Chapter 5 of the previously mentioned book, The Economics of Public Issues, is devoted to the topic of illicit activity, namely prostitution, alcohol, and drugs. Our class discussed different policies for controlling these activities and what trade-offs may exist.
In our discussion of drug policy, for example, we noted that since there is no legal market, there are also no ways in which quality or consumer protection can take place. Consumers cannot contact the local police to complain that their drugs are of inferior quality and that they need a refund. Therefore, we may predict that violence may be used to adjudicate disputes. Bruce Benson and David Rasmussen have written several nice articles that consider the economics of drug markets (click here for a readable example).
Additionally, illicit markets can alter incentives to such a degree that local police and other officials react to incentives in perverse ways. Bruce Benson, Brent Mast, and David Rasmussen wrote a nice article in the journal Public Choice entitled "Entrepreneurial Police and Drug Enforcement Policy". Here is the abstract:
The hypothesis that drug enforcement is relatively high in local jurisdictions where state laws dictate that police retain seized assets is tested in the context of a reduced-form equation of the supply and demand for drug enforcement. The results are robust across model specifications, some of which directly control for the level of drug use: legislation permitting police to keep seized assets raises drug arrests as a portion of total arrests by about 20 percent and drug arrest rates by about 18 percent. Police bureaucrats apparently desire discretionary budget increases, and they have considerable discretion in determining resource allocation.
Mast, Brent D.; Benson, Bruce L.; Rasmussen, David W. "Entrepreneurial Police and Drug Enforcement Policy", Public Choice, vol. 104, issue 3/4, September 2000.
The implication of this type of research is clear: policies that affect illicit markets can also affect legitimate institutions, and the trade-offs for such policies are not always what one expects.