Lecture 4 Corruption and Market Intervention

1. Anticorruption and the Design of Institutions 2010/11 Lecture 4 Corruption and Market Intervention Prof. Dr. Johann Graf Lambsdorff

2. Literature • 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.

3. Red Tape

4. Red Tape • 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.

5. Red Tape • 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.

6. Consumer surplus before maximum price Price of Housing Producer surplus before maximum price Price Controls Supply Demand 0 Quantity of Housing

7. Price Consumer surplus with maximum price of Housing Dead Weight Loss Producer surplus with maximum price Q1S Q1D Excess Demand Price Controls Supply Effective Maximum Price Demand 0 Quantity of Housing

8. Misallocation Costs Price Consumer surplus with maximum price of Housing Dead Weight Loss Producer surplus with maximum price Q1S Q1D Excess Demand Price Controls Supply Effective Maximum Price Demand Demand 0 Quantity of Housing

9. Price Controls • 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!

10. Supply+Entitlement Consumer surplus with maximum price Price of Housing Dead Weight Loss Producer surplus with maximum price Q1S Q1D Excess Demand Price Controls Supply Incomefrom Bribery Effective Maximum Price Demand 0 Quantity of Housing

11. Price Controls • “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.

12. Price Controls • 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.

13. Price of Consumer surplus with quantity restriction Imported Good Dead Weight Loss Producer surplus with quantity restriction Quantity Restrictions Supply p1D Demand Effective Quantity Restriction 0 Quantity of Imported Good

14. Consumer surplus with maximum price Price of Imported Good Dead Weight Loss Producer surplus with maximum price Quantity Restrictions Supply Income from Bribery p1D p1S Demand Effective Quantity Restriction 0 Quantity of Imported Good

15. Quantity Restrictions • 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.

16. Quantity Restrictions 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.

17. Quantity Restrictions 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.

18. Quantity Restrictions • 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

19. Quantity Restrictions • 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.

20. Discretionary Power • Countries with uniform tariffs are better capable of limiting corruption (Gatti 1997).

21. Discretionary Power • 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.

22. Discretionary Power

23. Discretionary Power • 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.

24. Discretionary Power • 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

25. Discretionary Power • 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

26. Appendix 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.

27. Appendix Case StudyAn 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]

28. Appendix 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?