Why your anti-drug policies just might annoy your neighbours

A few weeks ago, Michael Clemens on the CGD Views from the Center blog alerted me to this recent CGD Working Paper by Juan Camilo Castillo and Daniel Meija (both of Universidad de los Andes) and Pascual Restrepo of MIT. In the paper, the authors attempt to evaluate the effect of cocaine scarcity on violence in Mexico. The authors begin with the Hobbesian argument that in situations where there is a lack of third party enforcement (of contracts, property rights, etc.) through the rule of law, then individuals (or groups) would have to use their own means of protecting their interests, such as through violence. This seems likely for illegal drugs, as the government isn't going to enforce contracts or protect property rights with regards to the actions of cartels. The authors argue that:

Our basic intuition is that scarcity increases violence if the demand for certain goods whose market is illegal is inelastic. In this case, a decrease in supply causes a larger increase in prices, therefore increasing total revenues and the stakes. This leads to more predation and violence.

Now, it's not a simple matter to evaluate the link between drug supply shortages and violence in a single country as there are two mechanisms at work simultaneously. The authors note above one mechanism that links the ongoing 'war on drugs' to violence in Mexico: an increase in attacks on cartels reduces the supply of drugs, raising prices, and increasing the returns to having control over market supply, which can be gained through violence. The second mechanism is more direct - if you fight a 'war on drugs' against the cartels, they fight back, which increases the levels of violence. They may also fight each other, especially if you are moderately successful in reducing the power of one of the rival cartels. So, in order to disentangle the two effects the authors instead look at the effects of anti-narcotic policy in Colombia (the main drug supplier to the Mexican cartels) on the degree of violence in Mexico. I like the authors' approach here, mainly because it doesn't rely on instrumental variables to isolate the effect of the supply shocks.

The authors argument relies on demand for cocaine in the U.S. market being inelastic - thus when prices rise, the quantity demanded decreases but by a smaller percentage than the increase in price, such that total revenue increases (if instead demand were elastic, the decrease in supply would still raise prices, but would reduce total revenue). This argument assumes that suppliers make their decisions about effort (including violence) based on revenues, rather than profits - quite a strong assumption, given that we would usually expect firms (including Mexican drug traffickers) to make decisions based on profits, not revenues. However, once the drugs have crossed the border from Colombia into Mexico, and been paid for by the Mexican cartels (no self-respecting Colombian drug lord is going to extend credit to the Mexican cartels), the cost of their purchase becomes a sunk cost - there is no way for the cartel to recover the amount they paid for the drugs if they are captured by a rival (or by Mexican authorities), and thus the cost of the drugs is not relevant to the decision about how much violence is optimal to pursue in order to translate the drugs into cartel profits. Thus, the decision about the optimal level of violence is likely to be based on drug revenues and the costs of violence, rather than the profits (revenues minus the cost of the drugs). Of course, this assumes that the cartels aren't subject to the sunk-cost fallacy.

If the Mexican traffickers instead made their decisions based on profits rather than revenues, then we would have to recognise that profits must fall for the Mexican traffickers. The cost of obtaining cocaine from Colombia has increased (analogous to a decrease in supply), so even though prices have gone up, producer surplus must have decreased. This happens irrespective of whether demand for cocaine in the U.S. is elastic or inelastic. So, why would violence increase if profits are falling? In this case you could argue that the traffickers would still have to meet their fixed costs (paying your network of large-scale logistics, drug mules, not to mention armed guards, etc. doesn't come cheap). If the cartels were rational, they might downscale their operations, but we know that decision-makers are subject to the sunk-cost fallacy and are willing to increase investment in order to avoid a loss. Cartels are unlikely to be any more rational that anyone else, so they increase their level of violence as they try to capture a bigger share of the cocaine trafficking market into the U.S.

The difference between increased revenue driving increased drug violence, and decreased profits driving increased violence isn't just a minor quibble. The policy implications of the two possibilities are the exact opposite of each other. If you believed that increased revenue was to blame, then in order to reduce violence you find some way of reducing drug revenues, but that would actually increase violence if it turns out that decreased profits were to blame.

Anyway, regardless of how you argue that the decrease in Colombian supply would affect the incentives for Mexican cartels to engage in violence and the appropriate policy remedies to that violence, the authors find that:

...violence increases in Mexico during months with supply shortages caused by seizures in Colombia. Moreover, violence increases especially in the north, and within the north specifically in places close to entry points to the U.S., as predicted by our model. Violence also increases more in northern municipalities that have historically voted for PAN, President Felipe Calderon's party, in which local authorities are more likely to support federal government efforts against cartels in their area, thus increasing the turnover of cartel leaders. Finally, violence increases more in places with cartel presence, especially in places with two cartels or with two rival cartels operating at the time of the supply shock...

Our estimates suggest that, for the period 2006-2010, scarcity created by more efficient cocaine interdiction policies in Colombia may account for 21.2% and 46% of the increase in homicides and drug related homicides, respectively, experienced in the north of the country. Thus, at least in the short run, scarcity created by Colombian supply reduction efforts has had negative spillovers in the form of more violence in Mexico during its so-called War on Drugs.

So, Colombia's anti-drug efforts may be responsible for over 20 percent of homicides in northern Mexico over 2006-2010. Of the 28,000 homicides to occur in the 5 percent most northern municipalities over those five years, Colombia's anti-drug efforts may be responsible for nearly 6,000 of them. Now that's a bad neighbour policy - Colombia's anti-drug efforts have created a pretty large externality for Mexico.