What Is the Effect of Market Competition on Corruption? Some Surprising New Findings

How does market competition affect the prevalence of corruption? Some people think that increasing competition could decrease corruption (see here and here). The intuition is that increased competition lowers firms’ profits, meaning that public officials cannot extract as much money out of the firms through extortive threats (e.g., a threat to falsely report noncompliance with safety regulations unless the firm pays a bribe). As the saying goes, you can’t squeeze blood from a turnip. By contrast, the argument continues, in less competitive markets firms have higher profits, and officials, knowing this, can use threats to extract some or all of this surplus for themselves. However, others have argued that increased market competition may lead to more corruption. Those taking this position tend to emphasize collusive rather than extortive corruption (see here and here) and point out that increased market competition makes collusion—which is, of course, a risky proposition—more attractive to firms, because the firms have more to gain from a leg up on their competitors. For example, an importing firm that pays a bribe to avoid paying customs duty will receive greater benefit from this competitive advantage when competition is fierce, since it will allow the firm to reduce prices and increase its market share more extensively. A monopolistic importer, by contrast, has less of an interest in paying the bribe to avoid the import duty, since a monopolist can offset much of the duty by raising consumer prices without needing to worry about losing much market share.

So, one can construct plausible theoretical arguments in both directions. What does the empirical data say about which story is closer to the truth? There have been a handful of studies so far, but they provide contradictory or equivocal results—some studies find that more competitive markets are associated with less corruption (see here, here and here), but others have found the opposite. But these studies focus on “corruption” generally, while the theories sketched above suggest that the effect of market competition on corruption may differ depending on the type of corruption—coercive or collusive. One prominent study, by Alexeev and Song (2013), explicitly incorporates this distinction and finds—based on analysis of data from the World Bank Enterprise Surveys of manufacturing firms in different countries—that increased competition increases the prevalence of collusive corruption. While this is an important step in the right direction, the survey data used here is still not ideal: the measure of “collusive corruption” is based on the respondent firms’ answer to a question about the amount of money firms in their line of business typically need to pay to public officials each year “to get things done,” which seems both vague and potentially overinclusive.

Luckily, later on the World Bank Enterprise Surveys expanded the range of corruption measures collected as part of its Investment Climate surveys in developing countries, recently publishing the latest of these surveys (get the data here), that may shed new light on this debate. The attractive feature of this more comprehensive survey data is that, in contrast to the data used by Alxeev and Song, the new surveys ask not only about the one vague measure of corruption, but ask separately about four different kinds of informal payments: to tax officials (hereinafter tax bribe); to secure government contracts (hereinafter contract bribe); to secure an import license (hereinafter import bribe); and to secure an operating licensing (hereinafter operating bribe). The survey, both in its current and older version, further asked every firm to report the number of competitors that it faces in its market of operation, which provides a ready firm-specific measure of market competition.

A thorough analysis of the competition-corruption link using this new data will need to await future work, but as a first step, I conducted some preliminary, exploratory quantitative analysis of the Investment Climate survey data. The results were surprising, and suggest not only is asking whether “corruption” is positively or negatively correlated with market competition is too crude, but also that even the proposed collusive-coercive distinction does not adequately capture the nuances of the relationships between competition and various forms of corruption.

My preliminary analysis consisted of a multivariate statistical regression, where the primary explanatory variable of interest is the degree of market competition, and the primary outcome variables of interest are each of the four types of corruption noted above. (The regression also includes a set of control variables drawn from Alexeev & Song’s prior study.) My findings were as follows:

  • Higher levels of market competition have a statistically significant positive correlation with paying contract bribes and import bribes.
  • Higher levels of market competition have a statistically significant negative correlation with paying tax bribes and operating bribes.

This seems like strong evidence that the relationship between market competition and corruption depends crucially on the type of corruption, but at the same time, these results do not seem consistent with the simple version of the coercion-collusion theory. It does not seem plausible that contract bribes and import bribes are clearly forms of collusive corruption, while tax bribes and operating bribes are forms of coercive corruption. Indeed, paying bribes to reduce taxes and to get operating licenses could be seen as collusive, as they advance the firm’s interests. Furthermore, even if these practices include instances of coercive interaction, there is no apparent reason to think coercive tax and operating bribes would be more common that coercive contract or import bribes. So what is going on?

I would suggest that the emphasis on the coercion-collusion distinction in this context is premised on the mistaken conjecture that the relationship between market competition and corruption depends entirely on whether the firm benefits from the corrupt behavior (as in the collusive case) or is harmed by the corrupt behavior (as in the coercive case). While it is true that collusion occurs when there is a benefit to the firm from engaging in the corrupt interaction, there are different types of benefits, and only some of them are related to market competition. Specifically, we must distinguish (1) benefits that improve the firm’s competitive standing, from (2) benefits that aid the firm but do not improve its competitive standing. It is only the former types of corrupt practices that we should expect to be positively correlated with market competition. Recognizing this distinction helps account for the otherwise surprising pattern I found in the Investment Climate survey data, as follows:

  • Both contract and import bribes straightforwardly grant the firm that pays them a competitive advantage. Import bribes directly reduce a firm’s production costs, allowing it to lower prices and secure a larger market share. Similarly, contract bribes directly increase the firm’s market share by granting the firm a larger slice of the (finite) government contracting “pie.” So, greater market competition means that these forms of corruption (whether we frame them as “collusive” or “coercive”) are more valuable for firms, and they become more widespread. And this is consistent with my findings in the data.
  • By contrast, tax bribes, even when collusive, do not necessarily create a competitive advantage. Colluding with a tax official to lower a firm’s tax liability entails sharing the “profits” from this collusive deal with the public official at the expense of the state’s treasury, not other firms. This sort of corruption increases a firm’s profits, but it does not lower its production costs or allow the firm to do anything to lower its prices or obtain a larger market share. When the market is more competitive, firms have lower profits, and therefore there is less gain to be had from bribing tax officials. So, even when tax bribery is collusive, increased competition would be expected to result in less corruption of this type, which is consistent with what I found in the data.
  • Operating bribes are harder to categorize because they might enable a firm to enter a new market. But the costs associated with entering a new market are sunk once the firm enters it, and therefore decreased entry costs do not give a firm any competitive advantage once it has entered that new market and is competing. Therefore, three’s no reason to expect that even collusive operating bribes would be positively correlated with market competition. But what explains the negative correlation that I found in my preliminary analysis? One possibility is that the coercive nature of many of the operating bribe interactions (public officials extorting money to issue licenses to firms that meet all of the requirements) provides the explanation.

Two final notes: First, because the measure of market competition here is not a policy measure, but rather a measure of actual (and self-reported) competition, care must be taken in interpreting the results, and in deriving conclusions for policy. While the discussion here has focused on the ways in which market competition may affect the level of corruption, it’s certainly possible that the causal arrow runs in the other direction as well. For example, certain markets might be less competitive in practice because the public officials in charge of granting operating licenses demand bribes, thus erecting artificial barriers to entry. Or it could be that in countries with very high tariffs, import bribes might increase market competition by allowing a larger set of firms access to important production components. Again, the analysis here is preliminary; further research, and more rigorous statistical testing, will be needed to nail down the causation question. Second, market competition is undoubtedly important for numerous reasons unrelated to corruption, and so the findings here, even if they prove robust, should not be interpreted as standalone arguments for or against attempts to foster more competitive markets.  Nonetheless, it is useful for legislatures and administrative agencies tasked with promoting anticorruption policies to be more aware of the possible effects that competition may have on the prevalence of corruption, accounting for the unique economic characteristics of each corrupt practice.

8 thoughts on “What Is the Effect of Market Competition on Corruption? Some Surprising New Findings

  1. Here is an example of collusive corruption taking place on taxpayer-funded contracts in the UK right now – all because the government in not applying its own competition policy.

    The clear message behind the government’s defence procurement policy is that military equipment for the UK Armed Forces is to be purchased through fair and open competition – the only exceptions being off-the-shelf purchases and single-source development contracts, the latter to be handed out on a preferential basis (to the Select Few).

    For decades now, it has been the policy of successive governments of all persuasions to hand out single-source, development contracts to selected UK-based defence contractors on a preferential basis. Indeed, according to the government’s own figures*, 58% of new MoD contracts by value were placed on a non-competitive basis in 2016/17, up from 36% in 2010/11 – which leads one to conclude that the trend is towards more of the same.

    By letting government-funded contracts in this way, the Ministry of Defence has shown leadership and set an example by inadvertently directing prime contractors to adopt the same method of hand picking their first-tier supply chain partners, for each dissected workshare part of their evolving technical solutions.

    But unlike MoD, which has been disbursing such contracts on national security grounds, prime contractors have been using the tried-and-tested old boys’ network to choose their first-tier subcontractors, usually during a gathering at the 19th Hole limited to the great-and-the-good from subsidiary companies wholly-owned by the prime contractor, or some other favoured, old school-tie chums – which has allowed corrupt activities, characterised by artificially inflated subcontract prices and the obligatory kickbacks that go with them to flourish. It is the stupid act of disclosing the budgeted expenditure figure in the invitation to tender that has given prime contractors the opportunity to ‘divvy up’ this money in the same way as they dissected the technical solution into its workshare parts, thereby offering leeway for discretionary payments.

    By its very nature, this type of clandestine activity in the defence industrial supply chain is very difficult to unearth, because the extremely small number of people right at the top who benefit from it will go out of their way to keep it under wraps, citing the excuse of commercial confidentiality whilst skilfully covering their tracks.

    It is truly a bizarre situation, where the buyer tells the seller (confidentially) the price level at which he should pitch at, so that they can both profit. A scenario which can only occur on government-funded contracts – only because public servants are asleep at the wheel!

    But what is especially disturbing about this epic story of bribery and corruption is that, it is instigated and perpetuated by people who were previously in the pay of the State – given that the workforce on defence contractors’ premises, large or small, is made-up entirely of former public servants who came across in overwhelming numbers, via the ‘revolving door’ to pursue a second career in the private sector.

    Whatever happened to the much-vaunted principles of selflessness, integrity, objectivity, accountability, openness and honesty which was supposed to define these people?

    What’s more, MoD’s green lighting of this practice has prompted first-tier subcontractors to also select their lower-tier suppliers in the same manner, paving the way for the entire defence industrial supply chain to be corrupted, right down to the lowest level of piece-part & component manufacturers.

    But the real tragedy about this whole sorry saga is that agile and innovative engineering businesses from adjacent sectors, who have not previously engaged with MoD, have been shut-out from the opportunity to act as subcontractors to these defence prime contractors, which would explain why it has failed so miserably to comply with the government’s policy of spreading prosperity around by increasing the proportion of MoD spend with small and medium-sized enterprises to 25%. The actual figure for financial year 2017/2018 was 16.5%.

    Additionally, not using the market-based instrument of fair and open competition to select first-tier subcontractors has the effect of protecting these defence SMEs from being exposed to the full rigours of the free market, that is to say, shielding them ‘feeling the heat’ of competitive market forces, which has in turn, led to them becoming grotesquely inefficient, because they are simply being gifted a steady stream of uncontested subcontracts which they expect to receive in perpetuity – cultivating an entitlements culture.

    It is also the reason why engineered products manufactured by indigenous prime contractors cost substantially more than equivalent items in the non-defence sector – which would explain why they have become seriously uncompetitive both, in the domestic market and in export markets.

    It is a mystery why the government would want to tolerate this sort of criminal behaviour on taxpayer-funded contracts, given the intense focus of attention on the dubious habits of the private sector right now, and the uncertainty surrounding the continuance of free market capitalism in the UK.

    * Defence Industrial Policy document entitled “Industry for Defence and a Prosperous Britain: Refreshing Defence Industrial Policy”, published by UK Ministry of Defence, December 2017, page 23, PDF file (1.28 MB) https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/669958/DefenceIndustrialPolicy_Web.pdf

    • That’s fascinating! I wonder if increasing competition through other means, in a way that will incentivize more players to enter these markets and participate in MoD (or subcontracting) tenders, may put some pressure that will make it harder for the current small network of companies to get the entire share of the pie; or whether they are so unafraid of possible legal repercussions that they will maintain these practices despite the increased suspicions that will follow if they keep on winning at the same rate despite the increased competition

  2. Thanks for the great post Haggai, this is really interesting work. I know this is still fairly preliminary, but I do hope you’ll expand on this at some point. As of right now, I think the biggest concern I have relates to the possibility of reverse causality issues. Do different levels of competition cause different patterns of corruption or do different corruption structures lend themselves to different patterns of competition? Moving forward, it would be interesting to see if you could find some cases where one of these variables clearly changed, and do a deeper dive to track the timing of the other variables’ change. It seems like shifts in competition would probably be easier to identify externally. Perhaps you could look at a major shock like the breakup of the Soviet Union or China’s shift to a more capitalistic economy and see how corruption patterns change (if you can get that data, which I imagine could be challenging). Otherwise, perhaps you can focus in on some less dramatic, but more data rich examples, perhaps even at the sub-national level, and see what you find. I think the results could have a lot of important implications!

    • Thanks, Maura, it’s a great comment and I share your concern. Alexeev & Song used an instrumental variable approach to show that the (possible) simultaneous effect that I reported in the post remains qualitatively unchanged when instrumenting the measure of competition and thus separating the effect of competition on corruption from the opposite effect. While this is reassuring, since I reported results that replicate their specification on the same but more recent data, I will certainly need to go deeper at the next step of the analysis.
      As to exogenous shocks, at least in this context, I think it would be easier to try and come up with an instrument for competition, because I am slightly pessimistic as to the possibility of finding a natural sock to competition that is not only large enough, but also exogenous, and preferably affecting only some countries and not others (for example, the 2009 reform in the EU of competition law that I looked into did not prove exogenous enough)

  3. Very interesting post. It would be relevant to identify causation or correlation between corruption and other phenomena. However, I am a little bit skeptical about the feasibility of that task. One of the main difficulties related to the theme refers to measurement of corruption. When can corruption be considered higher? When more companies pay bribes or when more public officials receive them? When the (individual or total) value of bribes is higher, regardless of the number of payers and receivers? Or should all factors be considered jointly?

    From my point of view, corruption is like a mutant virus. It easily adapts to any kind of environment, democratic or not, liberal or statist, with or without concurrence. It only changes some of its characteristics.

    • Thanks Rodrigo, that’s a great point. I do control for several features that may be affecting corruption independently from competition, to get closer to causality, but I agree that it’s unlikely that we will ever be able to catch everything. The point about measuring corruption is also interesting. The current measure that I used is either binary, whether a specific firm did or did not make informal payments in a specific year; or the actual sum of payment/s that were made as a percentage of the firm’s sales, where that data was available. I certainly agree that our interpretation of corruption should be sensitive to the measure used – a lot of firms making small frequent payments to public officials is a different social phenomenon than a few firms making large payments. I don’t have a good intuition which is worse, but I imagine that you would agree that both are significant manifestations of corruption

  4. Dear Haggai Porat,
    A nice piece which opened a discussion in general and it may lead to more rigorous inquiry in in research circles. I want to add one more point based on the experience in the Indian ‘open’ markets. India embraced globalization post WTO and opened its markets. One of the sectors I would like to talk about is telecom. India is one of the countries where data revolution is happening (you will realise this if you check the sale of mobile phones and internet connections).
    That said, the mobile service players (who are four or five) seem to have systematically made a cartel in the guise of market competition (which I feel is doubtful). Apart from other types of corruption, this cartelisation is another method to reap windfall profits. This can also be looked into in due course of time. Good Luck. Am a journalist and a PhD candidate in corruption based in Bengaluru, India

  5. Haggai – this is excellent original work! Finding different statistical significance’s between market competition and the kind of corruption is very insightful. Building on the limitations you’ve stated with the World Enterprise Survey, I am wondering if you have any similar concerns with the methodology of the Investment Climate data itself. Are there any incentives for businesses to over or under report these measures? Also wondering about how the survey respondents are selected? The other thought is the relevance to developing countries where the economies are still largely informal, and perhaps face different categories of payments.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.