Wednesday, October 9, 2013

Attacking The Drug Problem Globally

I saw on LinkedIn that Richard Branson spent all of last week in Geneva debating drug policy at the Global Commission on Drug Policy. He welcomed suggestions on a slogan in the comments, but it got me thinking about how to tackle the drug problem as a whole. Do we legalize drugs and regulate them? Do we impose stiffer penalties? What results would they manifest? My approach is a little different. I say, tackle the problem at its source: the economics of the industry.

Unfortunately, stiffer prison terms for dealers by itself will only be marginally effective because the payoff remains relatively the same. Legalizing drugs won't do much because a legal market with regulation cannot thrive when a healthier black market exists for the same commodity. Anybody who's ever read "Freakonomics" by Steven Levitt will recall the lengthy chapter on the bursting of the "crack" bubble in the early 1990's. So this got me thinking: perhaps the way to control the drug problem is to create an artificially induced market crash.

The approach would be a 4-prong approach, but in order to implement it, we need to look at the supply chain of drugs, their players, and their incentives:

According to Levitt, the 'crack' bubble burst in the early 1990's happened because when 'crack' hit the market, the market price of cocaine dropped as 'crack' was a cheaper alternative to cocaine. This lead to drug-dealers starting to undercut each other, which eventually caused the crash because the risks associated with dealing were not worth the low payoff (getting killed, shot, arrested, etc. vs. the earnings of the average crack dealer of $7/hour*). So the first step would be to get the drug dealers to start undercutting each other in price to unload their inventory. 

To do this though, a few more things are required. Getting dealers to price cut each other and the second step of the approach, requires making the wholesale price of drugs cheaper. Temporarily higher margins to the dealers will make the industry attractive to price-cutters. In any commodity-based industry where no one supplier has a competitive advantage, the return on investment becomes compressed downwards towards the cost of capital because the only thing participants can compete on is price. So where a 70% margin is attractive to one participant, other participants are perfectly willing to settle for a 60% margin, 50% margin, etc. etc.

So to make the wholesale price cheaper, we need to increase the inventory of the manufacturers, which leads to our third step, have local governments subsidize sourcers that reach a certain production quota (lots utilized and total yield) and penalize sourcers who do not reach this benchmark with a "Agricultural Inefficiency Tax." This will incentivize all sourcers to both keep their total yield high and require minimum order quantities from manufacturers to hit the subsidy benchmark. Manufacturers now being forced to take on excess inventory, will both require mininum distribution quotas from their dealers. Dealers will then become loaded with excess inventory and thus incentivizes them to lower their prices just to move their stuff in larger sized deals.

But we're not done there, the fourth and final step is to make prison sentences even higher for drug dealers. What this does is increase the risk profile to drug dealers. Because of this higher risk, the dealers will demand for higher reward in the form of pricing pressure on the manufacturers to expand their profit margins. So what ends up happening is the entire supply chain becomes pressurized from both ends, and the incentive to each player gets flips on its head:

In these conditions, the market becomes unstable and cannot self-sustain, which inevitably will cause conflict between all participants and cause the market to eventually crash.

At least, that's my theory...implementing it is another story.

*See the financial statement of the average crack dealer provided by Steven Levitt in "Freakonomics."