new ones to become established. Chapter 2 explains some of the causes of smuggling, drawing on examples from the attempts to control drugs, tobacco, alcohol and other goods. It discusses the possibility of reducing smuggling, which generally means reversing the causes. The main focus is on products, especially tobacco, that are legal in most countries, yet are smuggled because of high levels of taxation.

It is useful first to define terms.Smuggling – the process of illegally importing or exporting goods (usually to avoid government duty). The product may be illegal (cocaine) or legal (cigarettes) in either the importing or exporting country, but products once smuggled are illegal (contraband). Counterfeit – something produced to be passed off as a copy (fraudulent imitation – bootlegged) of a legitimate product. The legality of the genuine product will often determine whether a copy is illegal but, regardless, the copy becomes illegal once it is passed off as an original.

Smuggling occurs because the incentives to avoid some form of government intervention are large enough to overcome the expected costs of undertaking an illegal activity. Therefore, smuggling can be understood from analysis of government intervention like regulation or taxation, the most extreme manifestation of which is prohibition (see Thornton, 1991). Most interventions on legitimate products such as alcohol and tobacco are intended to be supply-reduction policies. The result of the policy is that the cost of supplying the legitimate product increases, which at the margin decreases supply. The quantity demanded will fall at the higher price, and demand may shift to substitutes. Those substitutes may include inferior copies – counterfeit or, where there is significant tax disparity between countries, smuggled products. (Some smuggled products, such as major brand cigarettes penetrating third world markets, will actually be of higher quality than the legal product.) For products such as alcohol and tobacco which are presently legal but heavily taxed, both counterfeit and smuggled substitutes offer higher profits and lower penalties to smugglers than trafficking prohibited products such as illegal narcotics.

Many products and most markets are subject to some form of government intervention, but few products become widely smuggled. The main reason that products are smuggled is becausetransaction costsfor illegal activity (the cost of finding willing suppliers and distributors, the risk of being caught and punished, etc.) are low relative to the gains from undertaking such illegal activity. With more extensive and intensive government intervention, more products will offer benefits of smuggling that outweigh the costs.

As Cave and Reuter (1988) found, smugglers learn from experience, which manifests itself in many ways. For example, once a route and couriers are established to transport and distribute one product, switching to a new product is often easy. A group of smugglers dealing in narcotics can easily smuggle tobacco or even rhino horn, if and when the illegal rent they can obtain (the differential between the price they pay for the product and the price the legal product costs in the market) is sufficient.

In some contraband markets in legal products, consumer demand may instead be stimulated by a perceived quality difference. For example, smoking smuggled but genuine American cigarettes in India is fashionable because these are perceived to be of a higher quality than supposedly identical locally-produced versions. In this instance, high taxes on legal imports appear to act as a stimulus not by offering consumers a saving, but by providing a widened choice, thereby generating a significant profit margin for contraband vendors. Such policies ensure that contraband market vendors can retain a much larger profit margin than if they were lawful sellers of legal products, because there is no need to attract customers with lower prices. These fat profit margins also provide contraband sector participants with a great deal of room to manoeuvre should price competition develop.

AUTHOR  Roger Bate. This Policy Bulletin may be republished without prior consent but with acknowledgement to the author. As always the views expressed in this Occasional Paper are those of the author's and are not necessarily shared by the members, directors or staff of the Foundation.

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