Valentin Preobrazhenskiy PhD candidate, HSE 2008

1. For LIA Politicians and Firms: Russian evidenceOverview of A.Shleifer’s theory and its implications to Russia Valentin Preobrazhenskiy PhD candidate, HSE 2008

2. A VIEW ON STATE COMPANIES TURNED PESSIMISTIC IN 80th After 80th Before 80th • State companies seem efficient and maximizing social welfare • Cure market failures • Charge prices reflecting social marginal costs • Highly Inefficient (high labor costs, Investments misallocation) • Plague market with failures (high pollution, harm private firms, distort price signals) Why: • Patronage: politicians buy votes by excessive employment with higher wages • State companies invest in interest of politicians • Managers and politician bribe each others • Use subsidies to stay afloat

3. SHLEIFER&VICHY’s MODEL Describes a game btw public, politicians and managers with its outcomes for: • Level of employment and salaries of a firm • Amount of subsidies from Treasury to firm • Volume of bribes • Scale of detriment to social welfare I would present 4 major scenarios tested: 1. Corruption is allowed. Politician controls firm. 2. Corruption is allowed. Politician does not control firm. 3. No corruption. Politician controls employment. 4. No corruption. Manager controls all the firm. Assumptions: • Politicians cater to interests groups rather then median voter. • Residual rights control determine resource allocation rather then contracts.

4. THE MODEL OVERVIEW L – excessive labor, produce nothing w – wage of L (w > market wages) B(L) – benefit for politician from excessive labor P – enterprise profits before excessive labor costs a – share in profit of private stakeholders (1-a) - Treasury profit stake t – transfer to the firm from treasury T – net treasury transfer = t – (1 – a)*(t – w*L) = a*t + (1-a)*w*L C(T) – costs of T for politician b – cost of bribe Politician’s utility: Up = B(L) – C(T) + b Manager’s utility: Um = a(p + t – w*L) – b Constraint: a*p + T – w*L>=0, or T> = w*L - ap s – social opportunity costs of labor q – social costs of transfer T Social utility: Us = -sL - qT

5. SCENARIOS 1-2. Corruption is allowed. Politician and manager maximize resources under their common control then divide surplus by bribes. They extract cash from Treasury until: C’(T) = 1 (marginal costs of getting $1 from Treasury = $1) Employ extra labor: B’(L) = w (Marginal political benefit from additional employee = wage. Politician do not want to decrease his bribe by wiping out profits with over employment.) Divide remaining cash by bribes. Politician’s utility: Up = B(L) – C(T) + b Manager’s utility: Um = a(p + t – w*L) – b In case If politician control employment manager pays higher bribes with increase of a.

6. SCENARIO 3. No corruption. Politician controls employment. Since politician can not kick back by bribes manager’s profits he maximize his B(L): Also extract cash from Treasury until: C’(T) = 1 (marginal costs of getting $1 from Treasury = $1) Use all firm’s cash to hire employees. Thus manager’s utility: Um = a*(p + t – w*L) = 0 Politician’s utility: Up = B(L) – C(T) As a result employment is higher than in the 1st Scenario. However utility is less for each politician and manager. Thus they are both interested to introduce corruption.

7. SCENARIO 4. No corruption. Manager controls employment. Since politician and manager make choice non cooperatively T=L=0. Politician’s utility: Up = B(L) – C(T) + b = 0 Manager’s utility: Um = a(p + t – w*L) – b = a*p In this case both politician and manager utility is lower then in the first scenario while social welfare higher. Thus politician is interested to introduce control over employment and they both interested to introduce bribes. This helps them to redistribute social welfare through subsidies and excess employment.

8. SUMMARY

9. Russian evidence

10. LOTS OF MONEY AVAILIABLE FOR SUBSIDIES AND EXCCESS EMPLOYMENT Source:R.Gaidy

11. HIGH CORRUPTION By Transparency international

12. SCENARIOS 1-2. FOR RUSSIA Politician and manager maximize resources under their common control then divide surplus by bribes. They extract cash from Treasury until: C’(T) = 1 (marginal costs of getting $1 from Treasury = $1) In case of Russia politician provide perks redistributing resources from the market. Employ extra labor: B’(L) = w Manager does not fire excess employment and finance social projects combining bribes and excess employment. The higher manager’s stake in the company (a) the higher bribes pay manager as dividends to treasury from the firm lower.

13. SCENARIO 3. RUSSIAN EVIDENCENo corruption. Politician controls employment. Since direct bribes are limited to some extent politician maximize his B(L) (or more generally power) pushing manager to use more profits for power creation: spend more on political campaigns and on social projects.“

14. Implications for Institutional Change

15. A FRAMEWORK OF INSTITUTIONAL CHANGE Beliefs shapes rules for the power game and balance of power. E.g. electoral preferences. Groups strife to control sources of power. Then use them to maximize power. Strife for power btw interest groups Sources involve mass of people engaged to produce power . Sources of power Beliefs shapes ways to produce power. E.g. tolerance to corruption and administrative power. People adopt their beliefs to produce power. Beliefs systems and social networks

16. POLITICIAN AND MANAGER ACTIVITIES DETAILED • Politician’s activities: • Transfer state funds by subsidies or beneficial contracts. • Make administrative preferences to an affiliate leading to his greater revenues or savings. • Grant control over cash flows of a state company. • Manager’s activities: • Do not tend to increase efficiency in terms of costs and quality of output. • Finance campaigns and affect voting procedures. • Support politician by lobbying decision-making in the government regarding appointments, state finance and spheres of influence. • Influence other managers and groups by setting contracts or by administrative power granted by politician. • Affect information flows and attitudes through mass media and social networks. Could lead to spread of false. What are doing employees?

17. MASS OF PEOPLE ENGAGED TO PRODUCE POWER ADOPT THEIR BELIEFS TO NON PRODUCTIVE ACTIVITIES As incentives for a manager are spoiled in terms of value creation. He shapes spoiled business practices inside the firm. What employees of the rent networks actually do? 1. Create value as a market firm 2. Destroy value of competing clans inside the company 3. Lobby rent inflow to their firm together 4. Redistribute assets (steal) 5. Corrupt business partners and stakeholders 6. Use assets to increase power of a patron Productive beliefs Redistributive beliefs: No respect for: Property rights as a value Initiativeness Professionalism Freedom and dignity Rule of law

18. A FRAMEWORK OF INSTITUTIONAL CHANGE Strife for power btw interest groups Sources of power Beliefs systems and social networks Beliefs drift to non productive values proliferates power production with detriment to social welfare and beliefs itself. This vicious circle exists because detriment to social welfare is not clear for mass of people due to their beliefs, and ability to hide the detriment by natural rent. Thus decrease of natural rent exposes demand for changes. This could foster changes with costs impossible to recover in case if beliefs systems and networks will not be shaped to support relevant power game and healthy policies.

19. Thank you v.preobrazhenskiy@gmail.com