Hello, welcome back to our course on corruption. This is week 2, lesson 1. And in this lecture, we're going to talk about Societal Level Effects of corruption, the big effects of corruption. And those effects can be summarized in two words, distortion and misallocation. Distortion and misallocation occurs because of two separate kinds of things that are going on. One is a decision making process and the other is the creation of parallel institutions. We'll talk about the process first, and the process has a lot to do with distorted incentives. And when we talk about this, remember that these decision makers are very active in the economy. Just as an example, the largest consumer of personal computers in the entire world is the federal government of the United States of America. So a contracting agent for the federal government of the United States of America has a profound influence on the economy of personal computers. So decision makers we're talking, about even though each of them may seem insignificant, they're very active in the economy of the world and they have a lot of influence about what happens. Now in a clean system, the incentive for making a decision is price and fit, and that's the beauty in the market. The beauty in the market is decision makers are making the decision based on price and fit. But in a corrupt system a decision maker makes their decision based on the quality of a bribe. I'm going to pause here for a second and talk about the phrase quality of a bribe. A lot of people who haven't had a lot of experience with corruption think that a bribe is evaluated entirely on how much money's involved, but that's not quite accurate. All of the money in the world will do me no good if I can't use that money. So a high quality bribe is a bribe that's not just valuable, it's also something that I can use. Something that's hidden, something that's secret, something that's not going to get me in trouble. That's a high quality bribe. In a clean system, because decisions are based on price and fit, producers have particular incentive, and that is an incentive to use its resources to lower the price and increase quality. Again, the beauty in the market. A market, which obviously doesn't solve all problems and is not perfect for everything, but in general, a market creates an incentive. People who have resources use those resources to create goods or services that are offered at the lowest price and the highest quality, the best fit, for people who consume those goods or services. In a corrupt system, on the other hand, the incentive is to use resources to produce a high quality bribe, not high quality goods or services. If a decision maker is making decision based on the quality of the bribe, a producer who produces high quality goods or services is actually the disadvantage, because they've used their resources for something other than what the decision is being based on. The producer that produces without reference to, without thinking about, quality or [COUGH] price actually is at an advantage because they can use their resources to produce a high quality bribe. This results in all kinds of things and we'll talk about those in a second, but you probably have familiarity with some of them. When apartment buildings collapse, when bridges collapse, when department stores collapse, investigations into those collapse often find that the apartment building, the bridge, the department store was not built according to standards. It didn't meet quality standards. Why didn't it meet quality standards? Because the firm that constructed that building, department, the bridge, the department store used its resources to bribe inspectors. And having used those resources to bribe inspectors, there was no need, in fact, there's an incentive not, to meet standards. You see this all over the world. We also see projects that have no meaning. A bridge without a road on either end, a bridge not over a river or over a ravine, just a bridge sitting there in isolation. Why was it built? It was built because the corrupt incentive said we'll produce a higher quality bribe building this bridge than doing anything else. And those resources, the resources that went into that bridge, are not being used to build a hospital, to build a school, to build a vocational center, to build something productive, meaningful. Something that would contribute to that society and that economy. Corruption creates incentives that distort and misallocate where things go, specifically this manifests itself in all kinds of ways. Now, 40 years ago, maybe even 30 years ago, the predominant theory was that corruption merely moved rent and rent is a term that economist used to describe that which is produced, the value that's created. And the theory was that the value just moved from one party to another, we know, and we've shown in myriad ways that, that's no longer true. So for example, corruption distorts price. It distorts price because these incentives mean the money moves around in ways that it really shouldn't be moving around. And price, of course, is one of the most important piece of information in any kind of market economy. Without that market economy there are further distortions, all treated by these misincentives. Corruption creates monopolies and excludes competition. One of the most frequent stories about paying bribes is, I paid a bribe to be the exclusive. I paid a bribe to be the only one with access. I paid a bribe to exclude all my competitors. And of course, monopolies are their own form of distortion and create distortions throughout the economy. And the exclusion of competition means that we lose the beauty of the marketplace, and so there are further distortions created. Corruption reduces the flow of goods. This is why the World Trade Organization finally became interested in the issue of corruption. Corruption reduces the flow of goods because it acts as a hidden tariff on goods. When a party have to pay a custom's agent to get their goods across the border, that makes those goods more expensive to get in into that country and makes those goods more expensive once they're in the country. Because it's more expensive to get goods into that country, people send fewer goods into that country. And because the goods are more expensive once to get into that country, people buy fewer of them, creating an incentive to not send so many goods into that country. And so it reduces the flow of goods, and therefore, reduces the choice available to consumers in this country. It also denies access to goods that would increase the well-being of the people in that country and the overall benefits to people in that country. Corruption lowers the tax base. I'm sure you can see how it does that. In some circumstances it's less expensive, it's cheaper, to pay a bribe to the tax collector than it is to actually pay the taxes that are due. I want to pause on this one as well. Because remember, a lot of the polities, a lot of the countries that we're talking about, are still going through the profound changes that started in the 50s or 60s, or more recently, in the 80s and the 90s. We think of the 80s and 90s as being a long time ago, but in terms of developing a country, in terms of getting done all the things that need to be done in these kinds of transitions, it's still early days. So these countries are facing a lot of demands. There's a lot of things that need to be done and they need money to do those things. So the lowering of the tax base, the diminishment of the amount of money that these countries have to spend, has a profound effect all through the economy and all through society. An effect we can see is very difficult to measure. And then finally, these distorted incentives divert resources from efficient or socially desirable uses. I mentioned the bridge, again, that bridge is being built instead of a hospital, instead of a school, instead of a vocational center, instead of something that society wants. Or perhaps more importantly, the society really needs. And again, this is going to have the effects secondary, third, fourth effects, it's going to have the effects that go throughout the society and throughout the economy. So it's very important to understand. Corruption does not just involved taking value from one party and moving it to another party. Corruption is not just a transfer of rent. Corruption, because it changes incentives, distorts and misallocates how an economy operates in profound ways that ripple in effect for a very, very long time and well beyond the actual incident of corruption. There's another way in which corruption affects society and exacts a cost on society at a large level, and that is through the creation of parallel institutions. Now we talked about this a bit in the last lecture, but it's important to understand that people don't trust corrupt institutions. We're going to talk about that one some more. But right now, people don't trust corrupt institutions and you can understand why, but people will get done what they need get done. Again, we've seen this throughout history. And so rather than using institutions that they don't trust, they create their own, and we talk about this in everyday language all the time. We talk about black markets. We talk about underground economies. We talk about loan sharking. Wherever you're from, whatever language is your primary language, you have words for these things. They're so common that they've entered our everyday parlance. But parallel institutions do exact a cost, with parallel institutions we lose economy of scale. In one country that I did research in, I found that there were 11 parallel judicial systems, 11 parallel systems that were used to regulate business disputes. Rather than the economy of scale that would be accrued through having one nationwide system, the resources required to create 11 parallel institutions were devoted to the regulation of business disputes. Parallel institutions generally are not regulated. Now, they're regulated in an informal basis by the people that use them, but they're not regulated in a societal basis. They're not regulated by someone or something that's impartial. Loan sharking, for example, tends to predatory. It tends to involve rates that are exorbitant and people who are forced to turn to loan sharking rather than what would otherwise be an official source of loans, suffer and it exacts a social cost. And finally, parallel institutions are not accessible to everyone. Because parallel institutions are informally created they're informally enforced, and they are limited to people to whom those enforcement mechanisms extend. And that's why in that particular country that I looked at there were 11 different parallel institutions, because not everyone had access to 1 or to number 2 or to number 3. And so each group that didn't have access to another created its own. When institutions are not accessible to everyone it limits the number of relationships that we can form. And when we limit the number of relationships that we can form, we limit things like entrepreneurial activity, cooperation, or the synergies that are created when people cooperate. Therefore, we know that parallel institutions are costly to society. I caveat this with we don't know how costly to society. We have not yet developed tools to measure these costs. So while we can measure the costs created by the distorted incentives, it's very difficult to measure costs created and inflicted on society by parallel institutions. Costs to society are created through distortion and misallocation, and that occurs because incentives are distorted, there is misallocation, and there are parallel institutions. Thank you and I look forward to seeing you for the next lecture.
