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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.