A principal-agent model of corruption

One of the new avenues in the study of political corruption is that of neo-institutional economics, of which the principal-agent theory is a part. In this article a principal-agent model of corruption is presented, in which there are two principals (one of which is corrupting), and one agent (who is corrupted). The behaviour of these principals and agent is analysed in terms of the costs and benefits associated with different actions. The model is applied to political corruption in representative democracies, showing that, contrary to common belief, the use of principal-agent models is not limited to bureaucratic corruption. Introduction: Neo-institutional economics and corruption Although corruption is generally analysed as a social phenomenon, especially in comparative research, it is from the decisions of individuals that corruption stems. In this article a principal-agent model of corruption is presented, one which focuses on these decisions. Our choice of individualism is a methodological one, and must not be understood as a denial of the significance of the social structures of which individuals are a part. Indeed, neo-institutional economics, of which the principal-agent literature is a part, deals explicitly with the institutional factors that affect the decisions of individuals. What can neo-institutional economics contribute to our understanding of corruption? To answer that question let us first give a brief overview of neo-institutional economics in general.1 Institutions can be defined as collectively binding working rules.2 A contract between two persons is such a set of rules, as are school regulations. Proportional representation is an institution, just as the stock market and marriage are. Institutions are distinguished from the preferences of individuals; they structure and constrain the decisions made by them. These institutional constraints are emphasised in various ways, leading to three different, but related branches within the field of neo-institutional economics: the property rights branch, the transaction costs branch, and the principal-agent branch.3 In the property rights literature decisions by individuals concerning goods are assumed to be affected not so much by the goods themselves, but by the kind of property rights individuals can exercise. These property rights can be user rights, usufructuary rights and transfer rights. An individual who owns 208 NICO GROENENDIJK a house will make different decisions about maintenance than an individual who is a tenant. In the property rights literature institutions constitute property rights of individuals, as well as the means for these individuals to defend themselves against infringements of these rights. Stemming from the work of Coase, the transaction costs branch emphasises the importance of transaction costs for the allocation of resources and the structure of economic organization.4 Prior to Coase, the role of transaction costs was minimal since such costs are for the greater part information costs, and most economic theories and models assumed full information. Following Williamson, transaction costs can be divided into ex ante and ex post costs. Ex ante costs are the costs of drafting, negotiating and safeguarding an agreement.5 The costs of monitoring and controlling the execution of an agreement are ex post costs, as are possible revision costs. Transaction costs will differ depending on the incidence of the transactions, the degree of uncertainty that the individuals face, and the “asset specificity”, e.g. the extent to which the good and the transaction concerned are geared to one another. It should be mentioned that what Williamson calls an “agreement” must be understood to include not only contracts, but other more extensive institutions as well. In the principal-agent branch of neo-institutional economics (or: agency theory) elements of both the property rights theory and the transaction costs theory are integrated and used to model relationships between principals and agents. Principal-agent models assume that the interests of principal and agent diverge, that there is informational asymmetry to the advantage of the agent, but that the principal can prescribe the pay-off rules in their relationship. Furthermore, an important feature of the agency literature is that decisions are considered to be trade-offs between different kinds of costs (monitoring costs, bonding costs and residual loss). What contribution has neo-institutional economics made, to date, to the study of corruption? The most comprehensive economic models of corruption are those of Rose-Ackerman, Lui, Andvig and Moene, Klitgaard, and Alam.6 Rose-Ackerman focuses on a traditional form of corruption, namely, bribery of bureaucrats by companies in the government contracting process.7 The incidence of corruption is found to differ according to the degree of competition and the extent to which government has well-defined preferences for the good in question. Her analysis pinpoints the areas in which resources for anti-corruption measures can best be used. In later work, she extends her analysis to other types of corruption, namely, high-level political corruption as well as low-level bureaucratic corruption.8 Lui assumes that corruption is more difficult to detect and deter when a greater proportion of the officials is corrupt.9 Using a two-period model with overlapping generations of officials, A PRINCIPAL-AGENT MODEL OF CORRUPTION 209 Lui shows that there can be several stationary equilibrium levels of corruption in an economy. Andvig and Moene offer a fine model of bureaucratic corruption, focusing on the demand as well as the supply side.10 Their model also has multiple equilibria, which sheds light on the varying incidence of corruption across similar societies and activities. Klitgaard offers a largely heuristic principal-agent model, which encompasses a principal, a corrupt agent, and a client.11 He offers an overview of various measures to fight corruption as well. Alam explains variations in corruption across agencies and societies by the ability of the victims of corruption to engage in countervailing actions.12 These countervailing actions can be evasive, direct or illicit. The incentives to engage in countervailing activities depend on two kinds of factors, global factors and specific factors. Global factors like property rights explain variation across societies; specific factors such as the type of corruption explain variation across agencies. Elements of neo-institutional economics have been used by Bakker and Schulte Nordholt, to elucidate the mechanisms by which corruption can take root in societies, especially when societies are going through institutional turnovers.13 Similar findings have been put forward by Johnson and Huntington, with regard to institutional discrepancies within a society.14 To the possibility of such a horizontal institutional gap, Bakker and Schulte Nordholt add the possibility of a vertical institutional gap, which arises when national economic, political and legal institutions are not equipped to deal with internationalization. Other authors have combined neo-institutional economics with game theory. Manion analyses bribery in Chinese enterprise licencing, assuming that those who offer the bribes are fully entitled to their licenses and do not know whether the bribes are overpayments or fees for valued illicit services.15 Bribery can be shown to be an equilibrium solution in such an asymmetric information game. A similar analysis is that of Cadot who focuses on the situation in which an applicant has to pass a test in order to get a permit.16 Different solutions exist for this game, depending on the information sets of both players. Basu, Bhattacharya and Mishra, using game theory as well as the economic theory of crime, based on the work of Becker, offer a simple model of recursive corruption.17 Recursive corruption occurs when a corrupt official gets caught and bribes the official that caught him. Related work is that of Mookherjee and Png who analyse the delegation of enforcement authority in environmental policy, and the opportunities such delegation brings about for corruption.18 Focusing on political corruption, Rasmusen and Ramseyer have combined game theory with the theory of “rent-seeking”, which is related to neo-institutional economics.19 They note that the size of bribes in political 210 NICO GROENENDIJK corruption is small, and put that down to the imperfect coordination between legislators. When a legislator expects other legislators to sell their votes, and there is no coordination, he will take whatever bribe is offered. Because this is hardly satisfactory, legislators may opt for a ban on bribery. Myerson uses game theory to analyse the effectiveness of different electoral systems in reducing corruption in a multiparty system.20 Galeotti and Merlo, who also investigate the relationship between electoral rules and government corruption, have challenged Myerson’s conclusion that proportional representation guarantees the exclusion from government of corrupt parties.21 Looking at the contributions from neo-institutional economics we find that, apart from Klitgaard, and to some extent Rose-Ackerman, the principal-agent theory has not been fully used to enhance our understanding of corruption. This article aims to fill that gap, and to do so in two ways. First, unlike Klitgaard and Rose-Ackerman, who assume only one principal-agent relation namely the relation between a corrupt official and his superior, we will look upon the relation between the “client” and the corrupt official as a principalagent relation as well. Second, the notion of trading-off different costs is taken into account more explicitly. Johnston remarks that while the principal-agent approach is well-suited to the analysis of bureaucratic corruption, other more broadly-based forms of corruption may fit the framework awkwardly or not at all.