Production uncertainty, enforcement, and smuggling: a stochastic model

Abstract

A stochastic, joint-product model of smuggling is developed, merging the existing smuggling literature with the literature on competitive firm behaviour under uncertainty. The equilibrium and comparative static results of the model reconcile contradictory results found in the earlier literature concerning how risk and risk preference affect smuggling behaviour. The introduction of stochastic risk demon-strates that the models developed in the earlier smuggling-risk literature overstated (understated) the positive (negative) economic consequences associated with the introduction of smuggling. The analysis reveals that smuggling activity is not dependent on firm risk preference. However. risk preference does affect the amount of trade the smuggling firm will engage in. Government enforcement and tax policy are analysed. Increasing enforcement efforts against smuggling will reduce illegal activity. However, the affect on legal trade is shown to be dependent on whether the firm considers smuggling and legal trade to be complementary or substitute activities. It is demonstrated that the effect of a change in the tax rate on illegal trade is also dependent on whether the firm considers smuggling and legal trade to be complementary or sub-stitute activities.