Lecture 5 The Maximizing Bureaucrat

1. Anticorruption and the Design of Institutions 2009/10 Lecture 5 The Maximizing Bureaucrat Prof. Dr. Johann Graf Lambsdorff

2. Literature • Lambsdorff, J. Graf (2007), The New Institutional Economics of Corruption and Reform: Theory, Evidence and Policy. Cambridge University Press: 58-80.

3. The Request for Bad Regulation • Where market distortions exist, public servants seek to make rules vague and complex so that they are provided with bureaucratic discretion. • Once market distortion and bureaucratic discretion go hand in hand, reform becomes a daunting task. • Those who profit from corruption will oppose reform. • Corruption would not be the result of inefficient regulation but its cause.

4. The Request for Bad Regulation • Public servants have an incentive to keep inefficient regulation. • They will oppose attempts to get rid of regulation. • Regulation may even be initiated with the purpose of creating corrupt income. • Corruption and market restrictions can be two sides of the same coin. • In this case the causality is reversed: Prospects of corrupt income can be responsible for the creation of inefficient regulation. • A corrupt civil servant then regards his public office as a business, the income of which he will seek to maximize.

5. The Request for Bad Regulation • In return for the exclusive right to import gold, a private businessperson offered bribes to the Pakistani government. In 1994 the payment of US $ 10 million on behalf of Ms Bhutto's husband was arranged and a license to be the country's sole authorized gold importer was granted. • The Abacha family was behind the operations of the firm of Delta Prospectors Ltd., which mines barite, an essential material for oil production. Shortly after Delta's operations had reached full production, General Abacha banned the import of barite, turning the company into a monopoly provider.

6. The Request for Bad Regulation • Allegations concerning a son of the minister of the interior in Saudi Arabia: he established a chain of body shops for car repairs. Afterwards he engaged his father to obtain a decree by the king, imposing a requirement for the annual inspection of all 5 million cars registered in Saudi Arabia. • Twin currency system in South Africa was officially aimed at providing foreign currency to investors. But the parliamentary commission entitled to distribute the cheaper currencies was said to request favors in exchange. Abolishing this system was long impeded by the commission's influence on parliament.

7. The Request for Bad Regulation The Vicious Circle Low quality of institutions; bureaucratic discretion; improper government intervention Corruption

8. The Request for Bad Regulation Myrdal [1956: 283]: ”In many underdeveloped countries ... the damaging effect [of quantitative controls] have been serious. The system tends easily to create cancerous tumors of partiality and corruption in the very center of the administration, where the sickness is continuously nurtured by the favors distributed and the grafts realized. Industrialists and businessmen are tempted to go in for shady deals instead of steady regular business. Individuals who might have performed useful tasks in the economic development of their country become idle hangers-on, watching for loopholes in the decrees and dishonesty in their implementation.”

9. Price of Maximum bribe Maximum bribe Bribe Imported Good The Maximizing Bureaucrat Quantity Restriction or Minimum Price or Supply Maximum Price Demand Quantity of Imported Good Demand for Entitlements Optimum Bribe Marginal Revenues of Monopolistic Bureaucrat Quantity of Optimum Quantity Entitlements

10. The Maximizing Bureaucrat • The bureaucrats and politicians who are helpful in circumventing regulation may be the same who fight for their endurance or put them in place. • Corruption can therefore be worse than distorting state intervention into markets. • It cuts red tape but brings about even larger inefficiencies. • Only in the case of very large pre-existing distortions there is a net benefit from corruption. • Casual arguments that corruption can be beneficial relate to a rare incidence: the existence of government intervention that is totally irrational.

11. Q1D Q1S Excess Demand The Maximizing Bureaucrat The case of beneficial corruption Supply+Entitlement Price of Housing Income from Bribery Supply Maximum Bribe Income Effective Maximum Price Demand Quantity of Housing 0

12. The Maximizing Bureaucrat Look, I want to announce some rigid rules and regulations — so that I may liberalise them to give relief to the people! Laxman,Times of India

13. The Maximizing Bureaucrat • It is not easy to detect actual cases of beneficial corruption. • Around 1997 a prison warden in Nigeria took bribes for passing on a prisoner’s letter to the international media, describing the inhuman treatment. He was detained and his further fate not reported. • The movie “Schindler’s list” well illustrates another case: freeing Jews from Nazi camps sometimes involved the payment of bribes. • These rare cases have been given too much attention by academia and business. • These cases may be as numerous as cases of beneficial murder – too little to discuss the law.

14. A Principal Agent Approach • The principal-agent approach provides an alternative concept to the adverse welfare effects of corruption. • Agents may fail to maximize when being capable of maximizing. • The principal is in charge of delegating a task to the agent and may decide against this. • If costs of corruption are too large, they make the whole delegation unprofitable to the principal. The principal will thus prefer to cancel the whole project. • The agent will suffer from his own corrupt intention. • Corruption implies that potentially beneficial contracts are no longer tenable. • Those contracts that require honesty and the absence of corruption will not be sealed when the principal faces an agent who will take advantage of the arising opportunities.

15. A Principal Agent Approach • When agents cannot credibly promise to reject side-payments from clients, they are not trustworthy when writing contracts that require the absence of such payments. Principals will be reluctant to offer such contracts in the first place. • An illustrative example on this is provided by Bates [1981]. He argues that in Sub-Saharan Africa peasant farmers avoided corruption by taking refuge in subsistence production. They simply avoided exchange with those who might extort them. The welfare enhancing profits from a division of labor could not be achieved because farmers had no guarantee that they would not be cheated. • It may be worthwhile to construct good-quality roads. But principals may choose to cancel the project if bad quality is expected to result from unavoidable collusive behavior.

16. A Principal Agent Approach • A fair and efficient tax system is desirable. If tax collectors cannot be kept from taking bribes such a system may fall into disfavor and be terminated by the principal. • The citizenry prefers to vote against tax increases for otherwise useful purposes because administration and politics cannot be kept from embezzling the funds. • Supervisors may be unable to guarantee honest reports that are not influenced by bribes. Their contribution loses value for the principal and they may not be hired in the first place. • Ultimately, those agents who are willing to take bribes must bear the burden of the drop in welfare – they are jobless.

17. A Principal Agent Approach Source: The Wizard of ID, Parker and Hart, April 9 2000

18. A Principal Agent Approach • In this perspective, a bureaucrat who tries to maximize with a willingness to take bribes fails to maximize. • His actions can be anticipated; his superior (the principal) has no reason to trust in his loyalty. • The agent will not be hired in the first place. • Any new agent must resist the temptation provided by their discretionary power. • If an agent can commit to honesty, he will be preferred and given the job. • Commitment to such a mechanism provides agents with a competitive advantage.

19. A Principal Agent Approach • Bureaucrats thus often have an intrinsic motivation to resist temptation. They need help in this desire, just as anonymous alcoholics need their peer group to support their integrity. Reform may find support among the bureaucracy, even if it cuts down on the capacity to take bribes. • We have allies everywhere in the fight against corruption. There is honest willingness to contain corruption. • Some economist’s have suggested that corruption is just as natural as self-seeking. I suggest the opposite: the quest for integrity is part of human nature.

20. A Principal Agent Approach • Even those bureaucrats who are willing to take bribes have an intrinsic motivation to commit to honesty. They seek methods for guaranteeing the absence of corruption in order to be hired in the first place. • Bureaucrats can be helped by committing to honesty by advancing professional ethics and anticorruption networks. • Ideas for anticorruption need not be sought by the government, they may be implemented by bureaucrats themselves. Hints for Reform

21. A Principal Agent Approach • Countries with a large public sector (contrary to some economists’ belief) are not characterized by more corruption. Thus, it is not the size of government that counts. This is largely due to the fact that overall revenues decline with corruption. • How can declining public revenues in corrupt countries be explained? This may be due to the calculus just developed. Citizens (the principal) prefer tax cuts where bureaucrats (the agents) fail in committing to honesty.

22. Appendix Discussions:1) How does bureaucratic discretion affect the behavior of public servants? 2) On June 20, 2001, Reuters ran the following news: …Argentina now has two exchange rates -- one for domestic transactions that Argentines will use when they buy groceries or pay rent where one peso equals one dollar, and another for trade that applies only to exporters and importers. Under this new system, for instance, a grain exporter would receive 1.0748 pesos for every dollar sold abroad, raising the grain exporter's revenues and making his goods more competitive in markets like Brazil and Europe. But experts say the measure -- which amounts to a 7 percent subsidy for exports and a tax on imports -- is a form of capital control that creates massive opportunities for corruption.Explain why this system may invite for corruption! Why may it be difficult to abolish such a system? 3) How does a regulated market compare to one where public servants maximize income from corruption?4) Why may a maximizing bureaucrat fail to maximize? Explain by use of a principal-agent approach!

23. Appendix Exercise:The market for import of gold is characterized by customer’s willingness to pay: p=40-2x and the suppliers’ cost function K=x2. Assume perfect competition. The market is restricted and bureaucrats are able to sell entitlements to import, charging a fixed fee (b) relative to the quantity imported. a) The bureaucrats provide entitlements for free. Determine the resulting amount of imports (x)!b) The bureaucrats determine b so as to maximize their revenue. Show that imports as determined in a) drop to half the original amount.c) Show for a more general cost function K=a+fx2 that the fee (b) is independent of marginal costs. Interpret this outcome economically!