Corruption, Market Quality and Entry Deterrence in Emerging Economies

Author Name Krishnendu Ghosh DASTIDAR (Jawaharlal Nehru University) / YANO Makoto (Chief Research Officer, RIETI)
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This Non Technical Summary does not constitute part of the above-captioned Discussion Paper but has been prepared for the purpose of providing a bold outline of the paper, based on findings from the analysis for the paper and focusing primarily on their implications for policy. For details of the analysis, read the captioned Discussion Paper. Views expressed in this Non Technical Summary are solely those of the individual author(s), and do not necessarily represent the views of the Research Institute of Economy, Trade and Industry (RIETI).

This paper addresses highly theoretical issues, which might appear to be too abstract to permit a practical application. However, for both economics and government policymaking, our findings have important implications relating to what we call "market quality theory." Thus, in this summary, we will explain the findings from our study from the viewpoints of economics and policymaking.

Yano's market quality theory is based on the following two propositions (Yano (2009, 2010)):

  • High quality markets are indispensable for the healthy growth and development of modern economies; and
  • The development of properly designed market infrastructure, such as rules and laws, is indispensable to ensuring the high quality of the market.

In the paper, we attempt to verify these propositions theoretically from the perspective of the relationship between corruption and growth in emerging economies.

Yano (2009) defines "market quality" as a composite measure comprising two indexes, one indicating "efficiency in resource allocation" and the other measuring "fairness in dealing." Efficiency in resource allocation, needless to say, refers to the degree to which resources are utilized without waste, which has been one of the major themes in economics in the past. Meanwhile, fairness in dealing is a relatively new concept introduced in Yano (2007, 2008, 2009, and 2010). It refers to the degree to which rules and regulations governing market competition enable the effective utilization of the market. In this context, fairness in dealing depends on the design of rules and laws per se as well as on institutional systems for ensuring compliance and people's mindsets. Various studies have shown that a decline in market efficiency in allocating resources deters economic growth. However, no studies have examined how fairness in dealing affects technological innovation and economic growth.

Dynamics of Market Quality with Respect to Regulatory Changes and Technological Innovation
Dynamics of Market Quality with Respect to Regulatory Changes and Technological Innovation

This study is an attempt to verify the aforementioned two propositions of quality market theory by studying the process in which new technologies are embodied in an economy from the viewpoint of the relationship between corruption and regulatory restrictions on new entries in emerging economies, with a particular focus on India. Obviously, corruption is detrimental to fairness, and the presence of rampant corruption causes a decline in market quality. If incumbent companies can influence the government by bribery or other means, to implement entry restrictions and raise barriers to potential newcomers, they are also influencing the efficiency in resource allocation.

We show that corruption may deprive a country of its economic vitality by deterring technological innovation, using the Bayesian-Nash equilibrium in an incomplete information game. In order to expound on the content of our study, it is necessary to explain the underlying theoretical model. The paper considers a horizontally differentiated duopoly market and analyzes the relationship between corruption and entry restrictions by using a three-stage game of entry deterrence. We assume that a potential entrant is more capable of adopting a superior technology than the incumbent. This assumption enables us to incorporate into our model the possibility that corruption might create inefficiencies by slowing market metabolism. We assume that the incumbent can bribe the government to impose stricter entry restrictions and thereby delay the obsolescence of its technologies. Furthermore, the effectiveness of bribing depends on the level of fairness prevailing in the market. Thus, we assume that the higher the level of fairness, the less effective is bribing by the incumbent, and that the lower the level of fairness, the more effective it is.

In the first stage of our game, the incumbent is to determine the size of a bribe. In the case of developed countries, we may use the size of lobbying activities as a proxy measure. We assume that the greater the size of the bribe, the higher is the probability for the government to increase the potential entrant's variable cost (marginal cost) to make it difficult to enter the market. Next, in the second stage, the potential entrant is to decide whether to enter the market based on how the cost compares to its expected payoff after entry. In the absence of bribery, the potential entrant is certain to enter because its technology is superior to that of the incumbent. However, in the presence of bribery, it may or may not enter the market because of the higher variable cost resulting from the imposition of stricter regulations by the government. In the third stage, an equilibrium is to occur under Cournot competition to determine the level of payoff for each player. If the potential entrant decides not to enter the market, the incumbent will obtain the monopoly payoff.

Under this setup, we analyzed how the model behaves in two different situations, namely, when the incumbent has perfect knowledge of the entrant's technological capabilities (complete information) and when it does not (incomplete information). Our major findings are as follows. When the fairness of the market is sufficiently high, in equilibrium, the incumbent would not pay any bribe regardless of complete or incomplete information. Next, when the fairness of the market is at an intermediate level, the incumbent would pay some bribes but not so much as to block the entry of new players. In this case, we find that the greater the uncertainty about the potential entrant's technological capabilities as seen from the incumbent, the lower are the entry barriers. This finding is similar to that of Maskin (1999) in that an increase in such uncertainty reduces the incumbent's expected loss resulting from the entry of the potential entrant. Lastly, when the fairness of the market is sufficiently low, the incumbent would pay bribes large enough to block the entry of the potential entrant.

By defining the notion of fairness in terms of the level of corruption and bribery, this paper shows that the design of rules and the extent to which they are complied with affect the level of technological innovation. Attempts to introduce entry restrictions by illegal means or legal but socially unacceptable political means are often observed not only in developing economies but also in developed economies such as Japan and the United States. It is highly probable that such activities operate to slow the pace of technological innovation. In other words, increasing market transparency from the perspective of fairness will likely contribute significantly to economic growth.

In considering the case of developed economies based on those findings, one should take note that the positive significance of government activities is disregarded in the paper. As assumed in the rule of reason under the U.S. antitrust law, every activity has its positive and negative sides. The same holds true for government activities. It is not prospectively evident whether to rule out a certain government activity or to recognize its positive significance. The decision over where and how to draw the line between positive and negative government activities is also subject to the influence of incomplete information. Thus, we need to take this duly into account in conducting analyses as well as in designing regulatory systems.

  • 1. Maskin, E.S. (1999) "Uncertainty and entry deterrence," Economic Theory vol. 14, pp. 429-437.
  • 2. Yano, M., (2008) "Competitive Fairness and the Concept of a Fair Price under Delaware Law on M&A," International Journal of Economic Theory 4-2, 175-190.
  • 3. Yano, M., (2009) "The Foundation of Market Quality Economics," The Japanese Economic Review 60-1, 1-32.
  • 4. Yano, M., (2010) "The 2008 World Financial Crisis and Market Quality Theory," Asian Economic Papers 9-3, 172-192.
  • 5. Yano, M (2007), "Shijo to Shijo Kyoso no Ruru [Markets and Rules for Market Competition]," in Yano (ed.), Ho to Keizaigaku[Law and Economics] , University of Tokyo Press