The activities of criminal organizations like the Sicilian mafia are clearly driven by economic incentives. And like any other economic agent, they also face a variety of constraints. This suggests that economics could be a valuable tool, both for understanding how organized crime works and indicating how policy-makers can deter and combat its activities.

A recent CEPR publication gives an overview of the latest applications of economic theory to illegal markets. Its contributors also examine legal markets where criminal organizations operate. Since organized crime is active in so many different markets, it is difficult to use one single approach to analysing its behaviour. The book therefore draws on two kinds of models: one treating the criminal organization like a firm in competition with others; the other seeing it more like a government or powerful monopoly.

The first case is more applicable in the several illegal markets where there are no significant barriers to entry. These include numbers, loan-sharking, prostitution, smuggling and counterfeiting. In these circumstances, it seems unlikely that criminal organizations can have centralized control and operate like a government. These markets seem to be competitive and the elements which could constitute monopolistic rents are usually swept away by the forces of competition and by conflicts between rival organizations.

In contrast, there are several markets where criminal organizations tend to integrate themselves vertically so as to achieve some degree of central coordination. These include money laundering, large scale distribution of narcotics (especially to international markets) and the supply of violence for extortion. Such coordination is usually sought through the establishment of cartels mostly on a territorial basis - and the strengthening of vertical relationships between organizations specializing in the different inputs needed to provide illegal services - violence, corruption, financial expertise, etc.

Thinking of organized crime in terms of centralized control has been advocated by the Italian prosecutors in the so-called maxi-trial against the heads of the Sicilian mafia. Their view is based on evidence of the existence of a committee of local heads of mafia families. This apparently acts as a centralized decision-maker for the relevant economic activities of the families.

The advantages of centralization are said to arise from a number of different sources: first, economies of scale in some of the basic services needed to perform illegal activities; second, exploitation of monopolistic prices in some markets less open to external competition; third, internalization of negative externalities due to oversupply of violence; fourth, avoidance of resource dissipation through competitive lobbying and corruption; fifth, better management of a portfolio of risky activities; and lastly, easier access to national and international financial markets.

But other evidence suggests that there are strong forces that deter criminal organizations from having a high degree of central coordination. These include the fact that the risks involved in illegal transactions decrease more than proportionally with their size . This is because of the impossibility of making contracts binding in illegal markets. Large accumulations are also discouraged by the fact that property rights are not well defined, leaving property potentially subject to seizure by the enforcement agencies.

Major participants in illegal activities face other forces that operate against centralization. For example, the risk of detection of a particular criminal activity grows with respect to the number of people involved: the more members there are in the organization, the greater the likelihood that some may cooperate with the investigative agencies.

Establishing whether the centralized government model or the competitive firm model better describe the supply of illegal activities is not only a theoretical problem. The government’s most appropriate deterrence policies clearly depend on how the illegal markets are structured in terms of barriers to entry, the number of firms active, their coordination of pricing and marketing strategies, and their attitude towards the use of violence.

If criminal activity is highly centralized, an increase in deterrence against illegal transactions may increase the entry costs to that market and therefore raise the profits for existing illegal firms. This may happen in the case of ‘wars’ on drug-trafficking. On the other hand, if the illegal markets are mainly competitive, lowering barriers to entry (by legalising the process or reducing deterrence and enforcement) may increase overall output of the commodity. This may happen when prostitution or soft drugs are legalised or turned a blind eye.

The book suggests that the activities of organized crime are strongly influenced by policy-makers’ decisions about how to tackle them. For example:

• The larger the remit of markets in which transactions are treated as illegal by the government, the greater are the incentives for criminal organizations to compete for the establishment of local monopolies over coercion.
• The heavier is the fiscal and regulatory pressure on legal markets, the greater are the incentives for legal firms to shift resources to the illegal markets or to undertake transactions that are out of the government’s control.
• Investment in deterrence activities can have a destabilizing effect on the local monopolies of incumbent criminal organizations, potentially increasing their investment in violence and corruption.

These observations suggest that, in addition to the numerous standard constraints on economic policy-making, the government must consider those arising from the possibility of illegal markets being created. Such constraints cannot be removed simply by larger investments in deterrence. Indeed, quite apart from their cost and the distortions they impose on legal transactions, the more such deterrence policies are effective, the more they create incentives for investment in corruption and manipulation of the deterrence agencies themselves.

The Economics of Organized Crime is edited by Gianluca Fiorentini (University of Florence) and Sam Peltzman (University of Chicago). Other contributors include Annelise Anderson, Stergios Skaperdos and Constantinos Syropoulos, Michele Polo, Diego Gambetta and Peter Reuter, Herschel I Grossman, Vito Tanzi, Frank A Cowell and James P F Gordon, Jonathan M Karpoff and John R Lott Jr, and Marco Celentani, Massimo Morelli and Riccardo Martina. The book is published for CEPR by Cambridge University Press.