02 July 2009

The Economics of Illegal Activity

I find that the general understanding of economics is disappointingly low, but when it comes to the economic impact of illegal activity, it seems to be almost non-existent. Take the following claim from the trial of a man who was prosecuted for selling set-top boxes which allowed people to access scrambled cable TV without paying [1]:

Ari Alibhai, prosecuting told Liverpool Crown Court that the fraud deprived the industry of millions of pounds and caused customers to pay higher monthly charges.

That kind of claim is likely to go unchallenged and gradually become received wisdom, but I think the higher monthly charge claim can quite easily be shown to be the opposite of the reality of the situation.

The claim relies on an unspoken assumption that when a business operates, it sets out to make a fixed amount of profit and if it doesn't make it from one customer, it will make it from another. That is, of course, complete nonsense; almost every profit making business will seek to maximise its return, not just hit a target and go no further. The reality, as anybody with the most basic knowledge of economics will tell you, is that prices are set by supply and demand.

A cable TV supplier will generally set the price at a level which, in the long run, will maximise profit, which will be determined, in simple terms, by the number of customers multiplied by profit per customer.

So, how does the availability of illegal set-top boxes impact on the price? It suppresses demand, by providing cheaper competition. The box will be cheaper, but it will also bring with it the risk of prosecution, so, each customer who is prepared to use one of the boxes is faced with a simple decision - is the saving worth the risk of being prosecuted? As the difference between the price of a legal box and the price of an illegal box becomes greater, more people will say yes and opt for the illegal choice. What the illegal box does is introduce a reduction in demand for the legal product, which should, in theory, result in a reduction in the price charged.

To some that may sound counter-intuitive or even nonsensical, but there are examples of the effect in practice; for years the music industry claimed that copying music pushed up prices, but when file-sharing emerged as a technology which allowed people to easily share perfect copies, the cost of CDs fell.

Of course, none of that impacts on the guilt or innocence of the accused in a court case, but in the interests of economic accuracy, it would have been nice to hear the defence responding to the prosecution by saying "This kind of fraud deprives the industry of millions of pounds, but it keeps prices down for everyone else!"