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12.4 End-of-Chapter Material

In Conclusion

The underground economy is not new; it has been around for as long as rulers have been levying taxes and banning trades. If you read about the prohibition of alcohol in the United States, for example, you will quickly learn that there was still a thriving market for alcohol and alcoholic beverages, despite the illegality of these trades. This was partly due to the fact that the production of alcohol was legal in nearby countries, such as Canada. Alcohol produced in Canada and elsewhere was imported and sold in the United States.

The establishments that served alcohol at that time were called speakeasies. Today you can find local bars that advertise themselves as having started as speakeasies during the Prohibition years. Of course, while Prohibition was in force, the speakeasies did not advertise so loudly. They were generally run by gangs that were willing to take the risk of being arrested to get the profits from selling alcohol.

Associated with Prohibition are several infamous individuals, such as Al Capone and his competitor, Bugs Moran. They were leaders of gangs in Chicago that provided alcohol to speakeasies. But you can, if you like, think of them as managers of firms that were involved in the importation, manufacturing, production, and sale of a consumer good. In many ways these firms operated according to the same principles as firms in this textbook. They were interested in producing efficiently and maximizing their profits.

Capone was eventually indicted and convicted. But the legal action against Capone was not directed at his violation of Prohibition. Instead, the federal government indicted him for tax evasion. Even if you are a leading producer in the underground economy, you still have to pay your taxes.

This story of Prohibition reminds us that the government does more than simply restrict trades in the economy. The government also provides the framework that allows trades. It provides a system of laws that allows people to enter into contracts, and it provides courts as a mechanism for enforcing these contracts.

Capone and Moran could not turn to the government to enforce their contracts and agreements. The firms in the industry had to create their own mechanisms for settling disputes. You won’t be surprised to hear that these mechanisms were not pretty. One famous incident was the Saint Valentine’s Day Massacre in 1929 when the Capone gang engaged the rival gang led by Bugs Moran. This was like a strategic interaction between rival producers. In this case, their respective competitive strategies left seven people dead. When the government is not there to enforce contracts, agreements will be enforced by other, often violent, means.

Key Links


  1. List three additional examples of government restrictions on your ability to buy or sell something.
  2. The sharing of the burden of a tax also depends on the elasticity of supply. Draw diagrams like Figure 12.7 "The Deadweight Loss from a Tax" looking at the case of elastic and inelastic supply—that is, draw two diagrams with identical demand curves but different supply curves. How does the elasticity of supply affect the changes in the buyer surplus and the seller surplus? Can you explain why?
  3. (Advanced) In some countries, there are restrictions on the length of a contract to rent an apartment. Suppose the restriction is that contracts must last for five years. In response, some people sign private agreements to rent for shorter durations, such as a year. What are the problems that might arise from signing these private agreements? What happens if there is a dispute? What role might reputations play in the enforcement of these private agreements?
  4. Suppose there is a forecast that a hurricane will hit in a day. Everyone expects the government to ration the supply of coffee. What will likely happen to the price of coffee once the forecast is announced?
  5. How does rent control affect the incentives for an owner to invest in upgrades of an apartment?
  6. The payout from a social security system depends on years worked. How would an increase in social security payments affect the choice of workers between jobs in the formal and informal (underground) parts of the economy?
  7. If the underground part of an economy is large due to tax evasion, could a tax cut increase tax revenue?
  8. If two states have different rates of labor taxation, what can you say about wages before and after taxes in the two states?
  9. Can you think of a good or a service that the government requires you to consume? Why do you think the government has this policy?
  10. There are substantial differences in food and product safety standards across countries. Can you think of reasons why this might be the case?
  11. Liquor sales are state controlled in Pennsylvania but not in New Jersey. What effects do you think this has on the buying and selling of liquor near the border of the two states?
  12. Suppose that Principles of Economics is a very popular course at your school. More people want to take the course than there are seats available. Do you think it would be a good idea if those initially enrolled in the class were able to sell their seats to those who didn’t get a spot? What would be the advantages of such a system? What would be the problems?
  13. Sometimes armies are raised by a draft, while in other times armies are volunteer. Which way of raising an army do you think is most efficient in terms of getting the best people to participate in the army? Which way of raising an army is most “fair”?
  14. (Advanced) When Question 13 talks about “the best people to participate in the army,” does it make a difference whether we are talking about comparative advantage or absolute advantage?
  15. Explain how the incidence of a new tax on textbooks, collected at the point of sale, will be determined.
  16. Which type of trade barrier creates more revenue for the government—a tariff or a quota? Why would a government ever impose a quota?
  17. (Advanced) One benefit of working in the formal labor market in some developing countries is eligibility for both unemployment insurance and retirement pensions. All else being the same, would you predict that wages are higher in the formal or the informal sector of the economy? In addition, workers in the informal sector do not pay income taxes. What is the effect of this on wage levels in the two sectors?
  18. Due to mobility restrictions, the labor markets in China are not fully integrated. If restrictions on mobility of workers in China were relaxed, what would happen to wage differences across regions? What predictions would you have for the flow of workers across parts of China?
  19. If you are a member of a professional union, would you be in favor of licensing requirements to join that profession? How might you defend the need to have a license?

Economics Detective

  1. Suppose you live in Mexico. If you wanted to get a job in Canada, what would you have to do to obtain permission to work? What if, instead, you wanted to work in the United States? Does your answer depend on your occupation?
  2. Try to find estimates of the size of the underground economy in two different countries (for example, Portugal and Sweden). Is the underground economy of very different sizes in the two countries? Why?