The Effects of a Black Market on Supply and Demand

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What Happens When a Product Is Made Illegal?

When a product is made illegal by the government, often times a black market will emerge for said product. But how does supply and demand change when goods shift from a legal to a black market?

A simple supply and demand graph can prove helpful in visualizing this scenario. Let's see how the black market affects a typical supply and demand graph, and what that means for consumers. 

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Typical Supply and Demand Graph

Black Market Supply and Demand Illustration - 1.

To understand what changes happen when a good is made illegal, it is important to first illustrate what the supply and demand for the good looked like in the pre-black market days.

To do so, arbitrarily draw a downward sloping demand curve (shown in blue) and an upward sloping supply curve (shown in red), as illustrated in this graph. Note that price is on the X-axis and quantity is on the Y-axis.

The point of intersection between the 2 curves is the natural market price when a good is legal.

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The Effects of a Black Market

When the government makes the product illegal, a black market is subsequently created. When a government makes a product illegal, such as marijuana, 2 things tend to happen.

First, there is a sharp drop in supply as the penalties for selling the good cause people to shift into other industries.

Second, a drop in demand is observed as a prohibition of possessing the good deters some consumers from wanting to buy it.

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Black Market Supply and Demand Graph

Black Market Supply and Demand Illustration - 2.

A drop in supply means the upward sloping supply curve will shift to the left. Similarly, a drop in demand means the downward sloping demand curve will shift to the left.

Typically the supply side effects dominate the demand side ones when the government creates a black market. Meaning, the shift in the supply curve is larger than the shift in the demand curve. This is shown with the new dark blue demand curve and the new dark red supply curve in this graph.

Now look at the new point at which the new supply and demand curves intersect. The shift in supply and demand causes the quantity consumed of the black market good to decrease, while the price rises. If the demand side effects dominate, there will be a drop in quantity consumed, but there will also see a corresponding drop in price. However, this does not typically happen in a black market. Instead, there is normally a rise in price.

The amount of the price change and the change in quantity consumed will depend on the magnitude of the shifts of the curve, as well as the price elasticity of demand and the price elasticity of supply.