Many markets are characterized by unobserved behavior by agents. This can take the form of unobserved consumer behavior, for example the purchase of illicit products; unobserved firm behavior, such as illegal use of otherwise legal instruments; or unobserved market agents, as in competition in markets with illegal producers. To the extent that the empirical economic framework does not incorporate these unobserved actions or control for them in estimation, the resulting models are likely to be mis-specified. Naturally, if the models do not contain all elements relevant for decision making, then predictions based on the estimates will be misleading, which could result in incorrect policy recommendations.
This project addresses three situations (themes) in which unobserved behavior plays a crucial role. It does so by (i) developing state-of-the-art empirical models that incorporate illicit behaviors and (ii) proposing novel estimation methods that can be used to detect illicit behavior. In this sense, the methodologies put forward are "forensic" in nature as they deal with uncovering illicit or illegal behavior.
The first theme concerns markets where consumers engage in illicit behavior. These markets are prevalent in society as they constitute the market for illegal drugs, which is estimated at more than $300 billion per year (UN, 2012). Marijuana is the world's most widely used illicit substance (ONDCP, 2004) with vocal advocates for legalization. Indeed, legalization is quickly becoming the norm. In this theme we consider the impact of legalization on use of other licit and illicit products. We also propose a novel way to control for unobserved prices, which is crucial for measuring price sensitivity. Substitutability between illicit and licit products is critical information, as is the extent to which users respond to prices, for these together allow the authorities to gauge how, for example, an increase in marijuana taxes today will impact use across a portfolio of products in the future.
The second theme concerns markets where firms must make strategic decisions in the presence of an unidentified competitor. Many empirical models assume that firms observe (at least some) characteristics of their rivals. However, there are a number of markets where firms possess little information about their potential competitors. One such example is the market for legal drugs - legal marijuana dispensaries co-exist with illegal dealers, Due to the changing regulatory environment legalization is becoming commonplace,and we understand little about what policy tools can be used to curb the influence of the illegal producers.
The third theme examines the impact of firms using legal tools for illegal purposes, where our focus is on quantifying the impact of the illegal use of exclusionary deals, advertising, and market power. For example, upstream manufacturers often impose exclusive dealing contracts on their retailers, which may result in foreclosure of a competing brand. One of the challenging tasks has been to empirically identify the the (illegal) impact of vertical restraints imposed by one upstream firm on a competing firm.
In summary, this project addresses important challenges by developing methods to control for unobserved behaviors. Incorporating and estimating unobserved behavior in a variety of settings is an ambitious undertaking. However, it is vital as a key objective of the proposal is to provide policy makers with tangible tools that accurately reflect the unobserved nature of these markets.
