Scholars' Association News
Issue 40
November 2016


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The Underground Economy
Theodore Koutmeridis

There are two worlds, one on the surface and another in the shadows, on the margins of our society. This is the underworld economy. But how does the underworld function? What is the role of opportunity and disadvantage and how do they influence crime?

I will try to shed some light on these obscure aspects of our society that still remain underexplored, through my personal story and using economics as a vehicle, as a language, as a way to understand how society functions and how we can make it better.

Economics is typically considered a boring discipline - also known as “the dismal science”. But for me, it was a relief and a very interesting revelation the realization that I could study almost anything using economics: issues such as crime or sex, drugs, and rock ‘n’ roll. For instance, sex workers price discriminate and charge less the customers they like more. Drug gangs have sophisticated hierarchical organization structures, very similar to those of multinational corporations. While, rights holders lobby to extend the copyright term and keep on receiving royalties from the same old songs written by The Beattles or by Jimi Hendrix.

These are just some examples of what we can examine using economics. But which are the fundamental economic problems that all the great economists tried to solve? The most important issue relates to what promotes economic and social progress. I was surprised that in order to measure prosperity we rely heavily on just one number, per capita GDP. Of course this is a key index, as it correlates with other qualitative variables related to health and education, among others. Nevertheless, if for instance the ten richest people on earth double their income, GDP per capita will increase, while wellbeing for the vast majority of individuals will not change. This is the reason why I never felt comfortable with the exclusive use of GDP for the measurement of welfare. Instead, I realized that the distribution of wealth and the allocation of resources are equally crucial factors.

But often, poverty does not allow the less privileged to have legal access to resources, leading some of them to crime. In this way, crime enters the core of the main economic problem. Still, disadvantage is not the only source of crime. Criminality can also be the outcome of greed or misconceptions of specific social groups.

Thus, we attempt to use economics to answer a basic, almost Shakespearean, question of whether “to commit crime or not to commit crime”. The Nobel laureate economist and sociologist Gary Becker from the Chicago School was the first to apply economics in the examination of crime back in the 1960s. Despite the lack of adequate crime data, he broke new ground on clarifying and understanding the phenomenon, thanks to the clarity of his sharp economic intuition.

According to the Beckerian theory, holding other things constant, a person lying on the borderline between legality and illegality will decide to commit crime when the net illegal gains are larger than legitimate gains. Let us examine this reasoning step by step. If you increase the legal benefits - as roughly measured through employment, income or minimum wages - crime will decrease. Whereas, when sanctions or punishments increase, crime is expected to decrease. Similarly, if the probability of being arrested increases, crime will decrease. Ultimately, and mostly importantly, if illegal gains or the direct returns from crime increase, lawlessness will rise too.

This simple logic is full of interesting implications. The following is just an illustrative example. In cases where the probability to capture someone is too low, we can balance incentives by making the punishment more severe. Such theoretical predictions are undoubtedly reasonable. I wonder, however, whether these sensible theoretical results reflect what we observe in reality, since frequently we witness unorthodox, unpredictable and unexplainable behaviors.

Today, we can test these theoretical predictions empirically with detailed data and using insights from one other school of thought, the Glasgow School, according to which measurement is essential. In particular, the leading Glaswegian scholar, Adam Smith, focused on some key concepts such as sympathy in his “Theory of Moral Sentiments” and later on self-interest in his magnum opus, “The Wealth of Nations”, concepts which keep society in balance; but he also conceived the division of labor, the effectiveness of which he measured in a pin factory.

Similarly, the other dominant figure of the Glasgow School, Lord Kelvin, once said that if you can measure what you are talking about and express it in numbers, you know something about it; otherwise, if you cannot measure it, you are far from doing science. In the recent past, we did not have the empirical data for the measurement of crime. Nowadays, we have detailed crime data and appropriate research methods, so it is worth to analyze these predictions empirically.

To start with consider the legitimate profits. According to our theory, if unemployment increases, crime will increase too. The data on unemployment and crime from different sources show that there is indeed a correlation between the two. The basic theoretical model also suggested that, if sanctions increase, crime will decrease. According to this theory just before and just after the age of 18, crime should drop significantly, as sanctions increase by more than 200%. The data suggest that indeed sanctions increase sharply but crime does not change much, implying that sanctions have only a limited deterrent effect. Even though the evidence is still inconclusive, this finding can shed some light on the controversial discussion about the severity of punishments or even about death penalty.

Another theoretical prediction suggests that if the probability of being caught increases, crime will decrease. The data on the speed of police responses, approximated by the distance between the crime scene and the response station, suggest that indeed there is an association between the probability of being caught and crime.

Now we turn our attention to one of the most interesting aspects related to crime opportunities, the returns from crime. Surprisingly, this key feature has been overlooked by researchers and policy makers - but not by criminals! With my two co-authors, Mirko Draca (University of Warwick) and Stephen Machin (London School of Economics), we collect detailed data on crimes by the MET police, the so-called New Scotland Yard, to examine exactly this link between crime and illegal gains. We match the quantity of stolen goods with the price of each product. We show that individuals respond to changes in prices and commit more crime on the products that yield a higher return. This can be highlighted by the decrease in both prices and crimes of DVD players and by the increase in both the prices and crimes for watches. Performing the same logic across all goods, which cover the vast majority of marketable stolen property, we reveal that there is a strong positive link between crime and prices.

Apart from examining this relationship between goods, we also focus within a particular type of crime, metal crimes, which increased sharply recently. Metal crime increased substantially, while crime in general dropped significantly. Metal cable theft alone costs 770 million pounds per year, while “240,000 passenger minutes lost in 2006” in the UK due to delays caused by copper cable theft. Selected headlines from 2012 suggest that as metal prices increase criminals steal from churches, they steal a 10-ton bridge and animal cages, among others. The data reveal that crime and prices move very closely for all metals and for copper in particular. We are able not only to examine simple correlations but also to establish the link from cause to effect, by instrumenting local scrap metal prices with shocks in global commodity prices, which are exogenous to crime in London. We conclude that individuals respond to criminal opportunities and behave in a rational way, as entrepreneurs and businesspersons do.

Concluding, the big message is that individuals are in a perpetual search of opportunity and the approach of just punishing crime through tougher sanctions is misleading and incomplete. When individuals cannot access resources and opportunity legally, they search for opportunities outside the law. The relationship between opportunity and crime is the fundamental principle, according to which we should design policies based on rigorous evidence and not on prejudices.

Importantly, from drug dealers in Glasgow and copper cable thieves in London, to entrepreneurs in Silicon Valley and bankers in the Wall Street, they all obey some basic laws of human behavior. All of them follow some fundamental economic forces that determine the functioning of the economy on the surface but also the underworld economy, which still remains an underexplored and a challenging aspect of our society.

Dr Theodore Koutmeridis is a Research Fellow in Economics (Applied Microeconomics) at the University of Glasgow.

His scientific research and TEDx talk can be found here:

TEDX talk


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