The Annual Meeting of the Public Choice Society

Las Vegas, Nevada

March 6–8, 2009
Moshe (Konstantin) Yanovskiy, Sergey Shulgin, Sergey Zhavoronkov

DRAFT

Corruption’s efficiency boundary

conditions
The Problem

Generally, considering the corruption as a contract, all participants of this sort of

contract enjoy the benefits. So overall negative outcome follows from the negative
externalities caused by transactions of this sort (Shleifer, Vishny, 1993; Mau, 1996)
causing the Rule of Law destruction and encouraging the growing number of the market
agents’ opportunistic behavior (investment in the political decision making instead of
investments into efficient market decisions).
Corruption here is bribe for the illegal project realization only (not state run
robbery, blackmail etc.) i.e. it is voluntary transaction

Case described by famous Russian dissident Andrey Amalrik, Nazi and

communist regimes prisoners’ ransom cases proves almost strictly, that Corruption deals
could be Socially efficient if formal legislation basically denies any efficient outcomes
options.
So, the corruptive deal as a mean to avoid norms contradicting basic moral values
and common sense could increase common good significantly; corruptive deals
undermining actual “an empire of laws and not of men” decrease Social welfare.
The bribe, the corruption deal is basically beneficial for participants – both (for
example) as for official, obliged “to defend” poor morons from all kinds of self-reliant
decisions possible damage, who get money and for the businessman, who would like to
propose new goods or services to the consumers. Otherwise it called nod corruption but
robbery (blackmail etc). All the losses is caused for the 3-rd party by negative
externalities: See Shleifer, Vishny (1993). The situation for the mid-90-ties Russia

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described by V.Mau (1995) as “investment in the governmental decision-making” (the
situation which undermined incentives to invest in the goods and services production for
the market and the erosion of morale and confidence in the ability of authorities to carry
out the legal order, therefore - the general increase in transaction costs).
Case described by Andrey Amalrik (1982)– prominent soviet dissident of 70-ties.:
bribery for the wife’s visit in the concentration camp prolongation and the visits’ conditions
improvement which he presented as obvious example of socially beneficial corruption (he,
his wife, the corrupted officer benefited and no one lost).
Widely known cases of redemption in some form prisoners of the Nazi regime
(including the forgery of official documents, etc.). As well as the absence or extreme
scarcity of such practices in the USSR (which indicates a more serious and abhorrent form
of totalitarianism - see Buchanan). The same Soviet Union and most of it’s’ satellites
during the «cold war» nod permitted the free emigration of their citizens. At the same time,
Romania when Ceausescu practice permits to leave for the actual redemption. This kind of
corruption, obviously, increases the public utility (Social welfare).
Summing up we could stress: in a situation of lack of widely approved norms of
Rule of Law, basic individuals’ rights guaranties and respective legal order corruption
transaction avoiding the formal “legislation” and enforcement practices’ traditions
obviously contradicting to morals, common sense and the interests of the overwhelming
majority of agents, to bribe is an extremely effective as personally as socially (increases the
social welfare).
Marginal case is the coexistence of formal legislation based on the famous Rule
of Law and basic human rights principles supported by moral WITH the formal rules
obviously immoral, undermining Rule of Law by the immorality (some sort of modern
European and “progressive” US laws; in particular, - welfare state, universal suffrage and
caused by excessive regulations imposed on the business).
Perhaps, both liberals and conservatives, leftists and rightists could find a lot of
modern legal Acts which circumvention, including by means of corruption practices, they
would be willing to support or at least tolerated because of their belief that realization of
certain laws itself corrupts the legal system much worse than violation the same and
respective corruption (for the leftists it is - abortions ban, the death penalty, for the
rightists -legislation intervening in private family life with the aim of “defense” (actually -
wean) children from their parents, a violation of the rights of the 2-nd Amendment and the
right to defend itself, numerous violations of property rights, affirmative actions, political

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correctness censorship and application of the law on hate speech to suppress freedom of
speech and conscience, a ban on home schooling, etc.).

General model description

Assumptions

The bribery is the mutually beneficial contract.

Information about the contract and about the benefits broadly spread and becomes common
knowledge (hard version of the rationality of the market agents)
Under Rule of law (RoL) regime all non-prohibited contracts are acceptable.
All the deals are equally beneficial (because of equalizing effect of the competition).
Under Rule of Force (RoF) regime – all mutually beneficial contracts and agreements are
prohibited but officially prescribed.
So the bribe could cause the punishment (more or less determined and pretty severe) with
some probability under this regime.

Under RoL regime there is at least N contracts increasing aggregate social utility (welfare;
the more the contracts number - the higher GDP and social welfare)
The corruption deal benefits the both side. The benefit is caused by OR the budget
redistribution (so the deal burdens all the rest) OR the new barrier against free competition
establishment, preventing part of efficient (mutually beneficial without negative
externalities) deals (contracts) realization.
Assume, the number of the efficient contracts is the only criterion of economic efficiency
(Social Welfare).
If the corruptive deals appear to be more efficient than commercial, it causes switch of the
market agents from the commerce to corruption. Number of the contracts and GDP
decreases both because this effect and because the barriers established by the corrupted
official, preventing part of the contracts.
Common knowledge causes fall of trust the agents to each other and to the state, to the Law
so it prevents more and more contracts (negotiated by the most risk aversive people).
Political consequence: strengthening the groups of interest the most efficient in the
corruption and respective change of the political and legal framework of the business.
As under RoF almost all the contracts the bribe is given to avoid the barrier ant to promote
mutually beneficial contracts of the market agents (contract creative corruption).

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The common knowledge increases bribe – supply, the number of the contracts and social
welfare.
Political consequence: accumulation of the resources by the private persons and
strengthening their position in the political bargain with the State (if the state not ready to
use massive repressions against the people AND the people are not going to defend their
resources by force).

Rule of Law - General Welfare State

Let assume this oxymoron exists in Short Run (as transitional state from Rule of Law to
Rule of Judges under Judicial activism triumph, for example). To defend the market agents
against all imaginable and unimaginable externalities the state imposes restrictions,
establishes the barriers preventing a number of the contracts (for instance, FDA
administration prevents some projects). The barriers creation – doesn’t matter of the
incentives of the officials (caused by rent seeking or the general happiness seeking) not
only N of contract direct decrease. The barriers appeared by some occasion undermines the
trust to the state and cause suspects – the any contract could be cancelled suddenly and
would bring losses instead of profits, so the most risk aversive agents would abstain to
negotiate and to execute new contracts.
Let assume, the contract creating bribe causes double less trust erosion effect than contract
preventing bribe (because of rationality of the agents). Both type of the bribe could cause
the punishment with probability 3-fold higher and the severity 10-fold less comparing with
RoF regime.
The are trying to approach formal definition of the condition, when contract preventing and
contract creating behavior could made the market agents idle to the corruption as a
phenomenon.

Simplified model
Let begin our analysis from the simplified version of the model without calculation the
external effects. So we just assume the existence of two types of transactions – with
negative externalities and without same.
So, let’s assume that set of all deals di and suppose - there is the set of voluntary
negotiated and mutually beneficial transactions acceptable for economic agents (N).

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α - it is share of transactions containing (causing) negative externalities exceeding the
benefits of the participants of the respective transactions (so α N – is the set of transactions
decreasing the social welfare).
Let designate А >0 – general social losses of all transactions of set α realization (is got as
a result of summing all benefits and losses for this set of the transactions).

So (1- α) – it is all the rest transactions increasing general welfare. Let designate general
benefit of this set of transactions T. Generally W=W(N1- α) where is number of
transactions from the set 1- α.

There is two types of society Rule of Law and Rule of Force (see above).

Under case of unrestricted freedom (which never ends where 3-rd persons’ noses begin) the
Social welfare would be:
W=T-A

1) Suppose in the society perfectly targeted and prevented all transactions from the set α.
So social welfare would reach W = T.

In this very point every un-prevented transactions from the set α causes
decrease of social welfare.

2) Let examine the situation (RoF society) when prohibited all transactions but very narrow
set β, and designate the social welfare of this transactions
W=B

1- β – it is the set of prohibited transactions; let presume α∩β =0 (all permitted

transactions causes net gain for the W and all α – transactions is prohibited).

1- β > α

The ban violation could cause both growth and fall of social welfare W (if the transaction
without / with negative externalities has been executed).

A/ αN – losses caused by the transaction from the set α (with negative externalities);

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T/ (1-α)N – gain of the transaction without ones

If the transactions with (“bad transaction”) and without externalities (“good transaction”)
are equally probable the probability of good transaction’s realization:

Pg = (1- α - β) / ( 1- β)

And probability of the “bad transaction”:

Pb = α / ( 1- β)

Then the society would gain from the ban’s violation if the expected good transactions’
realization’s gains would exceed the bad transaction’s realization’ losses:

[(1- α - β) / ( 1- β)] * [T/(1-α)*N] > A α / ( 1- β) α N

OR

[(1- α - β) / ( 1- β)] * [T/(1-α)] > A / ( 1- β)

OR
T [(1- α - β) / (1-α)] > A

OR

T [1 - ( β / (1-α) )] > A (1)

Here β = (1-α) and it is the situation described above when set of permitted transactions это
как раз ситуация описанная в п 1. когда множество разрешенных сделок (β), coincide
with the set of externalities-free (1-α). In this very case the gain expected would be = 0
[1 - ( β / (1-α) )] = 0

If the β is relatively small (i.e. only small part of potentially profitable transactions is
permitted) and the gains of “good transactions” generally greater than losses of “bad” ones
(i.e. T >> A)

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And negligible part of transactions caused negative externalities exceeding the gross gain
i.e. :
α → 0. то β / (1-α) → β
and the bans violation is socially beneficial:

T(1- β) > A

Expression (1) described state could be reached from the initial conditions of Rule of Law
society too, where all non-prohibited transactions are permitted.

Let assume γ – it is the set of prohibited under RoL regime transactions.

The “good transactions’ ” probability:

Pg = (γ - α) / γ

The bad ones’ probability:

Pb = α / γ

In the expression (1) condition of net gain for social welfare of the ban’s violation
could be rewritten for the RoL case as:
T [1 - ( 1 - γ )/ (1-α) )] > A (2)

For the case γ = α the society obviously losses off the bans’ violation
independently of А / Т ratio, but if the number of the bans is increasing (i.e. γ is
increasing) the ban’s violation gains expected is growing too because of the probability of
net social gain of banned transaction’s realization.
The highest possible level of bans (overregulation would cause social profitability
of the bans’ violations) would be if aggregated expected gains of violations would be equal
aggregated expected losses.

T [1 - ( 1 - γmax )/ (1-α) )] = A (3)

[1 - ( 1 - γmax )/ (1-α) )] = A/ T

OR

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1 - A/ T = ( 1 - γmax ) / (1-α)

OR
( 1 - γmax ) =(1-α) (1 - A/ T )

OR

γmax = 1 - (1-α) ( 1 – A / T ) (4)

(1-α) – the set of the “good transactions”,

So if all transactions are “bad” (α → 1) so maximal level of the regulations (bans) → 1
independently of the ratio of gains (Т) and losses (А). I.e. even very heavy regulation
wouldn’t causes the efficiency of the violations because almost all transactions are “bad”.

If all potentially acceptable (without regulation) transactions are «good» i.e. not causing
negative externalities and, respectively, losses (α = 0, А = 0) then γmax = 0 i.e. violations
would be socially efficient for any level (share) of banned transactions.

If losses of «bad» transactions significantly less than gains of the “good” transactions (т.е.
A << T)
Than:
γmax = 1 - (1-α) ( 1 – A / T ) → 1 - (1-α) ( 1 – 0 ) → 1 - (1 - α) → α

it means, that for this very situation (good transactions opportunity overwhelmingly
dominates the bad ones) exceeding of pretty low level of regulation (share of banned
transactions) makes violations potentially beneficial for the society.

So only regulation restricted by condition γmax → α

Could be efficient in the sense that all violations of the bans would cause social losses.

Russian’s state-business relations practices (the preliminary results of the IET project
“Actual barriers and sources of political and legal risks for the business in the Russia”
granted by the Severstal company)

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The entrepreneurs interviewed last winter (2008-2009) complained of the absence of any
stable written procedures for preparation of documentation for the building in the
determined branches in Central regions of Russia.
The rules changes significantly twice a year for the importer of some groups of the luxuries
(looks like state’s care about the richest people of the country).
Survey ordered by IET to VCIOM public opinion research center (September 2008) shows,
that 53-71% of SME meets discretionary actions of the state officials of various bodies
more or less regularly (“sometimes” or “often”).
Under the conditions described the choice: OR to go out of business OR to bribe officials is
the only options of the menu acceptable. The first option causes losses for the businessmen
and for the employed people and for the state’s budget finally.
To damage the legal order (RoL) it is virtually impossible because of the absence of the
latter in the country. So, on the first look the models’ conclusion doesn’t contradict the
common sense and observed situations for the cases which are under research.

Preliminary conclusions:
1. Attempts to extend international anti-corruption war not necessary cause positive
outcomes for all countries;
2. Growing number of morally suspicious and anti-market regulations in the Western
countries shift the legal order close to the Corruption’s efficiency boundary.

Amalrik, Andrei “Notes of a Revolutionary” Knopf 1982

Mau Vladimir “The Political History of Economic Reform in Russia”, 1985-1994 London:
Centre for Research into Communist Economies, 1996.
Sleifer A. Vishny R. “Corruption” Quarterly Journal of Economics Vol 108 No 3 August 1993
pp. 599-617