Lecture 4 Market Intervention and Discretion

1. Anticorruption and the Design of Institutions 2012/13 Lecture 4 Market Intervention and Discretion Prof. Dr. Johann Graf Lambsdorff

2. Literature • Bandiera, O., A. Prat, and T. Valletti (2009), “Active and Passive Waste in Government Spending: Evidence from a Policy Experiment,” American Economic Review, Vol. 99:4, 1278–1308 • 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 • Kelman, St., (2002), “Remaking Federal Procurement,” The John F. Kennedy School of Government Working Paper No. 3 (Cambridge, MA). • Lambsdorff, J. Graf (2009), “The Organization of Anticorruption – Getting Incentives Right,” in: Corruption, Global Security, and World Order, ed. by Robert I. Rotberg, (Harvard Kennedy School and the Brookings Institution Press: Washington, D.C., 2009): 389-415.

3. Price Controls • The government often interferes into markets. The common justification provided by economists is related to market failure, for example due to externalities. In other cases, market outcomes are seen to be unjust and governments seek to help disadvantaged groups and insure its citizens against the risks of degradation. • At the same time, such government activities may open the door to corruption. • The welfare effects of this can be investigated by studying state intervention in otherwise well functioning markets. • Incentives for corruption can easily be depicted in a graphical analysis.

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

5. 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

6. 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

7. 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 from 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!

8. 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

9. Price Controls • Corruption is a symptom that something went wrong. The “good” side of corruption is that the market is cleared, supply and demand are equalized. • Corruption does not bring equilibrium back to the efficient equilibrium that would persist without state intervention. • But misallocation costs are avoided.

10. Price Controls • But whether these “misallocation costs” are a bad thing can be up to debate. The “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.

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

12. 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

13. 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.

14. 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 ThanhNien (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.

15. 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.

16. QuantityRestrictions • Due to the risks of corruption governments should not completely correct for market failure. This is the argument advanced by Acemoglu and Verdier (AER 2000). • Government intervention is more costly due to the increased risks of corruption. Optimal policy would thus involve allowing some market failure to persist rather than “costly” correcting for all failures. • For example, 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. This appears to be an area where government excessively intervenes and easier market entry appears to be justified.

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

18. Discretionary Power

19. Discretionary Power • In order to obtain bribes bureaucrats need discretionary power, the ability to act or decide according to their own judgment. • The government may limit discretion by downsizing government itself, less delegating the task to correct for market failure to its bureaucrats . • Another option arises if the government can also limit the bureaucrats’ discretionary power. It might then continue with its intervention. • Discretionary power is particularly strong where rules are vague. This assigns bureaucrats the sovereignty to interpret and apply rules. Keeping laws comprehensible and simple is a straightforward recommendation that will find few opponents. • Some further organizational methods for limiting discretion have become prominent:

20. Discretionary Power • Division of labor If power is concentrated among one actor this increases 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. • Automatic processes 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).

21. Discretionary Power • Complaints mechanisms Allowing citizens to complain limits the misuse of bureaucratic discretion. Disadvantaged competitors or extorted citizens have an incentive to complain. To the extent that investigators are independent they impede official malfeasance. • Rotation of staff Discretionary power may build up over time. Officials learn the rules quickly and need more time to understand how to circumvent them. For further reasons in favor of staff rotation see the script to the Economics of Corruption. Rose-Ackerman (1999) notes, however, that superiors may obtain discretion when rotating their subordinates.

22. Discretionary Power The costs of limiting discretion • There can be costs of limited discretion. Imagine, for example, that a bureaucrat enjoys discretion when the government employs procedure A but less so with procedure B. But procedure is the more efficient one. Which procedure should be preferred? • To illustrate, tale an example from procurement. • Procurement officials are mostly required to award contracts to the lowest bidder. This reduces discretion in judging on quality or experience related to the past performance of contractors. • The latter recommendation, however, has produced poor results, (Kelman 2002). Strict rules divert officers away from the actual goal of acquiring best-value products and services for the government.

23. Discretionary Power • Procurement officers observe the performance of contractors over time. They gather experience with respect to the quality procured in the past. But, due to fears of biased judgments, procurement guidelines often discourage the use of this experience. • Procurement officers’ tasks are limited to awarding to the lowest bidder and checking whether official specifications are fulfilled. But contractors look out for incomplete specifications and similar loopholes as a method for making extra profits. In an attempt to avoid this, the bid inviter and the procurement officials are supposed to add more detailed specifications. Take the example of a 26-page description for cookies procured by the US army. This increasing burden of specifications acts as a deterrent to bidders and suffocates competition.

24. Discretionary Power • Procurement officials are often prohibited to carry out pre-bid talks, as these may allow for collusion. But this limitation disallows them to profit from contractors experience with respect to current prices and available qualities. • We can thus conclude that policymakers must find a balance between the reducing corruption and the avoidance of inefficiencies. The former may have dominated lately. • In a field study Bandiera, Prat and Valletti (AER 2009) investigate these inefficiencies (called passive waste) for Italy and assess their magnitude relative to corruption (called active waste). • They investigate purchases of 21 generic goods, such as printers and gasoline, by 208 Italian public bodies between 2000 and 2005. These bodies can purchase generic goods through two channels: either on their own or through a central procurement agency (Consip), which establishes agreements with suppliers of generic goods which commit to selling a specified product at given price to any Italian public body.

25. Discretionary Power • When a Consip agreement is not active, the price increases with active waste and passive waste. • When Consip is available, the willingness to employ this mechanism is a decreasing function of active waste (because it does not allow for bribery), but an increasing function of passive waste (because it avoids the inefficiency that result from own procurement efforts). • The existence of Consip thus serves as an instrument that helps disentangle active and passive waste. • The authors conclude that on average, at least 82 percent of estimated waste is passive (1279): “Fighting this kind of passive waste requires giving public officials more discretion, not less.” and (1305) “… our results about the importance of passive waste also indicate that economists should not limit their attention to active waste: they should view sheer inefficiency as a problem which is potentially even more important than corruption.”

26. Appendix Discussions:1) Policy intervention tends to lead to misallocation costs. Why? Are these always detrimental to welfare?2) 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.3) Why may governments abstain from correcting for market failures?4) What are the methods available to governments to reduce discretion? 5) What can be the costs of reducing discretion?