How Legalization Can Expand a Black Market

Human trafficking is one of the most revolting crimes on the planet, and it is therefore understandable that some governments have taken radical action to attempt to eliminate it, including legalizing prostitution. The argument, which seems sound on its face, is that expanding the supply of legal prostitution will draw demand away from the illegal market that relies on human trafficking. It is thus both surprising and important that new research from the London School of Economics shows that legalizing prostitution increases, rather than decreases, human trafficking.

This finding is stunning until one recognizes that demand for prostitution, gambling, drugs and the like is highly elastic. When the demand-suppressing effect of illegality is removed, demand can increase, sometimes dramatically. All of this new demand does not necessarily go to the legal market. Some new legal market entrants engage in the parallel black market some of the time (e.g., play legal slots at the casino by day and participate in illegal mob-run poker games at night). If the size of the newly legalized market is rapidly growing, these “fractional customers” can make the black market larger than it was in the pre-legalization period when all market participants were 100% reliant on the illicit market to meet their demand.

Other people may develop demands in a newly legalized market that over time lead them to move exclusively to the illegal market. For example, a man who begins going to prostitutes when sex work is legalized may realize over time that he wants to have sexual encounters in which he is physically abusive to prostitutes. He would then migrate to the black market where he can more easily indulge his violent propensities. Similarly, people who becomes addicted to a newly legalized drug may come to want to consume it so often and in such quantities that only the black market will meet their demands.

It has long been speculated that the phenomenon of legalization of a market growing a black market has already happened with gambling. There has clearly been an explosion of legal casinos, poker competitions, state-run lotteries etc., but no definitive research indicates whether the prevalence of illegal gambling has increased, reduced or stayed constant as a result. The new LSE research is I believe the first formal test of the possibility that legalization can grow a black market, and for prostitution it appears that it can (full paper here).

There is clearly more empirical work to be done in this area. But in the meantime, wise heads in the policy world will not take it as a given that legalizing something will necessarily shrink the black market.

h/t: Eric Voeten.

[Cross-posted at The Reality-based Community]

Keith Humphreys

Keith Humphreys is a professor of psychiatry at Stanford University. He served as a senior policy advisor at the White House Office of National Drug Control Policy from 2009 to 2010.