Economics of the Somali Pirate Business Model

This semester, I'm teaching four recitation sections of POLI 150: Intro to International Relations here at UNC (which is being taught by Dr. Oatley with Sarah and Will as fellow TA's). In each recitation I always like to spend the first five to ten minutes of class talking about current news and events in international politics and try to connect the theories and frameworks that we are teaching our students to the real world so they see that what they're learning actually does have value and provides explanatory power over topics outside of the classroom.

For my Wednesday afternoon recitation, after whatever pressing new events (this week it was the coup in Niger, the Winter Olympics, Greek sovereign default, and the Dalai Lama meeting) that they bring up have been explored, somehow the conversation always turns to pirates, how Somali piracy works, how and why countries respond to pirate attacks, etc. It's a great topic to discuss anarchy, collective action problems, bargaining, state vs. non-state actors and informal networks and markets. It seems like my obsession with pirates is starting to rub off on my students as each week they're bringing up new interesting questions and finding really awesome articles like the one I'm linking to below.

I was going to go into detail about this article, but instead I'm just going to completely outsource this post to Wired Magazine who provide an absolutely fantastic analysis of the incentives, costs and benefits facing not only Somali pirates but "shippers, insurers, private security contractors and numerous national navies" operating off the coast of Somalia. This is just an absolute must-read. Here is the opening:

The rough fishermen of the so-called Somali coast guard are unrepentant criminals, yes, but they're more than that. They're innovators. Where earlier sea bandits were satisfied to make off with a dinghy full of booty, pirates who prowl northeast Africa's Gulf of Aden hold captured ships for ransom. This strategy has been fabulously successful: The typical payoff today is 100 times what it was in 2005, and the number of attacks has skyrocketed.

Like any business, Somali piracy can be explained in purely economic terms. It flourishes by exploiting the incentives that drive international maritime trade. The other parties involved — shippers, insurers, private security contractors, and numerous national navies — stand to gain more (or at least lose less) by tolerating it than by putting up a serious fight. As for the pirates, their escalating demands are a method of price discovery, a way of gauging how much the market will bear.
The risk-and-reward calculations for the various players arise at key points of tension: at the outset of a shipment, when a vessel comes under attack, during ransom negotiations, and when a deal is struck. As long as national navies don't roll in with guns blazing, the region's peculiar economics ensure that most everyone gets a cut.

All of which makes daring rescues, like the liberation in April of the Maersk Alabama's captain, the exception rather than the rule. Such derring-do may become more frequent as public pressure builds to deep-six the brigands. However, the story of the Stolt Valor, captured on September 15, 2008, is more typical. Here's how it played out, along with the cold, hard numbers that have put the Somali pirate business model at the center of a growth industry.

Some very interesting tidbits:

An ordinary Somali earns about $600 a year, but even the lowliest freebooter can make nearly 17 times that — $10,000 — in a single hijacking. Never mind the risk; it's less dangerous than living in war-torn Mogadishu.

The insurance business is a gamble. Insurers know that some ships will be hijacked, forcing the companies to dispense multimillion-dollar settlements. However, they know the chance of this happening is minuscule, which by the calculations of their industry makes it worth issuing policies. In 2008, only 0.2 percent of ships sailing Somali waters were successfully hijacked.

(The hat tip goes to Paula, one of my students in class who found and emailed me the article).

US Navy and Pirates!

In my never-ending quest to make this blog the go-to place for piracy news, I bring you the most recent details of the US Navy and multinational task force kicking some pirate ass:

Eight suspected pirates were apprehended after a counter-piracy task force foiled an attack on a vessel in the Gulf of Aden, authorities said Monday. The suspects were taken aboard a U.S. Navy destroyer, the USS Farragut, U.S. 5th Fleet spokesman Lt. Cmdr. Corey Barker told CNN. The 5th Fleet is part of multinational Combined Task Force 151, aimed at combating piracy in the Gulf of Aden and nearby waters. The eight were apprehended by coalition warships, the task force said in a news release issued Monday.

The Tanzanian-flagged MV Barakaale 1 came under attack in the gulf and alerted other vessels in the region by radio. An SH-60B Seahawk helicopter, from the Farragut, was dispatched to the vessel, the release said. "During the pirate attack ... the crew adopted defensive maneuvers" that resulted in a suspect falling overboard while trying to board the vessel, the task force said. The suspect was rescued by the suspected pirates' skiff and again tried unsuccessfully to board the Barakaale.

The arrival of the helicopter prompted the suspects to flee, and the copter -- after repeated warnings to the skiff -- fired warning shots across its bow and the skiff stopped, the release said. A team from the USS Farragut boarded the vessel and apprehended the eight suspects, it said. Although the number of piracy attempts in the region has increased over the past year, the task force said Monday, the number of successful attacks have been reduced by 40 percent.

Now that's what I'm talking about. Send in the Navy, shoot some warning shots into the water and get 'em to surrender. Eight pirates down, 876543567890 still to go. This will keep working in the short run, but as I've said before, the only way to dramatically decrease the number of attacks is to fix the problems in Somalia. Establishing a legitimate, functioning government that controls its borders and has a monopoly over the use of force is the only long run solution to this problem. Patrolling the waters and decreasing the success of attack will only help at the margins. But the lack of determination to actually fix the source of the problem provides the rest of us with entertaining pirate stories a couple times a week.

PIRATES!

Another ship was seized by pirates yesterday, the third of the new year. The hijacking was of a North Korean flagged cargo ship that is owned by a Libyan company and was seized in the Gulf of Aden.

Some cool little stats: Last year "Somali pirates attached 217 ships last year, according to the Piracy Reporting Center of the International Maritime Bureau. There were 47 successful hijackings, with 867 crew members being taken hostage." There are still about 200 hostages being held by pirates off in Somalia.

Somali Pirates: 21st-Century Robin Hood?

It just keeps getting better:

In the article, translated on Metamute.org, leaders of the pirate groups say they’re willing to “transfer part of their loot captured from transnational boats and send it to Haiti.”

”The humanitarian aid to Haiti can not be controlled by the United States and European countries; they have no moral authority to do so. They are the ones pirating mankind for many years,” said the Somali spokesman.

Somali pirate leaders say they have links around the world to help them ensure the delivery of aid without being detected by the armed forces of “enemy governments.”

Weekend Links

UNC alum James Surowiecki on Chimerica and Chinese consumer spending

Employment Outlook for Humanities Ph.D.'s: Not Good

Jeffrey Goldberg shows that American airport security is a sham:

Airport security in America is a sham—“security theater” designed to make travelers feel better and catch stupid terrorists. Smart ones can get through security with fake boarding passes and all manner of prohibited items—as our correspondent did with ease.

World's Tallest Skyscraper - Burj Dubai - opens soon in the UAE

Pirate Stock Exchange in Somalia

James Fowler, Associate Professor of Political Science at UC-San Diego (he'll be on Colbert on January 7th) talks Social Networks with Will Wilkinson of the Cato Institute in this bloggingheads diavlog:

The Pirate and Mafia Models of Corporate Management

This is normally Alex's provenance, but I smiled at these sentences:

It seems that today’s CEOs, facing public anger over executive pay, greed and governance failures, might have something to learn from “pirate management”. Those calling for greater employee ownership within struggling firms (as the Financial Times reports in Germany) might find ammunition from this tale of the high seas.

That's the PSD trying to apply Peter Leeson to the financial crisis. The gist is that pirate ships were owned by their crews, were democratic, strictly governed, and the pay-scale was non-hierarchical. This system of organization helped reduce principle-agent problems and lessened moral hazard.

Of course, pirate ships had other characteristics that made this management structure work: "workers" had no opportunity for exit (except by plank), and the potential gains were high so the incentive to get along with your coworkers was strong. Additionally, ships operated as cartels that benefitted the few sailers fortunate enough to be chosen for the crew, who faced no outside competition for their positions. Of course they were also criminals whose individual fates were somewhat intertwined. These criteria helped crews overcome the obvious prisoner's dilemmas and cooperate.

Many of the above are also true of crime syndicates, but their management structure is much more top-heavy. Why is that? It seems that in the top levels of a crime syndicate -- i.e. "the family" -- the mafia structure is somewhat similar to the pirate structure. But mafias need many more low-level operatives to be successful, and it is harder to keep them from defecting when better opportunities to arise. So "Omertà" is necessary for mafias but not for pirates.

Most corporations more closely resemble mafias than pirate ships: they are large and face constant pressures from without and within. Even the executives must be wary of encroachments on their territory, since executives are often removed or otherwise displaced. In most industries the corporation cannot act as a cartel, individual incentives diverge from corporate interests, and the potential gains from defection are often large. Of course, corporations cannot murder defectors, but they can tie them down with non-disclosure agreements and a host of other legal arrangements that function as "protection" for the corporation against the individual. At the same time and like mafias, corporations reward good service by a series of incremental promotions and increases in compensation. These opportunities do not exist for pirates, but only because they are already sharing the bounty more or less equally. Corporations can also "buy off" public officials directly or indirectly through junkets, gifts, campaign contributions, and other types of lobbying. Through these mechanisms corporations can extract "surplus value" from their workers and redistribute upwards in a way that pirates could not.

Some industries might work well under the Pirate Model, but most will do better under the Mafia Model. The differences are primarily structural -- what gains would stock traders capture by unionizing? -- and this isn't necessarily a bad thing.

Piracy in Europe?!

What?! Forbes and the NYTimes have the story. I will defer to CNN's report:

An international search was under way Wednesday for a cargo ship that vanished after its crew reported they were hijacked -- at least briefly -- nearly two weeks ago.

The last known contact with the Arctic Sea was July 31. Mystery surrounds its movements and the fate of its crew.

The Russian-crewed Arctic Sea, carrying a 6,500-ton cargo of timber from Finland to Algeria, was last heard from on July 31, when crew members spoke to Swedish police.

Its crew has told authorities that eight to 12 masked people posing as drug enforcement officers had boarded the vessel and bound and beat its crew in the waters off Sweden on July 24, according to a statement from the Maltese Maritime Authority.

On Wednesday, Russia said naval vessels authorized to use force were searching for the Arctic Sea with the aid of "space-based" detection systems. The Maltese Maritime Authority said Wednesday that the ship appears to have headed into the Atlantic Ocean, but mystery surrounded the ship's movements and the fate of its crew.

Russia's Defense Ministry said on its Web site that the Black Sea Fleet patrol ship Ladny was heading the search operation and had passed through the Strait of Gibraltar into the Atlantic.

The ship's crew said its troubles began about 3 a.m. July 24, when the masked group boarded and stayed on board for about 12 hours, according to Swedish police and the Maltese Maritime Authority. Watch an account of the crew's alleged ordeal »

According to witness accounts, the intruders restrained the 15-man crew and questioned them about drug trafficking before locking them in their quarters.

"During their stay onboard, the members of the crew were allegedly assaulted, tied, gagged and blindfolded and some of them were seriously injured," the maritime authority said in a written statement.

During the reported hijacking, the vessel's radar and satellite systems were off-line for two hours, during which time the ship was witnessed performing "extreme maneuvers," said Maria Lonegard, a spokeswoman for the Swedish police.

Three days later, on July 31, Swedish police reached the ship by phone and spoke with someone they believe to be the captain, Lonegard said. It was the last known communication with the vessel, which was believed to be off the coast of France then.

This is the best part:

A spokesman for the Swedish Coast Guard said the last known hijacking of a vessel in Swedish waters occurred in the 16th century.

THE 16TH CENTURY?!!?!?! If it's true that pirates are now operating off the coast of Sweden and starting to attack ships in the Arctic Sea, I'm sure there will be a pretty large response from the navies of Europe and the problem will be quickly taken care of. I highly doubt this is what's going on though.

First off, the ship was only carrying about $2 million worth of timber, hired by a Finnish lumber company, crewed by Russians and flagged in Malta. Not good prospects for a big ransom, especially if the ship remains anywhere in European waters. If they can find the ship, I see Europe's navies carrying out a rescue attempt and it ending much along the lines of the US navy's encounter with the hijackers of the Maersk Alabama. I don't expect the owners to pay a ransom to these random pirates. Even if they did pay a ransom, where would the pirates go? It's not like they could easily take refuge in Portugal or Sweden or the Faroe Islands.

If the ship was hijacked by pirates, I doubt the pirate clan is anything larger than an isolated single cell operating from some random little island in the Arctic Sea. We'll keep you posted if anything important comes out of this.

More on Pirates!

This post continues my obsession with the economics of piracy and the lifestyles of modern day pirates. I woke up this morning to a post over at The Economist's Free Exchange blog that linked over to an interview that Scott Carney did with a Somali pirate. The interview is really interesting. Here are some interesting excerpts (click the link above to read the entire conversation):

From what I’ve seen, initial demands tend to be about 10 times the previous publicized ransom, is this a rule of thumb?

We know that we won’t get our initial demands, but we use it as a starting point and negotiate downwards to our eventual target. But as a rule, yes, that’s about right.

Does the length of a hijacking change the ransom that pirates are willing to accept?

Yes. Armed men are expensive as are the laborers, accountants, cooks and khat suppliers on land. During long negotiations our men get tired and we need to rotate them out three times a week. Add to that the risk from navies attacking us and we can be convinced to lower our demands.

How much does it cost to outfit a pirate mission?

A single mission with 12 armed men and boats costs a little over $30,000. But a successful investor has to dispatch at least three or four missions to get lucky once.

How are the pirates organized? (Are there pirate leaders, financiers, and specialists?)

The financiers are the most important since they organize and plan the big shot operations and are able to pay running cost[s]. Financiers always need to forge deals with traders, land cruiser owners, translators, business people to keep the supplies flowing during operations and manage the logistics. There is a long supply chain involved in every hijacking.

Holy Smokes!

Pirate hunting has now turned into a vacation:

Luxury ocean liners in Russia are offering pirate hunting cruises aboard armed private yachts off the Somali coast.

Wealthy punters pay £3,500 per day to patrol the most dangerous waters in the world hoping to be attacked by raiders.

When attacked, they retaliate with grenade launchers, machine guns and rocket launchers, reports Austrian business paper Wirtschaftsblatt.

Passengers, who can pay an extra £5 a day for an AK-47 machine gun and £7 for 100 rounds of ammo, are also protected by a squad of ex special forces troops.

The yachts travel from Djibouti in Somalia to Mombasa in Kenya.

The ships deliberately cruise close to the coast at a speed of just five nautical miles in an attempt to attract the interest of pirates.

"They are worse than the pirates," said Russian yachtsman Vladimir Mironov. "At least the pirates have the decency to take hostages, these people are just paying to commit murder," he continued.

Three questions: 1) Who would pay that much money to go pirate hunting off of Somalia?, 2)Do the people that are shelling out this dough see anything wrong with what they're doing? and 3) Since when is Djibouti part of Somalia? We need to follow Ms. South Carolina's advice and get some people some maps!

(h/t: MR)

Links and Asides and more Game Theory

-- DeLong on E.M. Forster, the Bank Panic of 1825 (in England), and the origins of the modern central banking system.

-- Ron Paul says we should send mercenaries and bountyhunters after the Somali pirates. I am in favor of this plan, as long as it is televised. (ht: Dittmeier)

-- Blog Wars: Thoma vs. Shadab on financial regulation; Cowen vs. DeLong on stimulus.

-- Eichengreen and O'Rourke look at falling world output and fire up the 'D'-word.

-- Joseph Nye says I'm irrelevant.

-- Kling on financial regulation as a chess game, from the new (and interesting) site dedicated to financial regulation, FinReg21. I find Kling's arguments to be pretty persuasive, and worry that the end result of this crisis is a slew of new regulations that don't actually increase systemic stability, but do incur deadweight losses. Somebody should build a game-theoretic model of regulation (if one is out there, please let me know).

-- Speaking of game theory, Tim Harford's Logic of Life Youtube series (which accompanies the book of same name) explains racial segregation using the chessboard framework of Thomas Schelling. If you want to think of an IPE application, consider attitudes towards immigration, or resource scarcity in ethnically-diverse countries. There are many others.

Game Theory and Piracy

From Zero Intelligence Agents comes this really interesting piece on the use of Game Theory to analyze the strategic interactions between states and pirates (my apologies for becoming so pirate obsessed lately!):

There has been mounting consternation regarding the recent threats of violent escalation by Somali pirates in response to the successful—yet deadly—rescue operation undertaken by the U.S Navy. As the AP reports:

"From now on, if we capture foreign ships and their respective countries try to attack us, we will kill them (the hostages)," Jamac Habeb, a 30-year-old pirate, told The Associated Press from one of Somalia's piracy hubs, Eyl. "(U.S. forces have) become our No. 1 enemy."
While this rhetoric serves pirates' purposes, in conveying a menacing facade, if we view the history of events leading up to these statements through the prism of rational choice we can easily identify them as simple cheap-talk.

Consider each pirate incident as a sub-game in a indefinitely repeated game between a pirate group and a state entity. The pirate group can either be of the type that is willing to use violence to get its reward, or not. In each stage of the repeated game, the pirates send a message to the state stating their type. The state then decides whether to use force to end the incident based on this signal.

Now, extend this simple model onto the events that have occurred over the past several month off the Somali coast. Up to recently, the game had been in equilibrium; the state's posterior belief at each stage [hostage event] about the pirates' type was that they were willing to use violence, and as such gave into their demands to rescue the hostages to minimize the loss of life (i.e., maximize the state's utility).

Over the weekend, however, the U.S. Navy took an off-equilibrium action by attacking the pirates to rescue the hostages. In knocking the system out of equilibrium, the dynamics of the system become more well-defined. In the old equilibrium, the use of violence was ex ante inefficient for pirates, since they were able to maximize their utility without using it. The use of violence, then, becomes a costly signal for the pirates, as it reveals tactics, capabilities and weaknesses.

This more robust understanding of the dynamics provides insights into the pirates' actual type; that is, pirates were either always willing to use violence, but did not do so in the old equilibrium because it was costly; or, they never were willing to and never will be, because thei beliefs about the state's willingness to use violence had been made clear, and killing hostages in the future will not increase their reward.

Regardless of this distinction, the threat of violence is clearly cheap-talk, since it does not inform the state of the pirates' type, and should not affect their actions. Put plainly, the pirates are either threatening the status quo (continued willingness to use violence), or are making a non-credible threat (new willingness to use violence). Any future policies to cope with the pirate situation in Somali, therefore, should not use these threats as a foundation as they reveal nothing about pirates' willingness to use violence.

(ht: Tony Arend and Chris Dittmeier)

Map of Pirate Attacks in 2009...

The American captain of a cargo ship held hostage by pirates jumped overboard from the lifeboat where he was being held, and U.S. Navy SEALs shot and killed three of his four captors, according to a senior U.S. official with knowledge of the situation.

Capt. Richard Phillips was helped out of the water off the Somali coast and is uninjured and in good condition, the official said. He was taken aboard the USS Bainbridge, a nearby naval warship.

At the time of the shootings, the fourth pirate was aboard the Bainbridge negotiating with officials, the source said. That pirate was taken into custody.

CNN.com has a really interesting map that shows the location of pirate attacks in 2009. Check it out here. 

Piracy Update!

The US Navy announced today that it has put together a maritime force to battle pirates off of the coast of Somalia. 

The unit -- called Combined Task Force 151 -- is a spinoff of an existing force in the region that addressed a range of security issues, such as drug smuggling and weapons trafficking, as well as piracy.

The Gulf of Aden links the Indian Ocean and the Red Sea. About 20,000 oil tankers, freighters and merchant vessels pass along the crucial shipping route each year near largely lawless Somalia.

The United States is among at least 20 countries that are trying to combat piracy in the region, including Russia, India, Germany and Iran. In December, German sailors foiled an attempt by pirates to hijack an Egyptian cargo ship off the coast of Yemen, according to the German Defense Ministry, and the European Union launched its first naval operation to protect vessels. That came just days after China revealed its own plans to patrol the Horn of Africa's volatile coastline.

Task Force 151 is an outgrowth of Combined Task Force-150, which was created to conduct security operations at the beginning of Operation Enduring Freedom -- the U.S. effort in Afghanistan. The task forces are part of the Combined Maritime Forces, which includes naval ships and other assets from more than 20 nations.

If you're interested in pirates, a new book by Peter Leeson, a George Mason economics professor, will hit bookshelves near you very soon. The book, titled "The Invisible Hook: The Hidden Economics of Pirates" looks extremely interesting. An article by Leeson is forthcoming in the New York University Journal of Law and Liberty. Here is the abstract:

Can criminal profit-seeking generate socially desirable outcomes? This paper investigates this question by examining the economics of pirate tolerance. At a time when British merchant ships treated black slaves as slaves, some pirate ships integrated black bondsmen into their crews as full-fledged, free members. Enlightened notions about equality did not produce pirate tolerance, however. I argue that pirate self-interest seeking in the context of the criminally-determined costs and benefits of pirate slavery was responsible for pirates’ progressive racial practices. Analogous to Adam Smith’s invisible hand, whereby legitimate persons’ self-interest seeking can generate socially desirable outcomes, among pirates there was an “invisible hook,” whereby criminal self- interest seeking produced a socially desirable outcome in the form of racial tolerance.

Pirates

I talk about pirates (click on pirates for a very cool map) in my intro course in connection with the public goods hegemons provide--seas safe for commerce.

NPR had a nice piece on the rising incidence of such incidents. The shocker: "this is really the best thing Somalis have going for them economically. Piracy and ransom this year will exceed more than $50 million — it's Somalia's largest income-earner."