StudySpace: Economics in Development, 6th Edition

Worked Example: Rent-Seeking Behavior

The textbook explains that government interventions can create economic rents—abnormally high returns—that lead to parallel markets and rent-seeking behavior. You can see how this works by using simple supply-and-demand analysis. Figure 5–1 shows the supply and demand for flowers in Gardenia, per week. The government has imposed price controls to fix the price of flowers at $0.50 per bouquet, to benefit urban consumers. Flowers are sold at this price through state-owned flower shops. The supply curve shows that rural flower growers have an incentive, at this controlled price, to market only 100 bouquets per week (point A). Yet urban consumers demand 500 bouquets (point A′) per week. Because of the price controls, there is a serious shortage at the government shops.

The shortage at the government shops breeds opportunities for traders to earn economic rents in the parallel (or black) market. If the shops only sell 100 bouquets per week, unsatisfied flower lovers would pay as much as $2 per bouquet (point B on the demand curve). The shortage creates an obvious opportunity for unauthorized traders to earn high profits. For example, traders can offer farmers $0.75 per bouquet, at which price production will rise to 225 bouquets per week (point C on the supply curve). The traders find consumers are willing to pay $1.50 per bouquet (point C′ on the demand curve). Faced with an offer of $0.75 per bouquet, farmers divert their entire output to the parallel market; this leaves shelves bare at the government shops. The traders start to drive fancy cars, while government statistics—which exclude the parallel market—report that flower production shriveled to zero.
Then the government cracks down on “unscrupulous traders who fleece honest citizens” by charging high prices. Compelled again to deliver to official shops at the controlled price, flower growers reduce output to 100 bouquets per week. Before long, shelves in the shops are bare again. Why? This time it’s the government officials who are diverting flower supplies to the parallel market, to capture economic rents created by the price controls. Some of the rents are shared with the police, who solicit bribes to look the other way.

The figure suggests that competition eventually can drive down the price to the free-market equilibrium of $1 per bouquet (point E), where excess profits disappear. This is possible. But the illegality of the parallel market in Gardenia—in some countries profiteers can be sentenced to death—and the cost of bribes will limit the extent of market activity and hold the price above $1. Ironically, removing price controls would cause the average price paid by consumers to fall to point E.

The price-control policy is highly inefficient: The government runs a chain of flower shops with bare shelves while in furtive parallel markets flowers sell at inflated prices. Moreover, flower production wilts relative to the free-market equilibrium outcome. Why, then, did the government impose the price controls? The intention was to promote the urban industrial sector by holding down the cost of living for urban workers, and for government officials, who happen to be very fond of flowers. Why is the policy not reversed when the side effects appear? Maybe the answer has something to do with government officials who are sharing in the rents.

Exercises

1. It is your turn to analyze how government interventions create rents that lead to parallel markets and corruption. In Figure 5–2 the supply and demand curves are the same as in the Worked Example. This time, however, the supply curve (S) represents flowers that are imported into Gardenia from a neighboring country. Gardenia initially has no domestic flower industry.

FIGURE 5–2

a. What is the equilibrium market price and quantity of flowers in Gardenia (at point E)?

PE = $ .

QE = bouquets per week.

b. The government of Gardenia views flower growing as an infant industry, which should become competitive after a learning period. Initially, however, domestic production costs will be very high. The government concludes that the industry will not develop without protection.

(i) Draw a straight line through points F and G in Figure 5–2. Label this line S′. This line indicates the domestic supply curve (that is, supply from domestic producers).

(ii) To nurture domestic production, the government bans flower imports. The market equilibrium is now determined by the demand curve and the domestic supply curve S′. What is the equilibrium price and quantity after the ban on imports takes effect?

P′ = $ .

Q′ = bouquets per week.

(iii) The ban on imports succeeds in cultivating a new industry of flower production in Gardenia. But how does the import ban affect flower consumers?

c. This government intervention breeds opportunities for traders to earn economic rents—above-normal profits—in the parallel market through smuggling.

(i) With reference to Figure 5–2, explain how the potential rents arise as a result of the ban on flower imports. (Hint: Examine the import supply curve S in relation to the new equilibrium price P'.)

(ii) As an example, calculate the amount of rent that can be earned by smuggling in 100 bouquets per week. Supply curve S shows that smugglers can procure 100 bouquets at a price of
$ per bouquet.

To ensure a quick sale, the smugglers sell the contraband supplies in Gardenia for $1.40 per bouquet. This allow them to clear a profit of
$ per bouquet or
$ for the full 100 bouquets.

d. How does the smuggling activity affect development of the domestic flower industry in Gardenia? Explain.

e. What rent-seeking behavior might arise among government personnel in response to the profit opportunities created by import controls?

Think about how prevalent rent-seeking activities can be in an economy where prices and allocation decisions are widely subject to controls. In such an environment, business executives may devote more energy to lobbying for favors than to improving their products or controlling their costs!

2. This exercise presents a case study relating to controls, stabilization, structural adjustment, and growth. The textbook states that notable reforms in Africa have occurred in countries with stagnating economies. Let’s see what the situation was like in Ghana from 1963 to 1992.

a. Until 1983, when comprehensive reforms were introduced, Ghana’s record exemplifies the sad legacy of widespread controls and political instability. On gaining independence in 1960, Ghana embarked on a state-controlled development strategy, as was in vogue at the time. The macroeconomic results are summarized in the first two columns of Table 5–1.

Click here for Table 5-1

(i) From lines 1 and 2 you can calculate real GDP per capita:

In 1963, Cedi (at constant 1985 prices)
In 1983, Cedi (at constant 1985 prices)

Therefore, per capita real GDP by percent over the 20-year period.

(ii) Ghana’s import-substitution policies prompted a manufacturing boom for about ten years. Protected from import competition, investors found it profitable to set up high-cost infant industries. Over a longer time frame, however, manufacturing failed to thrive. The data on line 3 show that production in manufacturing by percent between 1965 and 1983.

(iii) One reason for the poor long-term performance in manufacturing was a growing shortage of foreign exchange, which was needed to import the inputs into manufacturing. The government controls had the effect of impairing exports. Line 4 shows that export earnings rose percent between 1963 and 1983 in nominal U.S. dollars. But dollar prices in 1983 were 225 percent higher than in 1963 due to inflation in the United States. Adjusting for dollar inflation, Ghana’s real export earnings by percent between 1963 and 1983. [Hint: (1 + real growth) = (1 + nominal growth)/(1 + price growth), where growth factors are expressed as decimals rather than as percentages.]

(iv) Agriculture also languished because the controls favored the industrial sector. The data on lines 5 and 2 show that agricultural production rose percent between 1965 and 1985 while population grew by percent. What happened to agricultural production per capita? [Hint: (1 + per capita growth) = (1 + total growth)/(1 + population growth), where growth factors are expressed as decimals rather than as percentages.]

(v) Ghana’s real economy was withering, but inflation was in full bloom. Line 6 indicates that average price level in 1983 was times higher than 20 years earlier.

(vi) Under the circumstances, it is not surprising that investment crashed and so dimmed the hopes for subsequent growth. The data on lines 7 and 8 indicate that the ratio of investment to GDP fell from percent in 1963 to just percent in 1983.

Of course, the full story is more complex. For example, Ghana made great progress on education and health. Long-term prospects for further improvements would be grim, however, without economic growth. External shocks certainly hurt Ghana’s economic health after 1974. But then other developing countries managed to adjust to equally severe shocks. Also, the official statistics overstate the collapse to the extent that part of the lost output simply went into the black market where it was not counted.

b. What was the effect of the structural adjustment program that was introduced in 1983? Compare columns 2 and 3 in Table 5–1. Compute the following outcomes for the period 1983 to 1992.

(i)  Per capita real GDP by percent.

(ii)  Production in manufacturing by percent.

(iii) Production in agriculture by percent.

(iv)  Dollar export earnings by percent. Taking into account the fact that dollar prices in 1992 averaged 41 percent higher than in 1983, Ghana’s real export earnings by percent.

(v)  Ghana still suffered from inflation, but less severely. Consumer prices rose by percent over the nine-year period 1983 to 1992.

(vi)  Investment rose to percent of GDP.

c. More difficult. Many observers contend that Ghana’s reforms failed to deliver benefits to the people. The textbook points out that the public often judges reforms by comparing the situations before and after, when the proper comparison for analyzing the effectiveness of a reform program is with and without. Let’s see what this means.

(i) In exercise 2b(i) you should have found that per capita real GDP rose 11 percent between 1983 and 1992. Calculate the corresponding annual rate of growth (R) during this nine-year period.

R = % per annum.

[Hint: When a variable grows G percent in nine years, the annual growth rate (R percent per annum) can be obtained from the formula (1 + r) = (1 + g)(1/9), where r and g are the same as R and G but in decimal units rather than percentage units.]

You can see that per capita income grew quite slowly after 1983. No wonder many people are not applauding Ghana's postreform performance, especially considering how poor the country had become by the start of the reform period.

(ii) Yet the postreform performance compares favorably with the two prior decades, when per capita income by percent per year.

(iii) If the economy continued on this same growth trend, then from 1983 to 1992 per capita real GDP would have by percent. This hypothetical projection is called the counterfactual.

(iv) Compare the value of per capita income in 1993, with reforms, to the counterfactual projection of what would have occurred without reforms. Using a with-and-without comparison, the reforms raised real per capita income by what percentage as of 1993?



(v) Performance after 1983 without the reforms might have been even worse than what was calculated above. We assumed that the trend from the previous two decades would have continued in the absence of reforms. In fact, the trend was worsening markedly at the time the reforms were adopted. How does this information affect your with-and-without evaluation of Ghana’s reform program?



On balance, Ghana’s reform program was effective in transforming a worsening downtrend into an uptrend. But no one should be satisfied with slow growth. Further gains in efficiency and investment are needed to achieve a true success story.

3. Let’s look at how markets and controls function in Pumpernickel, a poor country where 70 percent of the people are farmers and 30 percent live in urban areas. The farmers eat nothing but maize (the traditional crop), whereas the urban households eat nothing but bread (the main industrial product). Farmers grow maize for personal consumption, and they grow rye as a cash crop to sell to urban bakers.

a. Initially, the free market allocates cropland between maize and rye.

(i) Explain in general terms how the free market determines the allocation of cropland to maize and to rye.

(ii) If farmers were subjected to a heavy tax in order to finance a doubling of salaries for urban workers, who eat bread, then the demand curves for maize and bread would shift in obvious ways. How would this alter the market allocation of cropland to maize and rye?

b. Various market failure problems can distort the allocation of cropland, in Pumpernickel, relative to the social optimum. Consider each of the following problems.

(i) While urban households represent 30 percent of the population, they earn 80 percent of national income. One national goal is to reduce income inequality. Judged relative to this goal, does the market allocate too much or too little cropland to rye production? Why?

(ii) A monopolist gains control of the bakery industry. Compared to a competitive market outcome, he produces less bread in order to charge a higher price. How does this monopoly power in the bakery industry affect the market allocation of cropland between maize and rye? Why?

(iii) Wood-fired ovens used by bakers are a major cause of air pollution and deforestation in Pumpernickel. Considering these external diseconomies, does the market allocate too much or too little cropland to rye production? Explain.

c. A populist coup brings to power a government committed to helping poor farmers. To improve rural nutrition, the new regime wants to reallocate cropland toward more maize production. The regime adopts direct controls requiring each farmer to reduce rye production by 20 percent. At the same time, the government imposes price controls to prevent profiteers from charging high prices for rye or bread, as supplies decline.

(i) Although intended to help farmers, the farmers turn out to suffer as a result of the controls. How can such an adverse effect come about? (Hint: Think supply and demand, with Q held 20 percent below equilibrium and no increase in P.)

(ii) Do the controls on rye production create opportunities for rent-seeking activities, such as the emergence of a black market or corruption of officials? Explain.

(iii) Ten years after the coup, Pumpernickelian economists estimate that maize output is lower than it would have been under the free-market system. How can controls that increase maize output possibly lead to a decline in maize output in the long run?

4. There are five basic conditions for a “well-functioning market system.” This exercise checks your understanding of these conditions by examining a host of problems that plague the Republic of Bejeebers.

a. Macroeconomic environment. Bejeebers has a fixed exchange rate despite high inflation and a large trade deficit. This creates an unstable macroeconomic environment because everyone expects the currency to be devalued sharply, but no one knows when.

(i) A currency devaluation would cause imports to become more expensive. How does this unstable macroeconomic environment distort business decisions about importing inventory stocks?



(ii) A devaluation would increase the local-currency value of foreign currency. How does the macroeconomic instability distort the choice made by savers between placing funds in foreign banks versus investing in Bejeebers?



(iii) On the basis of the two previous questions, briefly summarize how the unstable macroeconomic environment impairs the “well functioning” of markets in Bejeebers.

b. Controls and the scope for market forces. Getting a license to open a new business or expand an existing business requires 17 signatures from officials in five different ministries. Dedicated entrepreneurs can complete the process in six months. Briefly explain how this red tape impairs the “well functioning” of markets in Bejeebers.

c. Competition. Imports of textiles are prohibited in Bejeebers because local production is viewed as an infant industry. To avoid wasteful competition, only one textile company is permitted to operate in the country. The company happens to be owned by the president’s daughter.

(i) Briefly summarize how the lack of competition impairs the “well functioning” of the market for textiles.



(ii) Would your answer change if there were still just one domestic producer, but with unrestricted imports of textiles?

d. Relative prices reflecting relative scarcities. Family cars that are imported into Bejeebers suffer a 200 percent tariff, which triples the price. Dune buggies, though, are imported tariff free.

(i) Would you expect to see more family cars or dune buggies on the streets of Bejeebers? Why?



(ii) Imports of vehicle components are duty free. Dune buggies can be assembled locally from imported components at a cost 50 percent higher than the world price of the vehicles. Family cars can be assembled locally at double the world price of the vehicles. Given the tariff on competing imports and the cost of local assembly, is it profitable to assemble either vehicle in Bejeebers? Explain.



(iii) Briefly summarize how the relative price distortions due to tariffs impair the “well functioning” of the market for vehicles.

e. Response to profit signals. The government of Bejeebers owns all the steel mills. The managers of the state-owned companies know that the national treasury will cover all losses. How does the lack of accountability for making profits impair the “well functioning” of the market for steel in Bejeebers?

The conditions described above may seem mildly outlandish, but similar conditions have been prevalent in many developing countries. No wonder structural adjustment programs are so complex and so important.

 

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