lecture 7 organized political corruption

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Lecture 7 Organized Political Corruption Prof. Dr. Johann Graf Lambsdorff Anticorruption and the Design of Institutions 2009/10

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Anticorruption and the Design of Institutions 2009/10. Lecture 7 Organized Political Corruption. Prof. Dr. Johann Graf Lambsdorff. Literature. - PowerPoint PPT Presentation

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Page 1: Lecture 7  Organized Political  Corruption

Lecture 7

Organized Political Corruption

Prof. Dr. Johann Graf Lambsdorff

Anticorruption and the Design of Institutions 2009/10

Page 2: Lecture 7  Organized Political  Corruption

ADI 2009/10

Lambsdorff, J. Graf (2007), The New Institutional Economics of

Corruption and Reform: Theory, Evidence and Policy. Cambridge

University Press: 81-108.

Shleifer, A. and R.W. Vishny (1993), ”Corruption.” Quarterly Journal

of Economics, Vol. 108: 599–617.

Myerson, R. (2008), “Perspective on Mechanism Design in Economic

Theory”, American Economic Review Vol. 98 (3): 600-602.

Literature

Page 3: Lecture 7  Organized Political  Corruption

ADI 2009/10

Businesspeople might sometimes be confronted with many public

servants extorting payments.

For example, setting up a new business may require various permits,

none of them can be missed. The organization of these multiple

payments becomes a daunting task.

Shleifer and Vishny [1993] model this situation: In Russia private

investors negotiate with various departments (fire, police, banks ...),

each of them requesting a payment in exchange for the speedy

approval of a business license.

This leads to the “overgrazing” of the corrupt marketplace.

Disorganized Corruption

Page 4: Lecture 7  Organized Political  Corruption

ADI 2009/10

The problem is comparable to road bandits.

Optimal income for road bandits requires a limit on their activity, so

as to avoid that too many travelers are scared off.

Taking, for example, only 20% of the traveler’s money may be best.

But competition among road bandits destroys this calculus: Any

money not confiscated will be taken by others.

In this spirit, investors prefer to deal with only one extortionist.

Parker and Hart, June 30 1999

Disorganized Corruption

Page 5: Lecture 7  Organized Political  Corruption

ADI 2009/10

Exercise:Assume that there is a total number of n symmetric departments (i, i=1, 2, ..., n) requesting a percentage (bi) of the investment (X). The costs for dealing with this payment, providing the corrupt service and obfuscating are cbi, 0<c<1. Investments (X) decrease with the total amount of bribes,

X=X(b1+b2+...+bn), dX/dbi<0.

Each department’s profit (Pi) is given by

i=biX-cbiX.

Let us assume that the departments are controlled by a strong party (a monopoly), which maximizes total income of all departments. In this case, they are all forced to behave symmetrically (b1=b2=...=bn), resulting in

i=(1-c)biX(nbi).

Disorganized Corruption

Page 6: Lecture 7  Organized Political  Corruption

ADI 2009/10

Profit is maximized in the monopoly case if:

After the breakdown of the party the departments start to maximize their income individually, each considering the other departments not to react to their own level of pay-off. Profit maximization is carried out individually by the departments, resulting in:

The second term is no longer multiplied by n. Therefore, a higher bi is needed to satisfy the equation. This is what is known as an “overgrazing” effect. The optimum level of total bribes collected (which was determined in the monopoly case) is missed, because individual bribes are too high.

i

i

d(1 ) (1 ) 0

d ii

dXc X c b

b db

i

i

d(1 ) (1 ) 0

d ii

dXc X c b n

b db

Disorganized Corruption

Page 7: Lecture 7  Organized Political  Corruption

ADI 2009/10The Economist, May 3rd 2007: “Rules of the road”

In many parts of the world, greasing the palms of corrupt officials is a fact of life. For lorry drivers in poor countries, for example, it can be even more commonplace than paying tolls or taxes. The extortionists are often armed police or soldiers, manning roadblocks, who make little attempt to pretend what they do is legal. Yet, although such people may operate outside the law of the land, they do obey the law of supply and demand. That, at least, is the finding of a recent study (“The Simple Economics of Extortion: Evidence from Trucking in Aceh”, by Benjamin Olken and Patrick Barron) of illicit transactions in Indonesia. In a rare attempt at documenting bribery, it shows how crooked officials act as independent monopolists, maximising their profits and employing sophisticated pricing schemes in ways that have an economic logic, as well as a criminal one.

The authors studied bribes paid by lorry drivers along two main roads in Aceh, an Indonesian province where separatist guerrillas had long been active. Over nine months in 2005 and 2006, data gatherers accompanied the truckers on 304 trips to and from Aceh, recording more than 6,000 illegal pay-offs at military roadblocks, police checkpoints and weigh stations. During the 637-kilometre (396-mile) trip from Medan to Meulaboh, for example, drivers typically passed through 27 checkpoints and forked out a total of $23 in bribes, representing roughly 13% of the cost of their trip—more, even, than the total wages of those in the truck.

In the early stages of each trip, transactions were typically conducted without negotiation—at each stop, drivers simply handed over a few thousand rupiah ($0.50 to $1.00) or a couple of packs of cigarettes. As the trucks neared their destination, however, checkpoint officials demanded increasingly larger sums. At each stop, drivers found themselves with a progressively stronger incentive to avoid hassle and safeguard their cargo, which gave the extortionists greater power over them.

Page 8: Lecture 7  Organized Political  Corruption

ADI 2009/10Midway through the study, after the Indonesian

government had signed a cease-fire with the rebels, it began a phased withdrawal of 30,000 troops, leading to the number of checkpoints falling by half. This gave the researchers the chance to see how the extortion market would adjust. As you would expect, the amount lost to bribery decreased—but only by 36%.

Fewer stops meant fewer bribes, but this was offset by a rise in the amounts demanded at the remaining checkpoints, whose operators, with entrepreneurial zeal, seized the chance to capture part of the newly liberated surplus. In fact, they behaved just like monopolists, setting their prices so as to maximise their own revenue, without considering the response of the fellow at the next checkpoint, or whether their activities would deter truckers. The result was a textbook example of double marginalisation—when a chain of independent monopolists charges more, but receives less overall than a single monopoly.

These results have intriguing implications for stamping out corruption. In theory, a centralised system of bribery is better for both truckers and extortionists than a string of corrupt officials acting independently. Taking out a kingpin may yield splashy headlines, but it can actually increase the total amount paid in bribes if it destroys co-ordination among his henchmen. A better bet, say the authors, is to reduce the number of troops and police officers. That would, indeed, be a novel way of fighting crime.

Page 9: Lecture 7  Organized Political  Corruption

ADI 2009/10

Is disorganized corruption better or worse than organized corruption?

This question can be posed more provocative: Should we help

extortionists to better organize their illegal business?

Yes: The model predicts that disorganized corruption is worse.

No: Often there exist legal alternatives to the payment of bribes, even

for victims of extortion. Disorganized extortion is more costly and

induces some actors to prefer the legal alternative. Once corruption is

organized, it becomes deeply embedded in a country and widely

accepted as the only way for doing business. The model fails in

recognizing such legal alternatives such as complaints mechanisms.

Disorganized Corruption

Page 10: Lecture 7  Organized Political  Corruption

ADI 2009/10

How should we define corruption when the government (the principal)

is maximizing only its own interests and disregards public interests?

The term corruption is misplaced when applied merely to a

disobedient agent. Instead, the principal’s own self-seeking behavior

may be termed corrupt.

”misuse” is not clearly related to the trespassing of rules, because

rules are themselves the result of self-seeking: – Markets are distorted where this profits the principal.

– Public resources are allocated to further the principal’s economic

interests.

– The principal is above any rules and immune to any accusations.

The Self-Seeking Government

Page 11: Lecture 7  Organized Political  Corruption

ADI 2009/10

Harden [1993: 186-7 and 208-13] reports about the devastating

environmental effects of the Turkwel Gorge Dam in Kenya and how it

was motivated by overpricing and kickbacks. But feasibility studies did

not have to be falsified, they were just forbidden to be carried out in the

first place. When the Financial Times published information from a

whistleblower, copies of the newspaper were seized at Nairobi Airport.

Inefficiencies that can be detected are there by design.

In contrast to a single agent, the principal (government) can follow its

corrupt goals in a much more systematic way.

The principal does not have to circumvent laws and regulations but

can design them to serve his own interests.

The Self-Seeking Government

Page 12: Lecture 7  Organized Political  Corruption

ADI 2009/10

The principal (government) thus takes advantage of his monopoly

position.

A common conclusion is that prices are likely to increase. Market

restrictions and price increases already occur with corrupt agents. But

principals can impose such restrictions in much more forceful way by

making them part of law.

While we may feel desperate about such a ruler, welfare losses are

difficult to prove. Imagine a “perfect” kleptocrat.

Welfare losses reduce the kleptocrat’s potential to take away income

from the citizenry; a kleptocrat therefore dislikes welfare losses.

A kleptocrat attempts to organize a corrupt system to operate like a

tax.

The Self-Seeking Government

Page 13: Lecture 7  Organized Political  Corruption

ADI 2009/10

He contains low-level corruption among the bureaucracy.

He prevents individuals from ”overgrazing” the market.

He dislikes low quality in public procurement.

He dislikes white-elephant projects.

He attempts to take more from those who can give more.

So, why worry about this type of corruption?

The Self-Seeking Government

Page 14: Lecture 7  Organized Political  Corruption

ADI 2009/10

Return from investment

0 sectors

Supply

Demand

Dead Weight Loss

Consumer surpluswith maximum price

Producer surpluswith maximum price

Welfare losses due to monopoly price setting

The Self-Seeking Government

Page 15: Lecture 7  Organized Political  Corruption

ADI 2009/10

Return from investment

0 sectors

Supply

Demand

Kleptocrats surplus

The kleptocrat can levy the burden equally by price discrimination

The Self-Seeking Government

Page 16: Lecture 7  Organized Political  Corruption

ADI 2009/10

Wizard of ID,

Parker and Hart,

September 17, 2000

The Self-Seeking Government

Page 17: Lecture 7  Organized Political  Corruption

ADI 2009/10

Some observers argue that a kleptocrat, also labeled as a predatory

regime, tends to squeeze his citizens without pity.

Indeed, a kleptocrat is able to gather large bribes. So why do we fail in

proving welfare losses?

It is argued that the “stationary bandit” exercises power consistent

with the interests of society.

A ruler has an ”encompassing interest”.

Murphy, Shleifer and Vishny [1993: 413] argue that the problems with

corruption are mitigated when corrupt rulers can collect bribes

efficiently. Perfecting corruption rather than fighting it is the avenue

suggested for reform.

The Self-Seeking Government

Page 18: Lecture 7  Organized Political  Corruption

ADI 2009/10

Example: One of the grandchildren of President Suharto in Indonesia

attempted to make a cut from taxes on beer which was collected by his

private company. But as a result tourism in Bali was suffering from a

shortage of beer and inflated prices, forcing President Suharto to

withdraw the tax.

Counterexample: One illustration of a strong and corrupt government

is that of Mobutu in Zaire, an uncontested kleptocrat for decades. But

his regime crippled the economy and established a strong example that

public welfare bitterly suffers from such regimes.

The Self-Seeking Government

Page 19: Lecture 7  Organized Political  Corruption

ADI 2009/10

In reality various problems exist for kleptocrats.

They assign property rights to comrades and contestants (rather than

to those making best use of resources) in exchange for loyalty.

A flourishing economy may threaten their power.

A short time horizon motivates them to “run with the loot while they

can”.

Kleptocrats set a bad precedent for lower level bureaucrats.

But, is an eternal dynasty of uncontested rulers the solution?

Wizard of ID, Parker and Hart, May 11, 2000

The Self-Seeking Government

Page 20: Lecture 7  Organized Political  Corruption

ADI 2009/10

Investments require the committing of resources, hoping that their initial

investment will be honored.

Such resources cannot easily be transferred or assigned to different

tasks. Railroads cannot be removed, power plants cannot be relocated to

different countries. Investors fear for the expropriation of their future

revenues. They carry out investments if political promises to honor their

revenues are credible.

In a survey of business people in Karnataka, India, it was found that the

software industry was less affected by the high level of corruption among

the local administration. Compared to the construction and manufacturing

industries these units could easily shift assets outside the state because

this industry depends less on immovable assets. This lower dependency

seems to have reduced extortionate demands for bribes among public

officials. For other sectors credibility is essential because investments

cannot be redeployed.

The Problem of the Kleptocrat

Page 21: Lecture 7  Organized Political  Corruption

ADI 2009/10

Corrupt tax collectors can impose an excessive tax burden on

investors; corrupt regulators may threaten an arbitrary application of

the law; corrupt customs authorities may control trade and demand

their cut; corrupt politicians may threaten an unfavorable application or

drafting of the law. All these actors may be in a position to appropriate

the investor’s future revenues.

We note in passing that investors fear corruption not only due to

kleptocrats or politicians who may extort them. Also private contractors

are frequently in a position to behave opportunistically and expropriate

an investor. Corrupt courts will not help an investor in protecting his

property but sell the judgment to the highest bidder.

The Problem of the Kleptocrat

Page 22: Lecture 7  Organized Political  Corruption

ADI 2009/10

Investors want to rely on binding laws, but corruption motivates rulers

to arbitrarily change the law and expropriate resources.

Strong corrupt rulers are motivated only by self-enrichment and face

no restrictions.

They cannot credibly commit to effective policies.

Due to kleptocrat’s failure to make binding commitments, they are not

trustworthy to investors.

Investments will be stopped unless the ruler is effectively limited.

The Problem of the Kleptocrat

Page 23: Lecture 7  Organized Political  Corruption

ADI 2009/10

There are no easy approaches to

avoiding adverse welfare effects of

corruption.

An organized type of corruption brings

about other forms of adverse welfare

effects than disorganized corruption.

Changing the type of corruption is not a

convincing approach for reform.

Hints for Reform

The Problem of the Kleptocrat

Page 24: Lecture 7  Organized Political  Corruption

ADI 2009/10

Even kleptocratic rulers may have an

(apparently very limited) interest to

engage in anti-corruption.

This is somewhat comparable to Mafia

bosses who attempt to legalize their

business in a strategy to avoid the

hazards for their offspring.

Totalitarian rulers must seek ways to

commit themselves to their announced

policies, which opens the door to reform.

Hints for Reform

The Problem of the Kleptocrat

Page 25: Lecture 7  Organized Political  Corruption

ADI 2009/10

Myerson (2008) provides a good model for the credibility problem faced

by autocrats.

Assume production, Y, in a country to be determined by capital, K, and

raw materials, n, according to Y=(K+n)0.5.

An autocrat may honor the investments and allow a return of rK. The

variable r is the country’s discount rate, which would just suffice to keep

capital in the country. The autocrat would thus tax (or take as bribes) only

the difference, which is (K+n)0.5-rK. The current value of his income would

be ((K+n)0.5-rK)/(r+b). The variable b is an additional discount rate due to

the autocrat’s exogenous risk of losing power.

An autocrat may also expropriate the capital, which suggests that in

future periods capital is no longer provided by international investors

(K=0). The current value of his income would then be K+n0.5/(r+b).

The autocrat’s moral hazard constraint is thus

((K+n)0.5-rK)/(r+b) ≥ K+n0.5/(r+b)

The Problem of the Kleptocrat

Page 26: Lecture 7  Organized Political  Corruption

ADI 2009/10

The ideal capital stock that maximizes ((K+n)0.5-rK)/(r+b) is obtained by

the first derivative, (0.5(K+n)-0.5-r)/(r+b) =0 (K+n)-0.5=2r. With r=0.05 we

obtain K=100-n. Let, for example, n=12 and we see that the moral hazard

constraint is violated. For any K>0 this results, suggesting that only K=0

(n=100) is feasible.

The autocrat may now liberalize his regime, for example by designing

constitutional constraints or countervailing powers that limit his

capacity to expropriate. The extent of liberalism , 0 ≤ ≤1, reduces his

income from expropriation according to (1-[K+n0.5/(r+b)].

There is also a random risk for an honest autocrat to be overthrown,

which is 0.05. His income from honesty thus reduces to

((K+n)0.5-rK)/(r+b+0.05),

which he seeks to maximize by setting subject to his moral hazard

constraint,

((K+n)0.5-rK)/(r+b+0.05)≥(1-[K+n0.5/(r+b)]

The Problem of the Kleptocrat

Page 27: Lecture 7  Organized Political  Corruption

ADI 2009/10

This moral hazard constraint is depicted in the figure below, alongside

with the isopayoff-curve.

Optimal liberalization is achieved with =0.504, inviting for capital

investments K=52.4

Liberalization and Capital with n=12

0

20

40

60

80

100

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7

Liberalization

Cap

ital

K

Moral Hazard Constraint

Isopayoff-Curve

The Problem of the Kleptocrat

Page 28: Lecture 7  Organized Political  Corruption

ADI 2009/10

In case of n=0 the autocrat’s optimal regime would have =0 and

K=44.2.

Intuitively, a lack of natural resources makes it more costly for the

ruler to lose his reputation for protecting capital, and so he can credibly

encourage substantial investments even without liberalizing. Examples

of such countries may be Singapore, Monaco or Liechtenstein.

Liberalization and Capital with n=0

0

20

40

60

80

100

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7

Liberalization

Cap

ital

K

Moral Hazard Constraint

Isopayoff-Curve

The Problem of the Kleptocrat

Page 29: Lecture 7  Organized Political  Corruption

ADI 2009/10

In case of n=25 the autocrat’s optimal regime would have =0 and K=0.

Intuitively, a great wealth of natural resources makes the ruler

unwilling to accept the additional political risk from liberalization, even

though it means that nobody will invest in the nation without

liberalization. Examples may be Saudi Arabia and Venezuela.

Liberalization and Capital with n=25

0

20

40

60

80

100

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7

Liberalization

Cap

ital

K Moral Hazard Constraint

Isopayoff-Curve

The Problem of the Kleptocrat

Page 30: Lecture 7  Organized Political  Corruption

ADI 2009/10

Discussions1) Why may a disorganized form of corruption be worse than an organized form, for investors and public servants alike; in how far may independent departments “overgraze the market” when requesting bribes? 2) Describe the type of corruption that emerges when self-seeking is the actual object of government!3) How may in this case allocation be distorted?4) Show that in a static model a “perfect kleptocrat” avoids welfare losses! 5) Why is such a static analysis misleading?6) What may motivate autocrats to abstain from taking bribes?7) In how far is abundance of raw materials important for an antocrat’s decision to restrict his actions by liberalizing?

Appendix

Page 31: Lecture 7  Organized Political  Corruption

ADI 2009/10

Exercise:There is a total number of 4 symmetric departments (i, i=1, 2, 3, 4) requesting a percentage (bi) of the investment (X). Costs for providing and obfuscating are cbi with c=0.5. Investments decrease with the total amount of bribes,

4

1

4800 1 ii

X b

a) The departments jointly maximize total income. Determine the resulting investment!b) The departments maximize their income individually, each considering the other departments not to react to their own level of pay-off. Determine the resulting level of investment!c) A powerful kleptocrat may unite the departments, but one type of welfare loss becomes particularly strong and unavoidable. Describe this type of welfare loss!