Profits, Pirates and Externalities

The government in Somalia blames payment of ransom for the explosion in piracy there, according to the BBC. Although this is obviously ignoring the root of the problem, it raises the interesting question of whether outlawing payment could eliminate the threat in the future.

Clearly, if it was in the interests of shipping firms to do so, they would already have agreed to it privately. That’s all that matters, if they’re the only victims. Recent developments have shifted the balance in this debate, as there is a question over whether these pirates are financing Al-Shabaab, the Islamic group that opposes the Somalian government. The importance of this question has intensified as more lives are lost.

It may be that payment of ransom does indeed proliferate piracy. Much of this money is reinvested in weapons and other goods, which facilitate more efficient piracy in the future. Since there is a feed-back loop between payment of ransom and attacks, it’s not immediately obvious where the optimum exists.

It might be that a properly enforced boycott on payment of ransom would eliminate the incentive behind piracy. However, if this were best, the market would already have caused it to happen. Individual shipping firms would recognise this and contract into such an agreement with their competitors, knowing that anything except total subscription in the industry would lead to failure of the plan.

These firms are all extremely large (and thus able to take individual losses in the short-term), and are repeat customers in this shipping lane. Thus, they have a long-term interest in the elimination of piracy. The benefits and costs are equally distributed financially and temporally amongst the firms, so there is no market failure.

This means that if it were in the interests of everyone collectively, it would be in the interests of everyone individually. Firms are also better equipped to prove they aren’t breaking the deal, than governments are at proving they are. The contract is thus enforceable.

Considering seizure of boats worth in excess of €250 billion, could it still be in the interests of individual firms to pay ransom regardless? More likely, the highest-value cargo would probably be transmitted through other naval channels under this system. Even risk-averse shipping firms could insulate themselves from loss. The contract is thus sustainable.

The fact that firms want to pay ransoms, is proof that it’s cheaper for them to pay than to go around the Horn of Africa (which they could do now, but don’t) or accept the loss of the occasional boat still stolen for its cargo (but with their crews murdered, as there is no incentive to keep them alive). The ransom payments are insignificant in the bigger picture, and deaths can be limited. This money is supporting Somali people who would otherwise be destitute, too.

In the past, it was commonly accepted that were scarce connections between the pirates in Somalia and the extremist Islamic groups that wreak havoc in the southern parts of the country. Finance that made its way into their hands was more reflective of their broader influence and power within the country, and not significant enough to warrant concern.

Bruno Schiemsky, former head of the UN Monitoring Group on Somalia, now claims that the links between the two groups are growing. As profits from piracy grow and the potential of the industry is exposed, it has attracted interest from terrorists and Al-Shabaab.

This changes the calculus, as piracy would then be directly financing violence. If ransom payment creates negative externalities in the form of funding for that civil war, the market has failed. The interests of international shipping firms are indeed coming into conflict with the people of Somalia.

© The Free Marketeer 2009

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