AN ECONOMIC PERSPECTIVE ON THE LEGALISATION DEBATE: THE DUTCH CASE

By Martijn A. Boermans, The Amsterdam Law Forum

28 October 2010

This paper reviews how economic modelling provides a deeper understanding of drug markets. The exercise focuses on ‘soft drugs’ (cannabinoids) in the Netherlands and outlines the effects of prohibition and legalisation. The purpose is to present an overview of analytical tools to non-economists. Based on a basic supply and demand framework the impact of enforcement, externalities, producer incentives and demand elasticity are highlighted. Results indicate that social welfare is maximized under legalisation given limited externalities associated with consumption and price inelastic demand. We recommend a liberalized soft drugs market that requires inter alia taxation, complemented with various health measures like quality controls and public campaigns. The Dutch case is exemplary, as this economic perspective offers universal building blocks relevant to the legalisation debate in other countries, and potentially to other substances.

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Conclusion

The propositions presented above provide us with a common understanding of the economic forces within the drugs market. This paper focused on a tentative interpretation of the Dutch drug policy. Key assumptions driving any policy recommendation from an economic perspective are the price elasticity of demand and externalities involved with consumption. A key point many economists have made is that the market structure causes most of the negative externalities, and not necessarily drug consumption; this is obvious in the Netherlands where consumers generally do not fear prosecution.

Two propositions derived from the core model are that i) prohibition hurts consumers and leaves rents to producers, ii) enforcement not only increases the price of drugs but under inelastic demand, enforcement pumps disproportionally more resources into the drug market because consumers and producers alter their behaviour in illegal goods markets. A corollary shows that higher punishment causes an adverse selection process, where only the ‘toughest’ producers remain while earning even more profits and causing greater negative externalities such as increased criminal activity. In other words, prohibition of drugs shifts the supply curve upward. Enforcement and punishment are effectively a tax on suppliers, which raises their production costs and allows them to profit. Prohibition shifts the demand curve downward and lowers consumption, although it was discussed why this deterrent effect is arguably small. Taking these factors into account together implies higher drug prices under prohibition, which is a disadvantage for consumers. Under prohibition the producer surplus results in negative externalities including criminal activity, health problems, distorted education and moral stigmas.

In legalized markets, producers lose the possibility of profits and prices drop to a competitive level. In order to balance the possible rise in consumption, government can apply a Pigouvian tax system to raise prices, lower consumption and obtain income transferred from consumption; yet, only up to the point where externalities from consumption can be paid back for. Hence, under legalisation the government earns some income and saves in costs typically put towards enforcement, while compared to prohibition, consumers are better off and producers cannot profit.

In order to estimate the impact of legalisation in the Netherlands a simple mathematical and conceptual model was demonstrated. As there is so much uncertainty about possible policy implications, it is proposed first to levy a tax on drugs that does not extensively affect the current price level. Based on preliminary back-of-the-envelope calibrations one can expect a yearly ‘net’ tax gain of up to 850 million euro in the Netherlands. It is not a concern that legalisation of soft drugs may cause a rapid rise in consumption, because the good is already widely available and prices are kept constant. Regulation and taxation can mitigate consumption and negative externalities though price effects and tax income. The core pillars of Dutch drug policy should remain and they would be strengthened under legalisation.

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