Drugs, Prostitution, and
the Economics of Black
Markets
Overview
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Recap of Black Markets
Drugs+Gangs
Economics of Prostitution
Economic Model
Drugs and Gangs
Invention of Crack Cocaine
•Technological
advance –
supply
“shifter”
•All other
things equal
•Lower
equilibrium
Conflicting Incentives: owner
versus labor
•Owners seek to
maximize profit
–Create stable and
safe market
environment
•Worker seeks to
maximize pay
–Move up the rank ->
higher pay
The Formation and Operation of
a Regional Monopoly
•Monopoly
distribution of
crack cocaine
in gang “turf”
•Downward
sloping elastic
demand curve
•Economic profit
Fixed and Variable Costs
•FC = Short-run
costs
Bribes, Family
Assistance,
Weaponry
•VC = the product
Drugs, Street
dealers,
mercenaries
“Winner Take All”
•Common market
structure (baseball
players)
•Low Success, High
Return
•Illegality drives
competition
A Model for Labor
•Far right of origin
•Workers taken
together require
lower wages
•Represents low W*
CEOs of Gangs?
•Top 120
managers
represented just
2.2%, > half the
profit
•Investor reward of
black market
intact
Prostitution
History
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In the 1910s estimated to be 200,000 women
prostitutes in US
1 of every 50 women in their twenties was a prostitute
At the time a common prostitute working in Chicago
would make $76,000 annually in today's money
A prostitute working in an upscale brothel at the same
time would make about $430,000 annually in today's
terms
Reported that one head of brothel accumulated as much
as $22 million
Current Day
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Typical prostitute in Chicago works 13 hours a week
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Performs 10 sexual acts per week
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Average hourly wage of $27, weekly pay of $350
The wages of prostitutes have fallen dramatically over
the last 100 years, why?
Supply and Demand
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Demand has noticeably fallen
 Not for sex, but for paid sex
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Social trends involving sex have evolved greatly
The arrest of many prostitutes has also caused a shift in
supply, though not great
Elasticity
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The demand for prostitutes has shown to be rather
inelastic
Illustrated by two examples:
o As prostitutes were arrested, supply dropped which
elevated the equilibrium price. Demand stayed the
same as customers continued to pay the elevated
wages
o Allie, a high end prostitute, consistently raised her
prices but did not experience a decrease in demand
for her services
Price Discrimination
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Prostitutes reported charging different rates based on
skin color
Named the price to African- American customers,
allowed White customers to name the price
Black customers pay on average $9 less per sexual act
than White customers
Substitutes and Product
Differentiation
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Prices at a certain location are the same from one
prostitute to another
Customers look at prostitutes as Perfect Substitutes that
can be easily interchanged
Firms, in this case brothels, can experiencing great
benefits from providing slight different products
Incentives, Incentives, Incentives
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Like all markets, prostitution is ultimately driven by
incentives.
The bottom line is that the incentives provided by
prostitution are enough to create a consistent amount of
people willing to sell their bodies
On the other hand, the incentives of paying for a
prostitute continue to be enough to cultivate a demand
for prostitution
Reducing Crime Rates
•Deterrent Effect: Increasing the potency or
likelihood of negative consequences for a
criminal
•Incapacitation Effect: Preventing a criminal from
being able to perpetrate a crime
Sentence Enhancements
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Type of crime Deterrent
Increased punishments that are added onto
prison sentences that would have been served
anyway
Example:
•Proposition 8 (1982) in California
•10% reduction in eligible crimes after 1 year
•After 3 years, had fallen roughly 20-40%
Sentence Enhancements
cont.
•Deterrent Effect vs. Incapacitation Effect
•Threat of going to jail for a longer time vs. Being in jail
for a longer time
•Can often save government money
Levitt & Kessler’s Crime
Model
•Equations before introduction of Sentence
Enhancements
•1. Maximization
•(ri-ptJt(S))Cit
•2. Crime Level
•Ct=1-(ptJt/R)-pt-1Ct-1
•Prison sentences in one period (t-1) are served in
the following period (t)
Decoding
•r= Gain from committing a crime
•p= probability of being caught
•J= Utility loss from being jailed for a time period
•S= Periods of time sentenced (initially 1 period)
•C= Choice to commit a crime or not
•If yes, C=1, if no, C=0
•R= distribution of ri for those who commit a crime
•1/R is the density of crimes
•t= current time period
•i stands for the individual in the calculation
L&K’s Crime Model cont.
•Equations After Introduction of Sentence
Enhancements
•First Period
•Second Period
Differences
•Addition of variable d, the disutility of an additional
period in prison
•Additional emphasis on pt-1Ct-1 : people arrested
from previous time period, pt-2Ct-2 : people arrested
from two periods ago
Conditions of Levitt and
Kessler’s Model
•Agents involved are assumed to live for infinite
time
•Agents are assumed to be risk-neutral
•Future Utilities are not discounted
•Gains from crimes are kept, regardless of whether
caught