Lecture 4

Corruption and Market Intervention

Prof. Dr. Johann Graf Lambsdorff

Anticorruption and the Design of Institutions 2010/11

ADI 2010/11

Gatti, R. (1997), Corruption and Trade Tariffs, or a Case for Uniform

Tariffs, World Bank policy research working paper No. 2216, http://siteresources.worldbank.org/INTWBIGOVANTCOR/Resources/wps2216.pdf

Glaeser, E. and E. Luttmer (2003), The Misallocation of Housing

under Rent Control, American Economic Review,

http://www.nber.org/~luttmer/rentcontrol.pdf

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

Corruption and Reform: Theory, Evidence and Policy. Cambridge

University Press: 1-26.

Literature

ADI 2010/11Red Tape

ADI 2010/11

A study of corruption should start with identifying preconditions

which favor corruption.

Corruption can result from inefficient rules and state intervention.

We have to distinguish between affluent laws/regulations and red

tape:– Affluent laws: Immense amount of regulations, laws etc.

Mostly unknown to bureaucrats, judges and private parties;

not enforced; not applied; contradictory

– Red tape: regulations that are enforced (or threatened to be

enforced). They are communicated and applied.

Red Tape

ADI 2010/11

Red tape often arises when the government unduly interferes with

market forces.

Informal methods are sought to better arrange the delivery of

bureaucratic permits and licenses.

Such informal methods open the door to corruption.

The welfare effects of this can be investigated by studying the effects

of state intervention in otherwise well functioning markets.

Incentives for corruption can easily be depicted in a graphical

analysis.

Red Tape

ADI 2010/11Price Controls

Priceof Housing

0 Quantityof Housing

Supply

Demand

Consumer surplusbefore maximum price

Producer surplusbefore maximum price

ADI 2010/11Price Controls

Effective Maximum

Price

Priceof Housing

0 Quantityof Housing

Supply

Demand

Q1D

Excess Demand

Q1S

Dead Weight Loss

Consumer surpluswith maximum price

Producer surpluswith maximum price

ADI 2010/11Price Controls

Consumer surpluswith maximum price

Effective Maximum

Price

Priceof Housing

0 Quantityof Housing

Supply

Demand

Q1D

Excess Demand

Q1S

Dead Weight Loss

Producer surpluswith maximum price

Demand

Misallocation Costs

ADI 2010/11

With demand exceeding supply we are short of a mechanism that

determines which customers are served.

This produces a misallocation cost. Clients are randomly assigned

the scarce good, rather than according to their willingness to pay.

As a result, some clients who little value a good (housing in our

example) are served while others with a high preference are

disregarded. Glaeser and Luttmer (2003) find the characteristics of

renters in a controlled market such as New York to differ those in other

markets, revealing misallocation.

In an economy with free exchange of goods and services this is

unlikely to be the equilibrium.

Bureaucrats can sell entitlements to the scarce goods!

Price Controls

ADI 2010/11Price Controls

Effective Maximum

Price

Priceof Housing

0 Quantityof Housing

Supply

Demand

Q1D

Excess Demand

Q1S

Dead Weight Loss

Consumer surpluswith maximum price

Producer surpluswith maximum price

Income from Bribery

Supply+Entitlement

ADI 2010/11

“Inefficient regulation” represents an effective means of generating

corrupt income for public servants.

Corruption is a symptom that something went wrong.

Corruption is a mechanism that allocates scarce goods according to

customers willingness to pay.

Corruption can equate supply and demand.

The new equilibrium is not the efficient old equilibrium without state

intervention.

Misallocation costs are diminished.

Price Controls

ADI 2010/11

But these findings of the model are valid only in few instances.

“Willingness to pay” may not be the allocation preferred by society.

This criterion disregards concerns related to equality (giving to the

needy) or security (handing out licenses to the qualified).

A good test whether misallocation costs arise would be by charging

an official fee for the scarce good.

Selling import licenses to the high bidder will usually be the efficient

strategy. But how about driving licenses to a blind person? How about

a job as a judge to the highest bidder? Or import licenses to those

who trade with poisonous products? This strategy would be rejected

due to concerns related to security or equality.

In this case, the misallocation costs are dominated by other

concerns.

Price Controls

ADI 2010/11Quantity Restrictions

Producer surpluswith quantity restriction

Effective Quantity

Restriction

Price of Imported Good

0 Quantity ofImported Good

Supply

Demand

p1D

Dead Weight Loss

Consumer surpluswith quantity restriction

ADI 2010/11Quantity Restrictions

0

Supply

Demand

Dead Weight Loss

Consumer surpluswith maximum price

Producer surpluswith maximum price

Income from Bribery

Price of Imported Good

Quantity ofImported Good

Effective Quantity

Restriction

p1S

p1D

ADI 2010/11

Producers excessively request the right to import goods.

Bureaucrats must allocate this right.

Producers are willing to pay for the right to import.

Bureaucrats can obtain corrupt income.

Corruption functions as a market mechanism which brings supply

and demand back into balance.

The welfare loss resulting from a misallocation is avoided with the

help of corruption.

Quantity Restrictions

ADI 2010/11

Wall Street Journal, 15 September 2004

Two Vietnamese officials have been arrested for allegedly forcing companies to pay bribes to secure textile and garment exports to the U.S., officials and state-controlled media reported Thursday. Le Van Thang, 50, deputy director of the Ministry of Trade's Import and Export Department and staff member Bui Hong Minh, 33, were arrested in Hanoi Wednesday, said Nguyen Thanh Bien, chief administrator at the Trade Ministry. Thursday's Thanh Nien (Young People) newspaper said police also seized documents relating to the case from their houses. The two men were flown to southern Ho Chi Minh City Wednesday night for further police investigations, it said. It was unclear how much money they allegedly collected in bribes.The newspaper reported that Thang and Minh required companies to pay bribes to ensure that textile and garments were included in shipments designated for the U.S. The case was exposed when some of the companies came forward to police, it said. Last year, the U.S. imposed quotas of $1.7 billion a year on 38 textile and garment categories shipped from Vietnam to curb a surge in exports that began after the two former foes signed a landmark bilateral trade agreement in 2001.Thang was responsible for selecting the local textile and garment companies to meet the quotas. The arrests come at a time when the ruling Communist Party is stepping up efforts to fight graft . Several senior executives at the state-owned oil and gas monopoly, PetroVietnam, have been arrested over the past two months.

Quantity Restrictions

ADI 2010/11

One of the biggest cases of systematic corruption also related to market distortions:

In the Iraqi Oil-for-Food program between 1995 and 2003 oil was allowed to be sold

only in exchange for humanitarian goods. The extreme public desire for much

needed goods did not only provide ample opportunities to mark up prices, it also

lead to high ranking UN officials to turn a blind eye to massive corruption.

According to an estimate, Saddam Hussein’s regime was able to collect as much as

1.8 billion US $. From the 4500 private firms involved in the program close to half

were involved in the payment of bribes. One paradigmatic case relates to a truck

being sold by Daimler Chrysler. While the regular price would have been 130,000

US$, the company charged 143,000 US$ and to passed on 13,000 US$ to other Iraqi

bank accounts. Likewise, oil left the country too cheaply and kickbacks were paid in

exchange. This case well fits standard economic modeling on the distortionary

effects imposed by market restrictions. Such restrictions create opportunities for

systematic corruption. But at the same time, the common economic advice to

abolish market restrictions is far from obvious. The standard economic recipe

would be to disallow the UN Security Council to impose trade restrictions as a way

of sanctioning countries – this is not at all a suggestion that will gain undisputed

approval.

Quantity Restrictions

ADI 2010/11

Fighting corruption must embrace its

causes.

Corruption arises where government

intervention is in conflict with market

forces.

Quantity restrictions or price ceilings

can create opportunities for corruption;

their potential social benefit must be

evaluated against this drawback.

Hints for Reform

Quantity Restrictions

ADI 2010/11

Empirical evidence from cross sections of countries reveals that high

barriers to market entry are strongly associated with corruption.

There is a higher level of corruption in countries with many

procedures required for starting a new business and much time

needed and high official costs involved.

"The extent to which public procurement is open to foreign bidders"

and "the extent to which there is equal fiscal treatment to all

enterprises" is negatively associated with corruption.

There is a high correlation between corruption and government

regulation of and involvement in the financial sector.

Quantity Restrictions

ADI 2010/11

Countries with uniform tariffs are better capable of limiting

corruption (Gatti 1997).

Discretionary Power

ADI 2010/11

In order to obtain bribes bureaucrats need discretionary power, the

ability to act or decide according to their own judgment.

To the contrary, where bureaucrats must abide by clear rules they

have little to sell.

Discretionary power is particularly strong where rules are vague.

This assigns bureaucrats the sovereignty to interpret and apply rules.

Empirical Evidence from a cross-section of countries reveals that

vague rules are associated with corruption.

For example, subsidies for housing may be designated for the needy,

but certification of the requirements may be sold to unqualified if

bureaucrats have discretion to determine qualification.

Taxes on fine counts of yarn were higher than those on inferior

quality in Pakistan. Bureaucrats took bribes and misused their

discretionary power to record the production of fine counts as coarse.

Discretionary Power

ADI 2010/11Discretionary Power

ADI 2010/11

Discretion is on the one hand an unavoidable part of public

administration: Someone must make the decision. Limiting

bureaucratic discretion by increasing political discretion is not a

convincing approach.

Total discretionary power can be amplified by market restrictions and

badly designed government intervention.

But bureaucratic discretion can also be reduced by help of

organizational features.

Public decision-making commonly involves many actors: heads of

state, cabinet, parliament, local government, bidders, tender board,

auditors, technical experts, … Each actor acts as a balance to the

power of others.

If power is concentrated among one actor, this increases discretion.

Discretionary Power

ADI 2010/11

Complaints mechanisms may help in

limiting (extortionate) bureaucratic

discretion.

Instead of leaving decisions to

bureaucrats a randomized mechanism

(e.g. with the help of computers) can be

employed.

Customs checks might invite for bribes

in exchange for being disregarded.

Instead, a computer based system of

random checks can be employed (as was

done in Mexico).

Hints for Reform

Discretionary Power

ADI 2010/11

Bureaucratic discretion increases with

the functions a bureaucrat simultaneously

carries out.

Division of labor limits discretion.

E.g. in public procurement writing

invitation documents, carrying out the

bidding, deciding on the winning bid,

executing the contract, inspecting the

procured quality and carrying out

financial transactions should be assigned

to different public servants/departments.

Hints for Reform

Discretionary Power

ADI 2010/11

Discussions:

1) What is the difference between red tape and disregarded rules or

those unknown to bureaucrats?

2) Policy intervention tends to lead to misallocation costs. Why? Are

these always detrimental to welfare?

3) Imagine a country imposing a minimum price on agricultural

products so as to protect the income of farmers. Use a graphical

illustration to describe why this may result in misallocation costs and

subsequently in corruption.

Appendix

ADI 2010/11

Case Study

An FBI sting operation videotaped inspectors from the city's

Department of Licenses and Inspections accepting money from

plumbing contractors... For years, one source said, there were tales of

plumbers' offering "tips" to L&I inspectors for a quick approval of job-

site work. L&I has also been dogged by other corruption scandals in

recent years... A standard "tip" was $20, a source said, and it could

grow if a plumber was in a bind of some kind. "A lot of it would occur

when a plumber would need to close an excavation hole where they'd

buried pipe, and it couldn't be closed until an inspector approved it,"

the source said. "So you could stand around with your crew waiting,"

the source said, "or you could page an inspector and get him out there

real quick, and thank him for it.“ ... One government source said that

the payments to inspectors have been suspected for years but that they

were hard to crack since those paying the bribes were happy for the

speedy service. [Philadelphia Daily News, March 14, 2001]

Appendix

ADI 2010/11

1) What was the plumbers advantage from bribing inspectors?

2) In how far can the incidences of corruption be related to government

regulation?

3) What favors other than speedier delivery might be offered by

inspectors?

4) How would you assess the overall effect of the bribes paid on public

welfare?

5) How would you assess the alternative of abolishing inspections

overall?

Appendix