Why Do Retail Drug Markets Survive? Understanding the Sources and Consequences of Unobserved Price Variability in Cocaine and Heroin Markets

Peter H. Reuter, University of Maryland at College Park
Jonathan Caulkins, Carnegie Mellon University

ABSTRACT
Price dispersion is a characteristic of many markets. It is particularly high in markets, such as those for "lemons", where information concerning quality is very costly to acquire. On the premise that extreme examples are instructive, we consider here the markets for illegal cocaine and heroin. In these markets, the state is actively engaged in suppressing the flow of information by, for example, making it risky for a seller to advertise. A characteristic of these markets that helps the government in this respect is that, as in the classic lemon's model, the buyer cannot observe the true quality of the good at the time of purchase. Unlike the classic lemon's model, sellers also usually have only a highly imperfect knowledge of quality, since sellers are not manufacturers but themselves purchase drugs of unknown purity from higher level dealers.

Using data on purchases over a 14-year period, we find that these markets are characterized by extremely high price and quality (purity) dispersion, apparently higher than that observed in any legal markets. Indeed the dispersion is so high as to raise a question as to how the market sustains itself in light of opportunities and incentives for defrauding of customers and the impediments to information dissemination. The dispersion of prices is very high across time, place and purchase quantity. However price dispersion falls in a narrower and more consistent range than does purity dispersion. We offer some hypotheses about why the markets function in settings which seem to invite the kind of persistent fraud that would lead to their demise and suggest what this adds to the literature on solutions to the lemons problem.

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Updated 05/20/2006