Extortion as an obstacle to economic growth: a dynamic game analysis

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Abstract

In this paper, we use a differential game analysis to study the dynamic strategic interaction between a criminal gang extorting money from local shop owners and the local police force. In particular, we are interested in characterizing the factors that are important in determining whether the capital stock of local shop owners continues to grow in spite of extortion or whether criminal activity leads to a phase of stagnation of the local economy. A Markov perfect equilibrium of the game is characterized in order to address this question and several policy implications are set out regarding measures to facilitate growth in regions affected by extortion.

Introduction

Organized crime is a significant source of concern for policymakers in many industrialized and nonindustrialized countries. One of the major problems related to the activities of gangs and organized crime syndicates is the extortion of money from local business owners, which makes the running of businesses less profitable and attractive in affected areas. Growth of the capital stock is then hindered. Because most instances of extortion attempts are not reported, the exact amounts extorted by criminal organizations are not known. Extortion is however a serious problem for local business owners in affected regions1 and has a significant impact on the economic growth in these areas. However, considering different regions where considerable extortion activity is documented, it becomes clear that there are large differences in the economic development. Whereas activities of criminal organizations in regions like southern Italy or East Asia seem to allow for certain—maybe reduced—local capital accumulation and economic growth, there are several examples of areas in major US cities where gang-related extortion has led to complete stagnation.2 The Economist (1994) reported that three-quarters of private enterprises in Russia are forced to pay up to 20% of their earnings to criminal gangs, which is seen as one of the major reasons for the absence of significant economic growth.3 Of course, these differences may be partly explained by regional differences in overall economic development, but it seems that also certain characteristics of the criminal organization, the police force and the local population have an impact on whether extortion leads to stagnation. A clear understanding of the factors determining the impact of extortion activities can help to design appropriate public policies.

Although the question of economic growth under extortion is important, little work has been done to rigorously analyze factors determining the effect of extortion activities in a region. Quantitative work on gang-related crime has rather focused on the problem of optimal crime fighting as such (e.g., Baveja et al., 1997, Dawid and Feichtinger, 1996, Levitt, 1997) than on the implications of crime given optimal counterstrategies.

Extortion activities in particular have been analyzed by Konrad and Skaperdas (1998) using game theoretic methods. They analyze the strategic interaction of gangs, shop owners and the police and characterize the optimal strategies of gangs and police in a static model. However, in the second part of their analysis, they assume that the decisions of shop owners about whether to enter the area depend on the relation of expected sales returns to expected extortion payments. Using this model, they argue that in the case of a forward looking gang, which takes into account the effect of their action on the number of entrants, the efforts of both sides (gang and police) in equilibrium are smaller than if the gang is myopic and ignores this effect. Konrad and Skaperdas (1998) also observe that shop owners in gang-affected areas are reluctant to use expensive equipment. Thus, the capital invested in local businesses is comparably small. However, they do not explicitly include such effects into their model.

The goal of this paper is to use a dynamic game theoretical model to explicitly address the question of how extortion affects the development of local businesses. As an indicator of the development of local businesses, we use overall capital invested by local shop owners. We will examine how different time preferences of gangs and police influence local business development and also consider the effects of the size of private labour demand, the attitude of the local inhabitants towards criminal behavior, police corruption and the interplay among these parameters. The goal is to characterize combinations of environmental parameters that make a region particularly vulnerable to economic decline in the presence of organized crime and to derive policy implications.

The paper is organized as follows. We present the model in Section 2, derive a Markov perfect equilibrium of the game in Section 3 and characterize the parameter constellations that lead to growth or stagnation in Section 4. We conclude with a discussion of our findings and some policy implications in Section 5.

Section snippets

The model

In order to investigate the effect of extortion activities of criminal gangs on economic growth in an area, we consider a model of dynamic strategic interaction between a representative shopkeeper, a gang, and the police. A differential game model is used to describe this dynamic interaction and the solution concept we use is that of a Markov perfect equilibrium (see, e.g., Basar and Olsder, 1995). The differential game formulation should be seen as the limit case of a model with discrete time

A Markov perfect equilibrium

We will characterize a Markov perfect equilibrium solution for the game described above. Both players choose their level of effort depending only on the current capital stock of the shop owners, i.e., eg(t)=eg(K(t)) and ep(t)=ep(K(t)). Define S as the set of all measurable functions from [0,∞)→[0,∞) such that (state) has a well-defined unique solution for all K0∈[0,∞). A Markov perfect equilibrium is given by a pair of strategies, eg*∈S and ep*∈S such thateg*∈argmaxeg∈S0e−ρgt(Kf(eg(K),ep

Characterization of growth and stagnation scenarios

In what follows, we focus on the qualitative properties of the regular equilibrium derived in Section 3. First, whereas in equilibrium the shadow value of the shop owner's capital for the gang is always positive, it might be negative for the police force. The intuitive explanation is that whereas additional capital always increases the amount a gang can extort, for the police an increase in capital stock—depending on future efforts on both sides—might lead to an increase of future losses due to

Conclusions

In this paper, we have used a dynamic game theoretical model to analyze the impact different characteristics of a region have on the effect of extortion activities on the local economic development. Using the solution concept of a Markov perfect equilibrium, we have identified conditions for continued growth of the capital stock of local shop owners and for stagnation. The main policy implications are the following: (1) If the local population in an area is not supportive of gang activities and

Acknowledgements

The authors would like to thank J. Caulkins, J. Worth and two anonymous referees for their helpful comments.

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