metadata: authors: 0: author: Basu, Kaushik
1: author: McGavock, Tamara
2: author: Zhang, Boyang
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docna: 0: docna: When competition corrupts : a theoretical
            analysis of market structure and the incidence of corruption
docty: Policy Research Working Paper
subtopic: Human Rights,Competitiveness and Competition Policy,Global Environment,Crime and Society,Environmental Protection
teratopic: Public Sector Development,Macroeconomics and Economic Growth,Water Resources,Finance and Financial Sector Development,Gender
abstracts: cdata!: The paper develops a simple model to
            demonstrate that, paradoxically, greater competition may
            exacerbate the problem of corruption. Market participants
            engaging in corrupt practices enjoy lower production costs
            -- maybe because they pay a bribe to avoid installing the
            environmental safeguards required by law -- such that honest
            players are driven out of the market when the market becomes
            sufficiently competitive.
repnme: repnme: When competition corrupts : a theoretical
            analysis of market structure and the incidence of corruption
display_title: When competition corrupts : a
            theoretical analysis of market structure and the incidence
            of corruption
listing_relative_url: /research/2013/09/18221190/competition-corrupts-theoretical-analysis-market-structure-incidence-corruption
topicv3: Competitive Industries m1326741 346,Environmental Safeguards m1327127 901,Environment, Natural Resources and Blue
            Economy m1327391 566,Crime m1439217 3041,Discrimination m1505707 3379
publishtoextweb_dt: 2013-09-01T00:00:00Z
historic_topic: Public Sector Development,Macroeconomics and Economic Growth,Water Resources,Finance and Financial Sector Development,Gender
no_of_pages: 10
model_extractions: WPS6596 Policy Research Working Paper 6596

# When Competition Corrupts

A Theoretical Analysis of Market Structure and the Incidence of Corruption _Kaushik Basu Tamara McGavock Boyang Zhang_ The World Bank Development Economics Vice Presidency September 2013
Policy Research Working Paper 6596

# **Abstract**

The paper develops a simple model to demonstrate that, paradoxically, greater competition may exacerbate the problem of corruption. Market participants engaging in corrupt practices enjoy lower production costs— maybe because they pay a bribe to avoid installing the environmental safeguards required by law—such that honest players are driven out of the market when the market becomes sufficiently competitive.

This paper is a product of the Development Economics Vice Presidency. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at tjm276@cornell.edu.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# When Competition Corrupts:

A Theoretical Analysis of Market Structure and the Incidence of Corruption Kaushik Basu, Tamara McGavock and Boyang Zhang September 7, 2013

**Abstract** The paper develops a simple model to demonstrate that, paradoxically, greater competition may exacerbate the problem of corruption. Market participants engaging in corrupt practices enjoy lower production costs–maybe because they pay a bribe to avoid installing the environmental safeguards required by law–such that honest players are driven out of the market when the market becomes sufficiently competitive.

**Keywords:** Market Competition, Corruption, Industrial Organization.

## **JEL Classification Numbers: D73, D4, L1, O1**

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# **1 Motivation**

As economists, we normally associate competition with healthy and desirable market outcomes. This is so in terms of standard measures that economists use, such as efficiency and consumer surplus: competition enhances these. Similar claims are also often made for some social indicators. For example, Becker (1957) argues that discrimination of different kinds, including racial, falls as market competition increases.<sup>1</sup> In this paper we argue that, paradoxically, corruption will tend to flourish under competition and may be less pervasive when competition is less fierce.

Some prominent papers in the literature have previously analyzed the link between corruption and market structure (see, eg., Rose-Ackerman, 1975; Ades and Di Tella, 1999; Yoo, 2013) but the present paper provides a very different approach. In our analysis, corruption itself generates rents arising from lower costs, which implies that standard competition leads to higher, not lower, incentives for corruption. In this manner, our paper shares a loose connection with Tirole (1986) in the sense that higher degrees of competition force “agents” to collude with a “supervisor” in the environment of Tirole’s paper. In contrast to the traditional argument made by Acemoglu and Verdier (2000), we posit the role of government in mitigating the undesirable effects of competition on corrupt practices.

# **2 Model with Two Types**

The standard economic model of corruption and crime is entirely amoral: the fact that an action entails corruption means nothing to the individuals apart from its economic returns, which they consider in isolation when deciding whether or not to choose an action (Becker, 1968). Other work goes further and attributes this amorality also to the enforcers of the law, by assuming that police and magistrates will enforce the law or choose to take bribes depending only on their personal returns from such actions (Basu, Bhattacharya and Mishra,

> 1One of us has elsewhere (Basu, 2010, Ch.5) argued that this may not be the case. There are strong theoretical explanations of how discrimination and racial prejudice can survive competition.

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1992). In this paper we break from that tradition and assume that while there may be amoral people to whom breaking the law is appealing if and only if it is economically profitable, there are also people who find corruption distasteful, with some even refraining from being corrupt no matter what the returns to being corrupt are.

In this section, we consider the polar case in which there are two types of people: the honest and the corrupt. The corrupt are like the standard human being in the models of economists (make what you will of the economics profession) and the honest are those who will, given a choice, never choose the corrupt option (see Guha and Guha (2011) for a similar setting).<sup>2</sup> Following this, we will speak of firms as being corrupt or honest, meaning that firms are managed by corrupt entrepreneurs or by honest entrepreneurs.

Firms choose to enter a certain goods industry if they will earn positive profits.<sup>3</sup> Suppose the number of firms in the industry is exogenously constrained to _n_ . If more firms desire to enter the industry than there are spaces available, firms who apply for entrance will be randomly selected to enter. Demand in the industry is linear, given by: Once in the industry, the _n_ firms have uniform fixed marginal cost _c_ ( _c < a_ ) and engage in Cournot competition. Denoting firm _i_ ’s output by _qi_ and using a star to denote Cournot equilibrium, we obtain (from the first order condition) the following condition for each _i_ : This means that the Cournot equilibrium price _P_ ( _n_ ) and aggregate quantity _Q_ ( _n_ ) will be functions of the number of

> 2This is in contrast to Myerson (2004) where honest behavior emerges in equilibrium from people who are fundamentally amoral and hence are fully corruptible.

> 3Note that this assumes that the outside option is equivalent for honest and corrupt managers. In practice, this may not be the case, but we assume this for simplicity.

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We will, in what follows, denote each firm’s Cournot equilibrium output by _q_ ( _n_ ). Clearly, _q_ ( _n_ ) = _b_ ( _<u>an−</u>_ +1) _<u>c</u>_<sup>.Now assume that before starting operation, a firm is supposed to incur a fixed</sup> cost _L_ to put in some environmental safeguards, but it is possible for the firm to avoid this by paying a bribe _l_ . We assume of course that _l < L_ and without loss of generality, we will assume _l_ = 0. Firms thus incur fixed cost _hL_ , where _h_ = 1 for honest firms and _h_ = 0 for corrupt firms.

**Proposition 1** _If the industry is sufficiently competitive (i.e. the number of firms in the industry is above a certain threshold level n_<sup>_∗_</sup> _) then all firms in the industry will be corrupt._

**Proof.** Suppose there are _n_ firms in the industry. Then profit earned by an honest firm is given by:

Using the definition of _P_ ( _n_ ) and _q_ ( _n_ ) from above, it is easy to see that the profit earned by an honest firm will be zero if: Denote the value of _n_ that satisfies equation (6) by _n_<sup>_∗_</sup> . It follows that if _n > n_<sup>_∗_</sup> then the industry will be populated only by corrupt firms.

Suppose next that the number of firms in the industry is not exogenously given. Instead there is free entry of firms. If the total number of corrupt people in the economy is greater than _n_<sup>_∗_</sup> , it is obvious that in equilibrium with free entry, all firms in the industry will be 4
corrupt. The argument is simple. As long as profits earned by corrupt firms are positive, corrupt firms will continue to enter. As this continues and the number of firms in the industry increases above _n_<sup>_∗_</sup> , only the corrupt firms will remain in the industry. Hence the next corollary:

**Corollary 1** _In a competitive industry with free entry, corruption will be endemic._

# **3 Generalization**

It may appear at first sight that our result is driven by the binary nature of the attitude people have toward bribery. The result that a critical point exists beyond which corruption suddenly increases in a competitive industry seems especially to be a consequence of the assumption in the previous section of there being only two kinds of people, the honest and the corrupt. Interestingly, this is not so. Even with different kinds of behavior, the threshold effect will be present. So let us move to the more general case by assuming, as indeed is real, that people vary in the degree of their attitudes toward corruption and honesty (which, in the present paper is equated with the aversion to corruption), ranging from incorruptible to the completely amoral. We shall here denote a firm’s (meaning its entrepreneur’s) propensity for honesty by _h ∈_ [0 _, ∞_ ), which denotes the psychological cost to a person of being dishonest. If _h_ = _∞_ , such a person will not be corrupt no matter how large the reward from corruption. Note that in this paper we are not distinguishing among different kinds of corruption. This is harmless here since the only corruption that occurs in this model is bribery to evade environmental regulations. We shall use _φ_ ( _h_ ) to denote the fraction of individuals whose propensity for honesty is less than or equal to _h_ . Let us denote a firm’s profit ignoring the fixed cost by _π_ ̃ and call this the variable profit. If there are _n_ firms in the industry, then: 5
Clearly, a firm of type _h_ will choose to enter the industry if and only if: If (8) holds and _h < L_ , this firm will enter the industry and be corrupt. If (8) holds but _h ≥ L_ , it will enter the industry but not be corrupt. We used an arbitrary tie breaker rule for _h_ = _L_ , but that is innocuous.

It is now easy to describe the relationship between the degree of competition and the ̃ incidence of corruption. Note that as _n_ goes to 1, _π_ ( _n_ ) increases toward<sup><u>(</u></sup><sup>_a−_</sup> 4 _b_<sup>_c_</sup><sup><u>)2</u></sup> . Starting from _n_ equal to one and increasing _n_ , it is obvious that _π_ ̃( _n_ ) declines monotonically. Define _n_ ̃ to be such that _π_ ̃( ̃ _n_ ) = _L_ . If the number of firms allowed in the industry _n_ is less than _n_ ̃, all firms will want to enter the industry and a random selection of firms will manage to do so. The fraction of firms in the industry that pay a bribe will be given by _φ_ ( _L_ ).

̃ ̃ ̃ If _n > n_ , then _π_ ( _n_ ) _< π_ ( ̃ _n_ ) = _L_ . Now only those firms whose _h_ is less than _L_ will find it worthwhile to enter the industry. But if _h < L_ , then it pays to give a bribe. Hence, the incidence of bribery will be total. In other words, all firms in the industry will be paying a bribe. Hence our fundamental result is unchanged: there is a critical level of competitiveness such that once an industry becomes competitive beyond this level, bribery and corruption will be ubiquitous. It is interesting to note that even if individual propensity toward corruption varies finely from the incorruptible to the totally amoral, the incidence of corruption rises abruptly beyond a certain level of competitiveness in the industry.

# **4 Observations**

We believe our paper points to an important reason why corruption is so rampant in some industries. India’s large system of ration shops has a high incidence of corruption (in 6
this case it takes the form of cheap grain received from the government and meant to be sold to poor households at a special low price instead being sold illegally at the higher market price). A little calculation shows that for a fully honest ration shop owner, the profit margin is so low that it is not worthwhile for a person to run a ration shop unless he or she is prepared to be corrupt (Khera, 2011). It is this idea that drives our theoretical model.

The model may give the impression that corruption is inevitable in competitive industries. That is, however, not true; our model was developed for an environment in which bribery is worthwhile for amoral individuals. The way to root out corruption is to make sure that this is not the case in society. If, for instance, we choose a police force by selecting innately honest people or by having punishment rules which make it not worthwhile for an officer to take a bribe, then even in competitive industries there will be negligible corruption. Further it is possible for societies to develop self-enforcement norms whereby bad behavior is collectively punished by all and where people punish bad behavior because not to punish bad behavior is itself bad behavior (Akerlof, 1976; Basu, 1986).

Finally, by moving away from the patently unrealistic textbook assumption that all human beings are amoral and by allowing for the fact that people incur psychological cost for being corrupt, the paper draws attention to the role of the distribution of morality in a society.

# **References**

Acemoglu, D. and Verdier, T. (2000). “The Choice Between Market Failures and Corruption.” _American Economic Review:_ 90, 194-211.

Ades, A. and Di Tella, R. (1999). “Rents, Competition, and Corruption.” _American Economic Review:_ 89, 982-993.

Akerlof, G. (1976). “The Economics of Caste and of the Rat Race and Other Woeful Tales.” _Quarterly Journal of Economics_ 90(4), 599-617.

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Basu, K. (1986). “One Kind of Power.” _Oxford Economic Papers_ 38(2), 259-282.

Basu, K. (2010). _Beyond the Invisible Hand: Groundwork for a New Economics._ Princeton University Press.

Basu, K., Bhattacharya, S., and Mishra, A. (1992). “Notes on Bribery and the Control of Corruption.” _Journal of Public Economics:_ 38, 349-359.

Becker, G. (1968). “Crime and Punishment: An Economic Approach.” _The Journal of Political Economy:_ 76(2), 169-217.

Becker, G. (1957). _The Economics of Discrimination._ The University of Chicago Press.

Guha, A. and Guha, B. (2011). “The Persistence of Goodness.” _Journal of Institutional and Theoretical Economics:_ 168, 432-443.

Khera, R. (2011). “India’s Public Distribution System: Utilisation and Impact.” _Journal of Development Studies_ 47(7), 1038-1060.

Lambsdorff, J. (2006). “Consequences and Causes of Corruption: What do we Know from a Cross-section of Countries?” in _International Handbook on the Economics of Corruption._ Susan Rose-Ackerman (ed.), Edward Eglar Publishing.

Myerson, R. (2004). “Justice, Institutions, and Multiple Equilibria.” _Chicago Journal of International Law_ 5(1), 91.

Rose-Ackerman, S. (1975). “The Economics of Corruption.” _Journal of Public Economics:_ 4, 187-203.

Tirole, J. (1986). “Hierarchies and Bureaucracies: On the Role of Collusion in Organizations.” _Journal of Law, Economics, and Organization:_ 2, 181-214.

Yoo, S.H. (2013). “Competition, Corruption, and Institutional Design.” Mimeo: Korea University, Seoul.

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