Lecture 2 The Briber‘s Dilemma

Anticorruption and the Design of Institutions 2008/09 Lecture 2 The Briber‘s Dilemma Prof. Dr. Johann Graf Lambsdorff

Literature • Lambsdorff, J. Graf (2007), The Institutional Economics of Corruption and Reform: 164-189. • Case Study: BAE-Systems and the OECD-convention: • 2007 TI Progress Report: Enforcement of the OECD Convention on combating bribery of foreign public officials: http://www.transparency.org/global_priorities/international_conventions/projects_conventions/oecd_convention Further Reading: • Brunner, K. and W.H. Meckling (1977), ”The Perception of Man and the Conception of Government," Journal of Money, Credit and Banking, IX (1), 70-85. • Friedman, M. (1970) ”The Social Responsibility of Business Is to Increase Its Profits,” New York Times Magazine, September 13. Reprinted in L.P. Hartmann, Business Ethics, (Chicago: Irwin/McGraw-Hill), 246-51.

The Bureaucrat’s Choice Decision tree for a potentially corrupt businessperson - Penalty - Bribe (Corrupt service confiscated) r Pay bribe 1-r Corrupt service - Bribe Do not pay a bribe No corrupt service

1. The Prisoner‘s Dilemma • Similarly, to the calculus of public servants (see lecture “The Economics of Corruption”), the following condition states whether a risk-neutral business person will pay a bribe: V  (rPd+B+Td)/(1-r), • with V being the value of the corruptly provided service and r the probability of detection. B is the value of the bribe. Detection results in confiscation of the favor and a penalty on the side which demanded it, Pd. There might be transaction costs arising, Td. • A high risk of detection, r, or severe penalties, Pd, induce businesspeople to abstain from paying bribes. • Another approach would be to increase transaction costs or to make sure that public servants have little to distribute. If V is sufficiently small, the calculus would equally lead businesspeople to prefer legality.

1. The Prisoner‘s Dilemma • There exists a controversy as to which side has greater responsibility. In a seminal contribution Friedman [1970] argues that the sole responsibility of business is to increase its profits. • Brunner and Meckling [1977: 82-4] consider it defendable for business people to disregard morality and pay bribes, when this is part of a maximizing strategy. • Industrial bodies of exporting countries often point to high levels of corruption in less developed countries when defending their strategy to condone bribery. Some even claim a cultural acceptance of these practices abroad. • By contrast, people from less developed countries point to the difficulty of establishing an honest administration and a transparent political environment when low-paid public servants are constantly offered side payments by business people from industrial countries.

1. The Prisoner‘s Dilemma

1. The Prisoner‘s Dilemma • A crucial question regards the interaction between competition and morality: Can a high standard of ethics survive? Is it the bottom line of the moral code that wins out? • Assume that two equally qualified firms compete in a public tender, yielding a profit of 100. The tender board consists of 7 members. Each firm has the possibility to pay a bribe worth 10 to one of them in exchange for a favorable vote. The resulting probability of winning can be depicted from following matrix.

1. The Prisoner‘s Dilemma • Considering the probability of obtaining the profit (100) and the costs of bribing (10), the following matrix determines the expected profit. • The matrix reveals that bribing emerges as the dominant strategy.

1. The Prisoner‘s Dilemma • Also in reality bribing may sometimes be the individually dominant strategy. One obtains an edge over competitors who do not pay, and looses by rejecting a payment when all others bribe. • But jointly the firms are worse off, because the costs of bribing lower their overall profit. • The overall decrease in profit arises because each firm disregards the damage that its bribing strategy imposes on the competitor. • There are two solutions to the problem. • Corporate liability: the payoff to the matrix is changed by penalties imposed on the firms. • Collective action: Firms unite in their efforts to fight corruption.

1. The Prisoner‘s Dilemma • Imagine the calculus of a firm’s employee who is given a bonus payment if he secures the contract for the firm. • Such a payment would act as an inducement to engage in bribery. • In an NBER paper (http://www.nber.org/papers/w12274) Bertrand, Djankov, Hanna and Mullainathan (2007) investigate the effect of bonus payments on the behavior of Indian applicants who wanted to obtain a driver’s license. One group was given free driving lessons, another a bonus payment for obtaining the license within 32 days. • Those who were given a bonus were less qualified in driving, less often participated in the official test and more often engaged local agents to arrange things.

1. The Prisoner‘s Dilemma

1. The Prisoner‘s Dilemma • Codes of conduct are at risk of “window dressing”: While they present the official policy, unofficially firms sometimes communicate that acquisition of a contract is all what counts. • The promise of a bonus supersedes moral considerations. • This inofficial culture of bribery can only be changed by imposing corporate liability. • Once the risk of detection and fines exceeds 5, bribing ceases to be the dominant strategy.

1. The Prisoner‘s Dilemma • Once firms have an incentive to allow bribery, penalties must concentrate on penalizing firms, not only individuals. • While quite often blacklisting of firms and threats of contract cancellation are mentioned in this context, in the lecture “The Economics of Corruption” it was shown that monetary fines are superior. Hints for Reform

2. Collective Action International multilateral approach • Unilateral approach: Foreign Corrupt Practices Act imposed in 1977, the USA: End tax deductibility and impose legal sanctions. • Most trading partners did not follow the US lead, because imposing stricter national regulation was seen to hurt their export industry. • This well resembles the problem of a prisoner's dilemma: while all export nations may profit from transparent procurement and good codes of conduct it is profitable to be the only one deviating from such behavior.

2. Collective Action • A CIA report claimed that between 1994 and 1995 the US lost $ 36 billion worth of business deals due to bribery and corruption by its competitors, inducing public complaints. • About that time talks at the OECD started for a multilateral approach. • In May 1997, an agreement was signed by ministers of the 29 members of the organization (and further non-member countries) to enact laws by April 1998 making bribery a punishable offence. • All major countries have meanwhile ended the tax deductibility of bribes and made bribing of foreign officials a legal offence.

2. Collective Action Will these laws be effective? • Will firms start to understand the new rules? • Will prosecutors start investigations in case of malfeasance? • Will firms invent new methods for making payments which are accepted under the existing legal standard, or which cannot be prosecuted and appropriately penalized? • Will firms just delegate the bribery to local agents or middlemen and claim ignorance when this is uncovered? • Will firms arrange deals via subsidiaries and off-shore companies to keep them off their books?

2. Collective Action Transparency International’s Integrity Pact (IP) • The IPs are developed for individual government (or subdivision) contracts and should enable the bidders to abstain from bribing. • All officials involved commit to abstain from requesting or accepting bribes or to unduly favor one bidder over another. This commitment is assisted by disclosure of all relevant information and potential conflicts of interest. • The bidders commit to not offer or hand out bribes or other favors and to not accept any inappropriate advantage.

2. Collective Action • Sanctions (to be negotiated) may include disciplinary or criminal sanctions against officials, cancellation of contract, forfeiture of the bid and blacklisting of bidder for future government contracts. • But: Sanctions and regulations exist anyways • An IP will only be effective if further sanctions can be tailored to a certain project. • Further actors (CEOs, Civil Society) can be involved. • Trust among participants can be created. • Assessments of effectiveness of IPs are biased because its implementation already suggests a political will to contain corruption.

3. Unilateral Approaches • Sometimes paying bribes is not the dominant strategy. Various reasons suggest that paying bribes is a costly approach: • A firm engaging in bribery might be exposed to denunciation and extortion. It fears legal sanctions or a bad reputation and may be forced to pay hush-money. • Corrupt agreements cannot usually be legally enforced. A potential risk is that public servants may fail to deliver after receiving a bribe. Some firms may be more reluctant than others to run such a risk. • Bribes requested may rise with the propensity of a firm to pay.

3. Unilateral Approaches • The Wall Street Journal, Jan 31 2007, cites from the prosecutorial investigation of M. Kutschenreuter, an executive manager at the German Siemens: A former Saudi-Arabian local representative, whose contract had been cancelled by Siemens, is supposed to have blackmailed the firm. He requested more than 900 mio. US$ as hush-money and threatened to pass on documents about corruption in telecommunications contracts to the SEC otherwise. In negotiations both sides agreed on a payment of 50 mio. US$.

3. Unilateral Approaches • A Hong Kong employee of the German Mannesmann was in charge of paying bribes to Chinese officials in exchange for contracts. It was later detected that he embezzled parts of the money. But the firm did not bring the case to court, because the employee threatened to expose the names of Chinese officials. Being confronted with the death penalty in China, this would have brought operation of Mannesmann in China to a standstill. • A staff member of the Christian Democratic party in Hesse, Germany, was alleged to have embezzled 1 Mio. DM of party funds. But he was given impunity due to fears he may denounce the party's illegal hidden accounts. The party even paid for his gambling debts.

3. Unilateral Approaches • In a recent study about truck drivers in Indonesia, Bolken and Barron (2007: 9-10) www.nber.org/papers/w13145, find that truck drivers do not truthfully report to their companies about the bribes they have to pay at checkpoints: “By exaggerating bribe payments, drivers may be able to extract more money from their bosses to pay bribes than they actually need, and pocket the difference. In fact, we compared the amount of bribes we observed on 40 trips between January 25th, 2006 and February 20th, 2006 with twelve interviews we conducted around the same time with drivers who had just completed their trips, and found that on average the bribes drivers reported in interviews were more than double the amount of the bribes we recorded by direct observation.”

3. Unilateral Approaches I have not taken any bribe and I swear I’m not hiding any money from you. Those are false allegations usually made during elections to discredit our party! Laxman, Times of India, Nov. 13 2003

3. Unilateral Approaches • Slush funds can be misappropriated by firm staff. • The secrecy surrounding corrupt side-deals can be used by firm staff to take their share. Employees are thus seduced to betrayal, for example, by requesting a share of the bribes to be sent to their own offshore bank accounts. • Internal auditors can hardly distinguish between bribing in favor of the firm and employee fraud. The red flags of the two misdoings are similar:

3. Unilateral Approaches

3. Unilateral Approaches Source: International Business Attitudes to Corruption – Survey 2006, Control Risks Group

From news.com.au, April 11, 2001: For Jakub Bierzynski, the wake-up call was of a personal nature. Head of the Warsaw-based media planning company OMD-Poland, a US-Polish joint venture, Bierzynski was confronted by corruption last year when two big international clients separately demanded bribes of "hundreds of thousands" for two advertising contracts. "It was like a very cold shower. I asked myself if I could do business in a corrupt environment," says Bierzynski, who had incorrectly assumed his firm's US mother company afforded him a degree of protection from kick-backs. The answer was no. "This is what scared me the most (that despite OMD and the clients all being international companies), they would dare to ask for a bribe," he says. "Leaving aside the moral connotations of (giving bribes), I have no skills in giving bribes. I have never done it before, I don't know how much, I don't know to whom and I don't know in what situations I'm supposed to give bribes, so I am losing in that competitive field and I am sentenced to death in the business world.” Instead, the 34-year-old channeled his outrage into a proposal to launch an anti-corruption business association unprecedented in central and Eastern Europe, in which members would pledge not to offer or receive bribes.“ 3. Unilateral Approaches

Appendix Discussions1) Disregarding ethics, how would businesspeople and public officials determine whether to engage in bribery?2) What forces the bottom line of the moral code to win out? 3) Which are the two strategies for overcoming the prisoner’s dilemma?4) Do “good ethics” survive in reality? Why?5) Discuss the subsequent case study! Why didn’t H. Davidson discuss the dilemma with his superiors?

3. Unilateral Approaches The Wall Street Journal Europe, Career Journal (03.12.2002): “In 1994, Howard Davidson faced his crucible. At the time, he was an investment banker, working in an Asian country. He was on the verge of pulling off a prestigious $500 million (502.8 million euro) stock offering for an Asian utility. "We invested $11 million in the deal and pre-sold the issue," recalls Mr. Davidson, now a financing consultant for the Institute, a management-consulting firm in Redwood City, California. "At the last minute, I was approached by a government official." The official's message: Give him a kickback or forget the deal. "To him, it was as logical as day follows night," Mr. Davidson says. It would have been simple to comply. He felt he couldn't even share the decision with superiors at the bank. What if they ordered him to pay up and push on with the offering? And with other people involved, how could he be sure the whole sordid mess wouldn't leak to the press? […] In the end, he declined and the deal was pulled, resulting in a lot of heat for his company from an unknowing public. Press critics wondered aloud if the company knew how to pull off a deal of that magnitude in a foreign land. The decision turned out well for Mr. Davidson, who finally confided in his superiors afterwards. The company's senior executives felt he'd made the right call, and he wound up with a promotion after his division went on to a "great year" anyway, he recalls. But it could have been a disaster. In another, less-ethical, get-the-job-done-at-any-cost culture, he could have been pushed aside, ignored or outright vilified by co-workers and his career could have come to a dead halt. […] In a highly competitive world, there's considerable pressure to adopt that point of view. When bosses talk about doing "whatever it takes" to make a sale, the salespeople see that as an easily decipherable code. Translation: "Do whatever you have to, as long as it doesn't come back on me." There's also social pressure to "go along with the gang." People who don't are ostracized. […]”

Lecture 2 The Briber‘s Dilemma