Black Market and its Consequences

Black Market and its Consequences

Sam Choon Yin (August 2004)


             In some markets, the government may view the equilibrium price as too high. This occurs for example in the market for housing. To assist the poor so that they can afford the rentals, the government intervenes and sets the rentals below the equilibrium position. In another example, the exchange rates (defined as the amount of foreign currency required to exchange for one unit of the local currency) may be viewed as excessive. To remain competitive or stabilise the country’s economy, the government may intervene and deliberately set the exchange rate below the equilibrium position.

            The interventions by the government essentially limits the quantity of the product supplied (the term ‘product’ is used here to represent all kinds of goods and services). A shortage problem is likely to be the consequence. Why is this so? According to the Law of Supply, a fall in the price of the products reduces the suppliers’ willingness to supply. In the case of demand, the Law of Demand postulates that the quantity demanded for the products will increase as their price declines. From the above, one can easily see that the decision to fix the price below the equilibrium position could create an excess demand situation.

             It is then the responsibility of the government to allocate the limited quantity effectively and fairly. This is unfortunately not easy to do in practice because it requires the government to understand the true needs of the residents. But one can never know for sure who deserves more than others. Incomplete information about the peoples’ true preferences is often the main problem hindering the works of the government.

            The problem also emerges in international trade. Classical international trade theories tell us that a small country imports those goods in which they do not have a comparative advantage. The world price of the imported products therefore should appear lower than the products’ domestic equilibrium price. Opening up the economy in this case creates a shortage problem. But this should not pose as a serious problem to the country at least for very long because the supply of imported goods helps to meet the excess demand. The problem only arises when the excess demand problem is not completely resolved through trade. This could be the case if the rich and powerful are the ones who actually ‘occupy’ the imported products thus leaving the poor without adequate supply. Also, excessive regulations in the customs may hinder the trade flows thus disallowing the importing countries access to their imports to solve the shortage problem. In both cases, the public officers in the customs department might be involved. They might have deliberately slowed down the trade process so that they could extort bribes from the exporters.

Essentially, corruption is a common problem hindering the implementation of the price ceiling policy. The consumers may have to offer bribes to the public officers so that they receive preferential treatment. Entrusted with the power to maximize the society’s interest, public officers may abuse this trust and extort payments from the consumers. This is likely to be the case if the public officers are given the responsibility to decide how the scarce goods and services are to be distributed.

The resultant price the consumers pay for the products is therefore higher than the price pre-determined by the government. How much the consumers might have ultimately paid depends on their preferences, which are reflected on their demand curve. The curve shows the price one is willing to pay for a given quantity of the good offered. The eventual price paid, which is higher than the price set by the government, is obviously illegally determined. Imposition of the price ceiling policy therefore creates a black market.

            Because the black market activities are illegal, the operators work in the underground sector. The underground economy, as commonly defined in the literature, encompasses those activities that escape the detection from the government authority.

In theory, the government should be aware of the expected sales generated from the market through the price ceiling policy. By fixing the price at a certain level, the government could determine the quantity supplied. With this information, the government expects to report a certain level of output derived from the market. For example, if the price is fixed at P0 per unit and the expected quantity supplied is Q0 units, the market in consideration is expected to contribute to the country’s national income equivalent to the amount (P0Q0). Since the product is offered at a higher price in the black market (say P1), the actual output generated from the black market exceeds the ‘recorded’ contribution by (P1Q0 – P0Q0).

            There are at least two negatives consequences of extensive underground economy in a country. First, the recorded national income is likely to be underestimated (as the above illuminates, the shortfall amounts to P1Q0 – P0Q0). This imposes problems to the government in identifying correctly the true economic status of the country. Accordingly, it will be difficult for the government to implement appropriate policies to stabilise the country’s economy and raise its standards of living.

The unemployment data may also be distorted. More specifically, the recorded data is likely to overestimate the true unemployment rate. The reason being that some of the persons who are supposed to be unemployed, as recorded in the economic statistics, could actually be gainfully employed in the underground sector. The country’s resources spent to provide more jobs to the people could in fact be more productively utilised elsewhere.

            The other problem relates to the collection of government tax revenue. The tax authority may fail to detect the income earned in the black market. This adversely affects the government’s ability to collect tax revenue to finance its expenditure programs. The official tax rates may have to increase as a result to compensate for the losses. Those who are currently taxes may perceive this to be unfair and find ways to evade taxes in subsequent fiscal years. There is an incentive for them to avoid contributing further to the government’s pocket. Because of budgetary problems, the quality and quantity of public goods may fall, indicating that the society eventually has to pay the price for increasingly extensive black market operations. In other words, black market activities impose external costs to the society, in the same way that pollution does.

            The level of tolerance of the black market differs between one country and another. As was mentioned above, the black market could provide employment opportunities to the people and thus income to spend. The black market in other words may be essential in some countries to alleviate poverty and financial difficulties. Those who are able to get jobs in the underground economy do not wish to change the status quo if there are no alternative employment opportunities available for them.

            However, while some jobs may be created, artificial shortages in the market may end up benefiting only the minorities (comprising businessmen and politicians) largely at the expense of the masses (because of allocative inefficiency and inequality problems). In fact, the black market activities are allowed to carry on because the prominent businessmen and politicians are involved in the operations. The politicians participate and allow the activities to flourish in exchange for votes in the elections and additional income through commissions. It would take a long time, if ever, to change the status quo. But the society must be aware of the problem and its possible consequences.