8400

ORGANIZED CRIME AND ILLEGAL MARKETS

Gianluca Fiorentini
Dipartimento di Scienze Economiche
Università di Bologna
© Copyright 1999 Gianluca Fiorentini

Abstract

This chapter discusses some of the most influential definitions of organized

crime focusing on the differences between ordinary illegal firms and
governance structures which supply public services such as the protection of
property rights and the enforcement of contracts. The chapter further
investigates the relations between the structural features of organized crime
and the basic working rules of illegal markets. In this respect, the economic
justifications to make markets illegal are discussed as second-best policies in
serious cases of asymmetric information and externalities. To understand the
origin of organized crime we analyze the implications of the proprietary
theory of government. Moreover, to understand the internal structure of
organized crime we concentrate on the role of input specificity in performing
illegal transactions. A brief discussion of the deterrence policies against
organized crime concludes the chapter.
JEL classification: K14, K40, K42
Keywords: Illegal Behavior, Enforcement of Law, Illegal Markets, Rent
Seeking

1. Introduction

After a brief description of the plan of the work the next section analyzes
some influential economic definitions of organized crime. We start focusing
on the differences between ordinary illegal firms and governance structures.
The former supply private goods in illegal or irregular markets while the
latter provide public goods such as the protection of property rights and the
enforcement of contracts. On this basis we analyze the relations between the
structural features of organized crime and the basic working rules of illegal
markets. The purpose of Section 3 is to explore the implications of the
proprietary theory of government for the analysis of organized crime.
Building on the rent-seeking literature we also discuss contributions on the
competition between organizations for the control of a given area. The
starting point of such models is that if property rights are weakly enforced by

434
8400 Organized Crime and Illegal Markets 435

the legitimate government there will be greater incentives to invest in

destructive activities against other criminal organizations or legal firms
exposed to violent threats. Finally, we show how such a rent-seeking
approach to the origin of organized crime allows one to draw some
implications on its role in influencing the long-run growth of the economy.
Section 4 investigates the relations between different forms of regulatory
intervention of the legitimate government and the firms’ choice to shift their
activities to irregular markets. To develop this point, we consider the related
literature on the empirical analysis of the irregular markets building on
direct surveys and on indirect monetary methods. In Section 5, we deal with
the role of organized crime in illegal markets when it completely substitutes
legitimate governments in most of their basic functions. In this area the
literature suggests that there is a positive relation between the volume of
transactions in illegal markets and the influence of organized crime in
legitimate business activities. For this reason, we report on the economic
justifications to limit transactions in illegal markets. In particular, we focus
on the contributions explaining prohibitions to exchange goods in terms of
second-best policies in serious cases of asymmetric information and
externalities. In Section 6, we discuss how organized crime is involved in
legal markets. In this respect we concentrate on three distinct activities: the
supply of illegal inputs to legal firms, the manipulation of public funds and
the joint production of legitimate and illegitimate outputs.
In Section 7, we focus on the internal structure of organized crime in the
supply of basic inputs required to compete in illegal markets such as
protection from police enforcement and money laundering. As for the
internal structure, much work has dealt with the enforcement of secrecy
codes in shaping the internal rules of organized crime. Similarly, the
literature on vertical integration deals primarily with the degree of
specificity of the inputs to explain different organizational models. In this
setting particular attention is paid to understand how the authority is
distributed between downstream firms active in the markets for illegal
outputs and upstream governance structures specialized in supplying
protection services. Section 8 analyzes some of the main deterrence policies
taken up against organized crime. We start discussing the classic defense of
organized crime as a monopolistic supplier of illegal goods based on its
interest in minimizing the use of violence and in restricting the output
levels. To further understand this issue, we briefly describe the effects of the
legalization of illegal markets on the barriers to entry and on the equilibrium
output. Taking as given the border between legal and illegal markets, we
examine some more specific policy issues. In this area, we discuss the
relative costs and benefits of addressing deterrence activities against
suppliers and purchasers of illegal goods and the merits of enforcement
policies exploiting conflicts between the two parties. Finally, we report on
436 Organized Crime and Illegal Markets 8400

the literature dealing with the broad theme of policy design against
organized crime with specific reference to the cases when different
organizations interact strategically.

2. Definitions of Organized Crime

Fiorentini and Peltzman (1995b) discuss three main economic definitions of

organized crime. Here we follow broadly their discussion, but we add a
fourth definition that builds on the differences between Schelling (1971) and
Gambetta (1988). One of the first definitions can be traced back in the report
of the President’s Commission on Law Enforcement and Administration of
Justice (1967). According to such a definition the core business of organized
crime is the supply of illegal goods and services. More specifically, Cressey
(1967) - one of the experts working for the Commission - suggests that the
differences between ordinary illegal firms and organized crime is that the
latter specializes in activities for which there is an autonomous demand,
while the former more often undertake purely predatory activities. As a
whole, the report admits that organized crime practices coercion against
other agents (firms, unions, police agencies) but this is more related to its
activities in legal markets that are relatively marginal. In this respect, an
occasional use of violence can be explained with the need to invest in
military technology to protect property rights in illegal markets, and with the
relatively low marginal costs in using such assets once they are in place.
The above definition correctly points at the crucial relation between
illegal markets and the more general influence of organized crime on the
allocation of resources in illegal activities. However, it suffers from three
limitations. First, it is purely descriptive and does not provide a convincing
economic explanation for such a relation. Second, it builds on an idea of
organized crime as a highly integrated firm - both vertically and horizontally
– that operates monopolies in various stages of the production and
distribution of illegal commodities. Third, it misses the difference between
the role of organized crime as a firm supplying illegal goods to final
consumers and as a governance structure imposing regulations and
supplying public goods to independent illegal firms. Starting from these
criticisms, Schelling (1971) suggests that the core business of organized
crime is to impose its protection to other legal and illegal firms under the
threat of violence. To practice extortion organized crime must reach a
monopolistic control over the supply of violence, at least in a limited area, as
its services necessarily include protection against other competing
organizations. Similarly, those who provide protection services have to
control the supply of corruption to local police agencies to reduce the threat
8400 Organized Crime and Illegal Markets 437

of competing organizations calling for police intervention against them.

To explain the main differences between illegal firms and organized
crime, Schelling (1971) discusses the features of those markets where the
latter typically develops a governmental authority. The first feature of such
markets is that victimized firms should be unable to protect themselves. This
explains why illegal or irregular markets are privileged areas for the control
of organized crime as illegal firms are less likely to call for police protection.
Second, victims should find it difficult to hide themselves. Accordingly,
organized crime concentrates most of its extortion on illegal firms that
supply goods to final consumers and not on other organizations specialized
in appropriative activities. Third, organized crime is more likely to impose
extortion on firms whose profits are easily observable. In fact, without an
independent auditing authority, monitoring problems may lead to continuous
conflicts. Fourth, Schelling notices that organized crime is more likely to
practice extortion on illegal firms the higher their asset specificity both in
terms of site specificity and of capital embodied in customer relations. For
this reason, independent restaurants and shops operating at a local level are
often victims of organized crime. Fifth, illegal or legal firms are more likely
to end up under the control of organized crime if the payments imposed are
tax deductible, imposed on all competitors and if they can be shifted onto the
final consumers. This explains why organized crime often covers its core
business with legitimate commercial activities as this allows levying taxes
supplying overpriced inputs to the victimized firms. Finally, organized crime
typically succeeds in becoming a governance structure if the victims of
extortion are individuals or small firms. This is because the risk of police
intervention increases more than proportionally with the number of agents
who know the details of the extortion.
At the end of his paper, Schelling (1971) introduces a qualification of his
thesis, which has been developed by Gambetta (1993), and constitutes the
basis for a third definition of organized crime. Schelling notices that often
illegal firms call for organized crime intervention to provide the public
services required to stay in business (for example, corruption of police
officers or enforcement of collusive agreements). In this perspective, the tax
levied on the protected firms represents the price voluntarily paid for the
above services. Gambetta (1993) builds on this intuition and argues that
organized crime operates as a governance structure mostly addressed to the
underworld so that its activities cannot be reduced to the supply of illegal
goods. Compared to Schelling, Gambetta goes further in denying the
coercive character of the relationships between organized crime and illegal
firms, and suggests that its core business is the supply of trust, that is of a
more stable institutional setting for illegal firms. Such supply does not
438 Organized Crime and Illegal Markets 8400

involve only the protection of property rights and the enforcement of

contracts, but also the provision of barriers against entry and the
organization of collusive agreements. Since there is a voluntary demand for
these services, the coercive elements in the relations between organized
crime and illegal firms are in its need to use violence occasionally to
preserve its reputation as an authority to solve disputes or to enforce
contracts.
The idea that organized crime does not only supply illegal goods to final
consumers and that behind extortion one can see implicit contracts with
illegal firms is coherent with the available evidence on its internal
organization (Anderson, 1979). In particular, this study shows that
organized crime operates as a firm mainly to cover up its governance
activities, but even such role is limited to the provision of intermediate
inputs to other small illegal firms. Moreover, to extract most of the rents
accruing to the firms using its services organized crime usually enforces a
strict control on the number of competitors under its protection.
More recently Alexander (1997) proposes three settings to describe the
relationships between organized crime and the firms under its control which
differ for the degree of coercion imposed by the former. First, a ‘leviathan’
model where a racketeer can extract surplus from small competitive firms.
Second, a model where a ‘dominant firm’ colludes with a racketeer in
imposing coercion over smaller competitors. Third, a ‘cartel’ model where
groups of legal firms demand the enforcement services of organized crime.
The ‘leviathan’ model builds on the idea that when organized crime acts as
a racketeer it can force all firms to adopt a monopolistic price in the
downstream market because its information set is complete and its threats
are credible (Rubin, 1973). Hence, the ‘leviathan’ can extract all profits
through firm-specific sales taxes and lump-sum taxes negatively related with
each firm’s marginal costs. This model predicts that organized crime will
levy higher firm-specific taxes on the most efficient firms to force them to a
greater reduction of their output. The ‘dominant firm’ model builds on the
idea that large firms often may be interested in calling for the intervention of
a racketeer to impose sales taxes on rival firms. To maximize profits, tax
rates are set to a level that the surviving fringe firms have marginal costs
just below those of the dominant firm. It follows that the latter extracts more
rents from the taxes than from producing the fringe output. Finally, the
‘cartel’ model builds on some evidence that legal firms in different
industries establish associations and acquire the services of organized crime
as an enforcer of collusive agreements.
Comparing these different settings with the available data on the tax
levied by organized crime on legal firms, Alexander finds out that the
former often imposes a two-part tax. The first component is a lump-sum tax
creating an entry barrier for relatively small new entrants and the second is a
8400 Organized Crime and Illegal Markets 439

sales tax to control for overproduction. However, the relatively low level of
both rates, and especially of the sales tax, is interpreted as evidence of weak
or no discrimination against more efficient firms, and therefore is more
easily reconciled with the ‘cartel’ model. Moreover, the organization
enforcing the cartel charges legal firms for the purchase of packaging labels
thereby monitoring the market shares of the participants. Finally, the
reported evidence indicates that firms belonging to the association, and
therefore purchasing the cartel enforcement services, are more stable over
the long run. Hence, the levy imposed by organized crime is compensated in
terms of higher and/or more stable profits over time.
Reuter (1983) provides a fourth definition of organized crime as a
hierarchical structure characterized by long-run horizon, and with an
involvement in multiple illegal activities. Such an inductive definition relies
more on the author’s empirical studies of organized crime activities in
different industries than on an attempt to deduct new elements to build a
general theory. In this respect, Reuter denies that organized crime can be
seen as a firm active in illegal markets since its protection extends to legal
firms, its activities include the control of public procurements, and its
investments in legal businesses often represent the largest share of its assets.
Analogously, Reuter does not fully accept Schelling’s idea of organized
crime as an authority with a coercive control over the allocation of resources
in illegal and irregular markets. Indeed, in his empirical work Reuter shows
how difficult it is for a central authority to control entry in such markets and
more generally to regulate illegal firms. This is because entry barriers are
often low, the costs of monitoring decentralized firms are high, and the
threat of such firms calling for police intervention against large
organizations is often credible. Arguably, the main lesson that can be drawn
from Reuter’s contributions is that there are a few economic elements which
can be used to characterize organized crime (hierarchy, economies of scale
and scope, specific capital assets, durability). However, such elements
cannot be used to design deterrence policies against organized crime without
a careful investigation of its internal structure and of the fundamentals of the
specific markets involved.

3. The Proprietary Theory of the State and the Origin of Organized

Crime

After Schelling (1971) who put forward the view of organized crime as a
governance structure, other authors analyzed the relations between the
origin of organized crime and the different activities of legitimate
government. In this respect, Anderson (1995) suggests that there are three
main factors for the emergence of organized crime: the investment in
440 Organized Crime and Illegal Markets 8400

military technology to enforce legislation, the definition of regulatory

measures including direct public intervention, and the legislative definition
of illegal markets.
In this section we discuss the effects of a relatively weak investment in
military technology on the origin of criminal organizations specialized in
predatory activities. To do so, we follow the analysis of those economists
who applied to the activities of legitimate government the same conceptual
framework used by Schelling for organized crime. For instance, Baumol
(1990) proposes a proprietary theory of the government where the ruling
class is made of agents whose objective is to extract rents from their subjects
under given institutional constraints such as winning the next elections
and/or preserving their tax base. To meet these constraints, legitimate
governments have to provide at least some public services in exchange for
the taxes they levy. Such services are those primarily required for a system
of decentralized markets to operate (protection of property rights and
enforcement of contracts) and are the same as those supplied by organized
crime to firms in irregular or illegal activities. Hence, Grossman (1995),
following Gambetta (1993), builds his model on the close analogy between
the taxes levied by the legitimate government and the extortionary duties
levied by organized crime, as both share some elements of coercion and of
voluntary transactions.
More precisely, Grossman (1995) assumes that firms and individuals can
purchase the above public services from the legitimate government or from
organized crime. In such a setting, the emergence of organized crime has a
positive effect as it reduces the monopolistic power of the legitimate
government. However, it may have negative consequences in terms of
resources wasted in the competitive process to establish the monopoly over
coercion. One of the worst possibilities for the victimized firms is when the
two enforcers collude imposing revenue-maximizing taxes to their subjects.
On the normative side, Grossman shows that as the ruling class appropriates
the tax revenue there will be no widespread opposition to the growth of
organized crime that reduces the fiscal pressure. Conversely, if the contest
between organized crime and the government makes it possible for the
former to become the new ruling class, it is rational for the victims to oppose
its growth because it will eventually restore a monopolistic supply of public
goods.
In the proprietary theory of government, organized crime becomes a
competitor in setting taxes and providing public goods only because the
latter has been unable or unwilling to invest enough resources in military
technology. Baumol (1990) notices that in doing so the government
indirectly provides incentives to other groups to specialize in appropriative
activities rather than in productive ones. The most frequently used
framework to investigate appropriative activities is that of rent-seeking
contests (Hirschleifer, 1988). In these models competitors invest their
8400 Organized Crime and Illegal Markets 441

resources to win the exclusive right to extract economic rents through

extortion. Hence, if the monopolistic control over the supply of violence is
relatively weak, entrepreneurs will invest in appropriative activities as long
as they are more profitable than productive ones.
Skaperdas and Syropoulos (1995) combine this rent-seeking literature
with the proprietary theory of government to investigate the origin of
organized crime. In their model agents can choose to invest in appropriative
or productive activities in an anarchy situation where none has the exclusive
right to use coercive means and where agents are characterized by a
comparative advantage in one of the two activities. The possibility to
appropriate other agents’ property is modeled in a rent-seeking contest
where the larger the asymmetry between agents’ productivity in military
technology, the smaller the overall investment in such technology. This is
because agents with a lower productivity are aware that their investment has
little or no effect on their final share of resources. The outcome of the static
game with no exit is that agents specialized in productive activities end up
with a smaller share of the total output. Furthermore, in a more sophisticated
setting, where agents with a comparative advantage in productive activities
have an exit option, there is a progressive self-selection of agents in more
homogeneous communities with a loss of productive capacity in those with a
greater proportion of agents specialized in appropriative activities. When
agents specialized in productive activities are complements to each other,
they have a greater bargaining power as their exit further reduces the size of
the pie. Finally, in a dynamic setting if there is no clear competitive
advantage in the use of the military technology, all agents have strong
incentives to invest in such technology. Here, the ongoing conflict reduces
the effective protection of property rights and the returns from productive
activities. In its turn, this induces exit or deters entry of new agents
specialized in productive activities. Even this process does not provide
sufficient incentives to reduce the investment in military technology as
cooperative agreements do not represent equilibria of the rent-seeking game.
Indeed, small initial differences in investment bring about large differences
in the final pay-off. Hence, the model suggests that, due to the high returns
of investing in violence at the beginning of the interaction, it is crucial that a
group of agents emerges from the beginning as the most productive in using
the military technology to deter other groups’ initiatives.

4. Regulatory Policies and Irregular Markets

Anderson (1995) suggests a second relation between the activities of

legitimate government and those of organized crime based on the features of
442 Organized Crime and Illegal Markets 8400

the regulatory regime imposed on legal firms. There are two institutional
elements involved in this relation. First, a high degree of regulation
increases the compliance costs for legal firms and may induce them to
switch some activities to irregular markets where property rights are defined
and contracts are enforced by organized crime. Moreover, as firms operating
in irregular markets often increase their market shares due to their lower
costs this brings larger parts of the productive system under the control of
organized crime. Second, as noticed by Tanzi (1995), regulation is usually
coupled with a high degree of bureaucratic discretion and this provides
strong incentives to shift potentially productive resources into corruption.
Since the supply of corruption is more efficiently managed through
monopolies or collusive agreements to avoid a dissipation of resources, this
represents an incentive for criminal organizations to acquire some control
over the allocation of public resources.
Along these lines, Smith (1976) investigates the effects of regulation on
the size of the irregular markets building on the assumption that there is an
unavoidable conflict between the objectives of the government in passing
legislation and those of the economic agents who strive to minimize costs.
The main purpose of the model is to show that the effects of any regulatory
measure can be understood only taking into account the incentives of the
regulated agents to shift resources into irregular markets. More specifically,
Smith focuses on taxation as an instance of cost-increasing regulation
because it is relatively easy to be measured and because of greater data
availability. He elaborates a relatively simple two-market model, where
goods in the legal and irregular markets are imperfect substitutes for
consumers due to an expected sanction if discovered trading in the latter. In
this setting Smith analyzes the effects of changes in taxation and in
enforcement activities over the equilibrium in both legal and irregular
markets. The reduction in the output level in the legal market, due to an
increase in taxation, is understated if one does not take into account the
possibility for producers to trade in irregular markets. Moreover, no clear
effects of a tax increase can be derived for the equilibrium price in both legal
and irregular markets. This is because legal and illegal goods are substitutes
in consumption and in production so that a change in the price on the legal
market (due to increased regulation) has effects on the shape of the demand
and supply curves in both markets. Overall, the effect of a tax increase on
the profit levels for firms dealing in both markets depends on how they
distribute their output across the two. More definite results can be obtained
only for firms dealing exclusively in the legal market as an increase in
production costs reduces, ceteris paribus, the unitary profits. Smith also
provides an empirical analysis of the effects of an increase in regulatory
standards on the volumes traded in both legal and irregular markets for
distilled spirits. The main result is that demand and supply respond more to
8400 Organized Crime and Illegal Markets 443

changes in tax rates than to changes in market prices with no relation with
government regulation. Indeed, both consumers and producers substitute
between legal and irregular markets after a change in the regulatory costs.
Smith also finds a positive correlation between tax rates and prices in the
legal market: the shift of producers and consumers to the illegal market has
a greater effect on the supply curve (shifting it upward) than on demand
(shifting it downward) in the legal market.
In a similar vein, Anderson (1995) examines other regulatory measures
that provide incentives for legal firms to invest in irregular markets and
therefore to create a market for the public services supplied by organized
crime. First, there is regulation aimed at increasing quality standards which
often involves a limited supply of licenses or permits (building, commercial,
professional, polluting) or other entry barriers. In these circumstances
organized crime tries to control the distribution of the licenses using its
comparative advantage in centralizing corruption and/or in enforcing cartels
among incumbent firms. Second, there is price control regulation or
interventions to set subsidies, quotas or other constraints to exchange. In
these cases organized crime avoids quality standards and/or reports
non-existing output taking advantage of its protection against the
enforcement of police agencies. According to the New York State
‘Organized Crime Task Force’ Report (1989) the involvement of organized
crime in the allocation of public funds is a consequence of two distinct
sources of comparative advantage. First, in bribing and threatening public
officers and, second, in coordinating collusive agreements between firms and
the public administration. When such collusive agreements take place,
organized crime succeeds in extracting rents from both public purchasers
and private suppliers. According to Grossman (1995), in these collusive
agreements greater stability is often obtained when electoral support is
provided in exchange for a reduction in the enforcement efforts. In these
circumstances the criminal organization can also manage to direct the
enforcement activities against its rivals. It follows that while the
enforcement agencies meet their targets in terms of quantitative indicators,
the incumbent obtains further positive externalities. Moreover, both sides
strengthen their fiduciary relationships and reduce the incentives to act
opportunistically. On similar lines, Tanzi (1995) observes that collusive
agreements between local politicians and criminal organizations become less
stable in case of fiscal crises as the latter reduce the possibility to activate
public expenditure without a corresponding increase in the fiscal pressure.
In such a case it is unlikely that public administrations succeed in
appropriating large rents from direct interventions without reducing their
electoral support. A greater political instability may therefore decrease the
incentives for criminal organizations to collude with politicians as their
expected stay in power is shortened.
444 Organized Crime and Illegal Markets 8400

To measure the size of irregular markets and the potential threat they
represent for the activities of the legitimate government some authors
attempted to overcome the complex methodological problems due to a lack
of reliable data. In this perspective, Feige (1994) proposes a definition of the
illegal economy which includes all transactions that violate specific statutory
rules concerning the scope of what is regarded as legitimate trade. On the
other hand, irregular activities include all transactions which belong to the
area of the legal economy as defined above, but violate statutory and/or
administrative rules related to one or more of the following areas: property
relationships, commercial licensing, labor contracts, torts, financial credit
and social security. Feige describes two lines of research aimed at measuring
the size of the irregular markets. First, the direct approach based on the
analysis of tax auditing and other reports concerning the level of compliance
with fiscal legislation and regulatory standards as a whole. Second, the
indirect approach based on the analysis of macroeconomic indexes over
time. As for the latter, Tanzi (1983) develops a currency approach which
builds on the assumption that irregular transactions are mostly undertaken
via cash payments. Accordingly, one can detect changes in the irregular
transactions observing, ceteris paribus, changes in the demand for liquidity.
Similar in spirit is the approach proposed by Feige (1989) which builds on
the assumption that the Fischer quantity equation holds through time. On
this basis, knowing the amount of liquidity, the level of prices, and the
velocity of rotation, one obtains relatively good estimates of the total
transactions taking place in the system. Comparing such total transactions
with the nominal GDP one could approximate the transaction volume in the
irregular markets. Feige also discusses other lines of research that adopt an
indirect approach but rely on real variables from national accounts and labor
market data. In this group of contributions, Macafee (1982) and Park (1979)
propose a quantitative analysis of the irregular markets which relies on the
discrepancy between national expenditure and national income as it can be
related to unreported income from illegal or irregular transactions.
Analogously, Contini (1981) tries to estimate the overall size of the irregular
markets looking at changes in the labor force participation rate with respect
to a standard level which is assumed to be observable in the absence of
illegal or irregular activities.
Although the above authors admit that the lack of reliable data represents
a serious obstacle to measure the size of the informal economy, building on
these results Schneider (1994) proposes an approach to investigate how that
size is related to the overall burden of taxation and to the level of regulation.
More precisely, Schneider shows that increases in fiscal pressure or in
regulatory intensity (the number of existing laws) and in the complexity of
the tax system (a Herfindahl-Hirschman concentration measure of the
revenue sources) are all strongly related the size of the illegal and irregular
8400 Organized Crime and Illegal Markets 445

markets. Moreover, Schneider’s results suggest that even a decline in the

fiscal pressure is not a sufficient condition for a reduction of the size of the
irregular economy if it is not followed by a fall in the indexes of regulatory
complexity and intensity. Related to this literature on the size of the shadow
economy, Reuter (1984) tries to quantify the multiplier effect of the
expenditure in illegal markets on the economy as a whole. In a first model
he assumes that illegal goods are produced by foreign criminal agents and
therefore can be regarded as imports in national accounts. For this reason,
purchases of illegal goods have no impact on national income. Then Reuter
assumes that the producers of illegal goods are domestic so that the
expenditure on such goods becomes an export to another country, as they do
not emerge in official statistics. In such a case an increase in the demand for
illegal goods is similar to a purely exogenous demand shock as it originates
outside the regular economy. Assuming that the expenditures in illegal
goods result in income for the domestic producers, the multiplier is lower
because it depends negatively on the differences in saving propensities
between producers and consumers of illegal goods.

5. Organized Crime and Illegal Markets

The neo-institutional literature focuses on the effects of different

mechanisms for defining and protecting property rights and for enforcing
contracts to explain market performances. In one of the leading
contributions to this literature Demsetz (1967) notices that the participants
in illegal markets should in principle self-protect their property rights.
Indeed, if the government does not provide the basic services required to
support the working of decentralized markets private agents willing to trade
have to substitute it. As most rent-seeking literature suggests, in similar
situations it is likely that after a competition among private agents or groups
one of them will emerge as the specialized supplier. Schelling (1971) notices
that after such an authority becomes established it is likely that its activities
will also include the use of violence and corruption and the provision of
inputs at regulated prices. Furthermore, when illegal organizations with
large specific assets protect themselves from the police and from other
opportunistic behaviors they often generate a positive spillover to other
producers not only in the same line of product but also in related markets. It
follows that they will find it convenient to exploit these economies of scale
and scope. Eventually, when large investments are sunk in protecting
property rights and enforcing contracts, such organizations may have
sufficient incentives to compete with the legitimate government for the right
to provide the above services even for agents active in legal markets.
446 Organized Crime and Illegal Markets 8400

Building on this perspective, Paul and Wilhite (1994) show that the full
social cost of making goods or services illegal should also take into account
the dissipation of resources invested in the attempt to establish a monopoly
in the supply of protection and enforcement services. In this respect, even
agents not interested in obtaining a monopoly position but willing to protect
their endowments are forced to invest intensively in that direction. In order
to derive their main result, Paul and Wilhite discuss Becker and Stigler’s
(1974) claim that an increased enforcement against producers of illegal
goods on average increases their profits. The authors argue that to draw such
a clear-cut conclusion one should address directly the effects on producers’
costs of the increased enforcement and, more to our point, on the resources
wasted in the attempt to monopolize the illegal market. Paul and Wilhite
claim that producers are not attracted by the price increase brought about by
the government-induced supply restriction, but by the perspective to obtain
rents from the monopolistic control of the illegal markets. Hence, the main
consequence of a lack of public enforcement of property rights is to increase
the investment in military technology and in corruption. Given these
negative consequences, different economic justifications have been offered to
explain relatively low levels of public enforcement. Traditionally, authors
like Buchanan (1973) or Rubin (1973) stress that in most instances markets
are made illegal for paternalistic reasons, that is because consumers do not
fully understand the consequences of their actions. According to this view,
such markets would have usually reached an efficient equilibrium as agents
transact voluntarily and there are no significant imperfections such as
external effects from production or consumption.
In a different perspective, Rose-Ackerman (1985) explains the decision
of making transactions illegal as a second-best policy to reduce the negative
effects of market imperfections. Rose-Ackerman proposes two arguments to
limit the rights of exchange on efficiency grounds, and a third argument
which has to do with the intrinsic limits of the technology used to enforce
the ban. First, goods such as body organs or human blood need costly quality
controls which make it difficult for purchasers to evaluate the available
alternatives. Moreover, even if purchasers were able to discriminate, such
goods are often demanded in such an urgency that their bargaining power is
negligible. Hence, Rose-Ackerman argues that to avoid excessive ex post
litigation over the terms, the government might declare such contracts
illegal on efficiency grounds. Following this argument, one could object that
if the government’s objective is to increase the standards of quality,
measures aimed at reducing entry but not blocking it completely (for
example, licenses) should be used to deter producers who would specialize in
low quality supply. However, licensing practices tend to discourage
particularly low-income consumers and to shift their demand to irregular
8400 Organized Crime and Illegal Markets 447

markets where non-licensed suppliers operate. Hence, the government’s ban

could be further rationalized as a measure to avoid negative redistributive
effects from the attempt to regulate such markets.
The second efficiency argument to make markets illegal is that the
production and/or consumption of illegal goods with a voluntary demand
can give rise to negative external effects, which are not accounted for by the
parties involved. For instance, the consumption of heavy drugs may lead to
the impossibility for consumers to face their obligations using their legal
incomes and therefore increase the number of thefts and other predatory
crimes. In its turn, this would force other agents to invest in defensive
measures that increase the opportunity costs of holding property and trading.
Moreover, the consumption of drugs may lead to a worsening of consumers’
health conditions to a point that they cannot cover the resulting medical
expenses and therefore require some sort of public or charitable intervention.
Rose-Ackerman also suggests an additional and subtler source of externality
arising from the imperfections of the enforcement mechanisms. Her example
is centered on the trade of species in danger of extinction. In such a case the
purpose of the ban is to deter further killing of endangered animals and, on
efficiency grounds, this should not be extended to animals killed in the past.
However, due to the impossibility of detecting differences between animals
killed in different periods of time, all transactions are banned. In this
respect, the suppliers of new animals in danger of extinction create a
negative externality for the owners of animals killed in the past. The
example could be regarded as trivial due to the relatively small dimension of
such a market compared to other illegal markets, but its logic can be
extended to cover other interesting cases. For instance, in the market for
illegal drugs, a similar external effect can be relevant as most economists
(Moore, 1973; White and Luksetich, 1983) suggest that an appropriate
regulatory practice would be to increase the price only for new consumers to
discourage their consumption. At the same time the deterrence policy should
interfere less with the market price for old consumers not to create rents for
producers and traders. However, as most illegal drugs are characterized by
very small hoarding costs, it is virtually impossible to enforce a
discriminatory regime against new consumers, as the old ones would have
too great incentives to enter the trade. As arbitrage would then be declared
illegal, it is likely that organized crime would take over from old consumers
at least for the large-scale trade.

6. Organized Crime and Legal Markets

Although most economists agree that the larger share of activities of

organized crime is linked with the provision of governance services for firms
448 Organized Crime and Illegal Markets 8400

involved in irregular or illegal markets, some influential contributions

investigate its intervention in legal markets. For instance, Reuter (1987) and
Gambetta and Reuter (1995) investigate the enforcement of cartel
agreements in industries with auction markets managed by public
administrations (for example, waste disposal, road construction, building).
Such markets are often highly competitive due to the relatively low level of
specific inputs and cartel agreements are unstable as it is difficult to detect
and to sanction defections. The role of organized crime is therefore to
increase the stability of such agreements threatening to punish the firms who
defect. On similar lines, Gambetta (1988) suggests that a separate service
provided by organized crime to legal firms is protection from entry of new
competitors. This is because it is neither in the interest of the incumbent
firms nor of organized crime to allow entry, since this would ultimately
reduce the rents that are at least in part appropriated by the latter.
Organized crime activities in legal markets extend also to the direct
investment and management of legitimate businesses. In this respect,
Anderson (1979) suggests that the main reason for organized crime to start
legitimate business activities is that these activities allow organized crime to
exploit economies of scale and scope related to its illegal activities. First,
members of the organize crime need a source of legitimate income to hide
their true business. Analogously, in the supply of illegal goods or services
there is a need for places to trade so that small shops, bars and restaurants
are used to cover activities related to loan-sharking or illegal betting.
Second, illegal activities often produce outputs or use inputs that are also
needed in the legal ones (transportation, communications, warehousing) so
that it is profitable to integrate the two. Third, organized crime needs to
launder at least part of its profits. To do so through a business activity under
its control reduces the risks involved in money laundering. Fourth, the
legitimate business can be seen as an occasion to diversify the organization’s
portfolio with investments characterized by a different mix of risk and
returns. Fiorentini and Peltzman (1995b), following Schelling (1967),
discuss the features of the legitimate activities in which it is more likely to
observe direct investments by organized crime. In this respect, profits from
illegal activities are often invested in industries with relatively mature
technologies and protected from international competition. In more
competitive settings the comparative advantages of organized crime in legal
businesses (monopolistic control of the input markets and especially of the
labor unions, availability of capital at low cost and direct threats to rival
firms) are not likely to be relevant. For instance, large multinational firms
active in open markets often compete over product and process innovations
and/or financial diversification. Also Gambetta and Reuter (1995) discuss
the market features more likely to elicit the intervention of organized crime,
8400 Organized Crime and Illegal Markets 449

reaching similar conclusions. In particular, they find that such intervention

can be observed in markets with low barriers to entry both in terms of sunk
capital and product differentiation.
Anderson (1979) notices that in the debate on organized crime’s
legitimate activities opinions differ on how much coercion is used against
legal firms. According to the report of the President’s Commission on Law
Enforcement and Administration of Justice (1967), organized crime disrupts
competition through predatory practices and represents a serious threat for
all legal firms involved. On the contrary, MacMichael (1971) suggests that
the possibility for organized crime to take advantage of these practices is
limited by the greater visibility of legal activities. Indeed, there are
increasing risks of losing profits from both legal and illegal activities due to
a more active police enforcement as legal firms are more likely to call for its
intervention. More generally, although an increase in the transactions under
control of organized crime has negative consequences for the development of
a given area, it may not be always appropriate to concentrate deterrence
efforts to prevent money laundering. Fiorentini and Peltzman (1995b)
suggest that when criminal organizations obtain a high level of illegal
profits one should compare the relative social losses from their investment in
other illegal activities or in legal ones. This is because, even if an extremely
costly deterrence mechanism could prevent their laundering, illegal profits
would be invested in other illegal activities or in other countries. Hence, for
a given level of enforcement, one must face a trade-off between reducing the
area of legal transactions under control of criminal organizations and
reducing the area of the illegal transactions.

7. Internal Structure and Vertical Integration of Organized Crime

One of the first studies of the internal structure of organized crime is

Jennings (1984). In his view, the central function of organized crime is to
require its members to take an oath not to cooperate with the police and to
enforce such an oath by punishing those who fail to comply with it.
However, since the relative monitoring and enforcing costs are high and
rapidly increasing with the number of members and markets involved,
organized crime core business is concentrated in relatively few activities.
Moreover, Jennings shows that the enforcement of the oath is valuable only
if the illegal activities of organized crime require specialized agents working
in teams and running substantial risks if one betrays the others. On the
contrary, if the illegal activities are mainly performed individually, the
enforcement of the oath is relatively useless. Also Gambetta (1988) draws
attention to the relevance of secrecy in shaping the internal structure of
450 Organized Crime and Illegal Markets 8400

organized crime not only to avoid detection from the police, but also to
manage different sources of intelligence which can be used to maximize its
profits. In this respect, Gambetta notices that the comparative advantage of
organized crime in selling its protection services is much greater when those
on the demand side know little of its internal structure as the organization
would be more exposed to police intervention. A recent development in the
analysis of the internal structure of organized crime is Polo (1995) who
models the latter as a hierarchical organization where the principal hire
agents to carry out tasks usually requiring to commit serious crimes. The
main problem of the principal is to design a set of incentives constraining
agents’ opportunistic behavior in absence of legal contracts. To solve this
problem the principal offers contracts where the enforcement of the terms
depends on the credibility of the mechanism to sanction the agents who
defect.
More generally, the economic literature on the vertical structure of
organized crime begins with Schelling (1971) who suggests that the latter
integrates downstream with illegal firms’ markets when one or more of the
following conditions apply: First, when the downstream markets are natural
monopolies so that the implicit contracts described in Polo (1995) are
particularly subjected to the opportunistic behavior of the illegal firms that
might threaten the governance role of organized crime. Second, when there
are external effects mainly due to the need to supply violence and corruption
which can be internalized through integration. In these circumstances a
centralized control avoids duplications of costs and reduces the dissipation
of resource in appropriative activities. Third, when financing illegal firms’
activities through an integrated structure allows for a more efficient portfolio
strategy (Rubin, 1973). Fourth, when contracts may become source of
evidence against the agents who sign them. In other words, the impossibility
to use detailed contracts in dealing with complex transactions reduces the
advantages of the market over an integrated structure. Fifth, when the illegal
firms enjoy large informative advantages and are able to hide most of their
profits.
However, some authors (Reuter, 1983; New York State Organized Crime
Task Force, 1989) stress that there are limits to the benefits of increasing the
area of economic transactions directly managed by a centralized
organization. According to Reuter, the main limit of such organization has
to do with the rapidly increasing costs of monitoring and coordinating
agents with conflicting interests. In this respect, the need to keep a
centralized control over the use of violence and the fact that police agencies
invest more intensively against large-scale organizations might explain the
emergence of relatively small local monopolies. Indeed, the first condition
provides incentives to reach a monopolistic control while the second limits it
to a local area. Second, precisely because the property rights over resources
8400 Organized Crime and Illegal Markets 451

used in illegal activities can only be enforced at very high costs, to

concentrate such rights in a centralized organization increases the negative
consequences of police enforcement. An analogous reasoning holds for the
human capital integrated in large organizations which is at greater risk in
case of violation of the secrecy code. Third, in some illegal markets it is
virtually impossible to impose a centralized control because of the low level
of the barriers to entry. Finally, there might be a structural instability in the
financial flows used in illegal activities due to the police enforcement
against money laundering which can discourage large-scale sunk
investments even by risk-neutral agents.
More recently Dick (1995) develops a framework to analyze the issue of
the vertical integration in different institutional settings. In particular, Dick
focuses on the illegal firms’ choice between buying protection from a
specialized organization and producing it internally. To investigate such
issue, Dick suggests an decomposing the total transaction costs between
production and organizational costs. Production costs are typically lower in a
specialized organization due to economies of scale and scope and would call
for market supply by a non-integrated producer. On the contrary, the
organizational costs to coordinate inputs in specific uses and to adjust to
unforeseen contingencies are lower in an integrated structure because of the
high specificity of the assets involved. Building on this general framework,
Dick (1995) suggests that small firms active in illegal markets are usually
interested in buying protection from organized crime only if the latter is not
specific to the local market. In such a case protection is more efficiently
provided inside the illegal firms so that one of them will enforce the rules
underlying the working of the illegal markets. Conversely, illegal firms will
buy protection from specialized organizations when their expected time
horizon is sufficiently long so that it is worthwhile to define and enforce
complex market transactions. Such a longer time horizon is often observed
when illegal firms and organized crime share a common culture, for
instance due to ethnic networks, so that transaction costs are low and
self-enforcing agreements are more likely to be feasible. Finally, illegal
firms will self-supply protection if there is a high degree of uncertainty over
the terms of the transactions. This explains why organized crime supplies
protection to illegal firms dealing with victimless activities where the
activities are easily observable, while self-protection is the rule for
organizations involved in appropriative activities.
452 Organized Crime and Illegal Markets 8400

8. Normative Analysis

Buchanan (1973) introduces a controversial argument in the analysis of the

deterrence strategies against organized crime. His basic assumption is that
organized crime tends to control, directly or indirectly, the allocation of
resources in illegal markets. In such a role it operates approximately as a
monopolist whose interest is to block entry of new competitors and to limit
output. Accordingly, a legislator willing to minimize the level of
transactions in illegal markets should not target its deterrence policies
against organized crime, which helps to pursue a similar objective.
Buchanan also evaluates the distributive effects of a monopolistic structure
characterized by a large share of surplus invested in other illegal activities.
In his view, such distributive effects do not represent a sufficient reason to
concentrate deterrence efforts against organized crime. Indeed, if there are
economies of scale in the production of illegal goods a monopoly reduces the
opportunity costs as it requires fewer resources per unit of output.
Buchanan’s analysis deals only with the role of organized crime in illegal
markets and not in predatory activities. This means that his model does not
address the negative effects of organized crime’s supply of violence and
corruption. This notwithstanding, compared to other supply structures one
can argue that illegal monopolists prefer lower levels of violence and
corruption precisely because they internalize such external effects.
Schelling (1967), building on his analysis of organized crime as a
coercive authority, suggests that the first priority of any deterrence policy
should be to legalize as many illegal markets as possible. The idea behind
this is that only by reducing the rents available in the illegal markets can one
limit organized crime’s role as a governance structure for firms active in
legal, irregular and illegal activities. Moreover, among the social costs of
making some markets illegal one should consider that profits are used to
bribe enforcement agencies and the public administration and that potential
victims are led to invest in appropriative activities. To strengthen his thesis
Schelling suggests that organized crime is unlikely to keep its control of the
legalized markets since they are not characterized by high barriers to entry.
Following the same reasoning, Tanzi (1995) proposes reducing the areas of
direct public intervention because they are often run through auction
markets where organized crime operates as the enforcer of collusive
agreements between legal firms and the public administration.
Given the particular relevance of the features of police interventions in
explaining the size of illegal markets, several economists analyzed the
specific deterrence policies adopted against the criminal organizations
running such markets. In this respect, Fiorentini and Peltzman (1995b)
report that in most illegal markets (drugs, betting, loan sharking,
8400 Organized Crime and Illegal Markets 453

prostitution, smuggling, counterfeiting) police agencies concentrate their

efforts on agents involved in productive and trading activities more than on
consumers. This is probably due to the recognition that demand is voluntary,
and therefore if consumption gives rise to relatively low negative
externalities, to target consumers would impose on them a rather high
welfare loss. Moreover, if one takes into account the enforcement costs,
consumers are often too many and too dispersed to be an efficient target for
effective deterrence efforts. On similar lines, most empirical studies on
industries where irregular activities involve a large size of resources show
relatively low levels of entry barriers and asset specificity (New York State
Organized Crime Task Force, 1989). This makes it difficult to design a
deterrence policy against producers or traders as they are easily replaced by
new organizations. To reduce the consequences of this problem Lott and
Roberts (1989) suggest that the police should try to exploit the conflicts
between parties involved in illegal transactions. This follows the analogy
with those irregular markets where transactions violate price or safety
regulations (house rents, loan sharking) and where one of the two
contracting parties can be given enough incentives to denounce the other. A
similar strategy, centered upon the use of potential conflicts between agents
in the same organization, has been extensively used in fighting organized
crime through informants’ protection schemes.
These difficulties in targeting small illegal firms can explain why most
resources are used to contrast the organizations involved in large-scale
trading of illegal goods, in financing other illegal firms’ activities, in
laundering the profits from such activities and in bribing public officials.
Indeed, all these activities involve human and physical capital assets
extremely specific and rather difficult to be replaced in the short run.
However, large organizations are also more reactive against the enforcement
activities of the legitimate government as they have much more at stake.
Hence, especially if such reactions take the form of increased corruption and
violence against the police agencies (Fiorentini, 1995) it might be advisable
to address part of the deterrence efforts against consumption strengthening
the enforcement on the demand side. This is especially so if such policies are
targeted against markets with a high demand elasticity (Becker and Murphy,
1988).
To specify appropriate deterrence policies aimed at reducing illegal
transactions, agencies should also consider the strategic interactions between
criminal organizations. In this respect, if there is a monopolistic or
oligopolistic supply the allocative and distributive effects of an increase in
the deterrence effort depend on the market structure emerging after the
enforcement. For instance, if the market becomes competitive and barriers to
entry are eliminated, in the long run more illegal goods will be traded at the
new equilibrium (Buchanan, 1973). On the contrary, if the entry barriers are
454 Organized Crime and Illegal Markets 8400

not lowered, strong enforcement activities against an incumbent may favor

the surviving organizations increasing their profitability and therefore their
capacity to supply violence and corruption (Cellentani, Marelli and Martina,
1995). In similar situations it is likely that an increased deterrence effort will
lead to greater resources invested in corruption and violence.
Finally, the design of effective deterrence policies should take into
account that organized crime’s supply of services to legal, irregular and
illegal firms is a relevant source of income in areas with large-scale
unemployment. For this reason, although the aggregate negative
consequences of organized crime activities on the growth of the legal
economy are extremely large, there are problems in eliciting continuous
support for the fight against it. This is not only because organized crime can
directly threaten its opponents and corrupt police agencies, but also because
it can buy support with distributive policies implemented jointly with local
politicians (Grossman, 1995). Accordingly, most communities where
organized crime plays a relevant role can be described using a prisoners’
dilemma framework where individual agents are damaged in the short run
by its disappearance and are therefore unable to coordinate themselves to
reach more efficient outcomes.

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