A Curious Miscellany of Items Philosophical, Historical, and Literary

Manus haec inimica tyrannis.

Wednesday, February 17, 2010

Rent-Seeking Revisited

In my post “Are We All Keynesians Now?” (March 16, 2009) I introduced the concept of rent-seeking. There, I had loosely defined economic rent as follows: “By the term ‘rents’ I mean things like subsidies, special rights or privileges, monopolies, trade concessions, etc. Rents, in this special sense, we may define as profits accruing to persons or organizations which are not otherwise available for purchase through the operation of a free and open market.”

This definition is fine as far as it goes, but upon reading Gordon Tullock’s book The Rent-Seeking Society (Indianapolis: Liberty Fund, 2005), a collection of his essays on the subject, I have come to see that more is required to make the concept clearer. As it stands, my definition captures too much.

For example, even though a patent is a kind of time-limited monopoly, seeking a patent is not necessarily an example of rent-seeking, despite surface similarities. Offering a patent to the first firm that finds a drug that will cure a certain disease provides an incentive for different firms to invest in research and development, in the hope that at the end of the process they will have a drug from which they can profit exclusively. Now, insofar as this incentive causes several firms to duplicate each other’s research in the scramble for the patent, patent-seeking behaviour on the part of firms has caused waste and inefficiency.

(On the other hand, one can only imagine the waste involved in having a government scientific planning bureau dole out the funds to a single firm. After all, what’s to guarantee that they’ll bet on the right horse? Maybe the firm they fund will turn out to have been on entirely the wrong scientific trail.)

Perhaps we are inclined to see the problem not in the waste incurred in multiple firms seeking the same objective, but rather in the “excess” profits that will accrue to the firm that wins the race. Fair enough. If the patent were effective in perpetuity there would be some truth in this.

On the other hand, it is not necessarily the existence of a monopoly per se that constitutes a rent. For example, Tullock points out that a monopoly may arise in a fully competitive market because it can produce something more efficiently or offer it at a lower price than anyone else. If it ceased to do so, new competitors would arise to fill the vacuum. In the absence of artificial monopoly-creating interference by government, it is rather difficult for a monopoly to make “excess” profits in a competitive market.

The reason the drug company’s seeking after a patent is not an example of rent-seeking is because its activities constitute a net social benefit. We are all presumably made better off by the existence of the drug, which might not exist if the incentive of the patent were not available. Similarly, the reason that the competitive monopoly is not an example of rent-seeking is because it constitutes a net social benefit, in that goods are provided to the public in the most efficient way, at the lowest possible price.

True Rent-Seeking

Now imagine a different scenario. A drug already exists, but instead of finding a way to manufacture it cheaply and offer it at a lower price, its manufacturer instead decides to invest its resources in lobbying the government to block the sale of a competitor’s drug, one which is cheaper and more effective. This would be rent-seeking, because the firm’s activities result in negative social benefit. The public now only has access to a less effective drug, and at a higher price than it would otherwise pay. The firm might make large profits, but at the public’s expense. As such, those profits represent a misallocation of resources that could have been more efficiently spent or invested by the public elsewhere.

Thus, we can refine the above definition of rent as “profits accruing to persons or organizations which are not otherwise available for purchase through the operation of a free and open market, and which represent a negative net social benefit.”

The Harm of Rent-Seeking

We have seen that rent-seeking, when successful, results in net loss of social benefit. Still, it might benefit the rent-seeker very much. But we can imagine situations where this is not the case.

Imagine firm A is lobbying a politician to support a restrictive tariff to protect its home market from foreign competition. Further imagine that such a policy would hurt firm B, which depends on the lower-priced product imported by one of A’s foreign competitors. B now has an incentive to lobby for a countervailing policy to block A’s rent-seeking attempt. The dynamic here can quickly become a classic prisoner’s dilemma: both may be locked into redoubling their efforts, because now, if firm A is unsuccessful, things will not simply go back to the status quo, but rather the firm will fall back to a worse position than it started from. The money, time, and resources expended will have been for naught.

In such a dynamic, both firms may end up investing more resources in rent-seeking than the rent itself is worth. Both firms would have been better off if they had never begun to seek rents in the first place. They are like two children tearing apart the teddy bear they are fighting over. In effect, such rent-seeking represents a negative-sum game.

Although such rent-seeking arms races seem particularly wasteful, they might be relatively easy to fix. Since ultimately, neither firm in the situation described stands to gain, they both might at some point welcome outside intervention to stop it. If this claim sounds odd, think of how it was the case that many cigarette companies actually were relieved when various governments placed severe restrictions on their advertising activities. Because the restrictions applied to all cigarette companies, many of them were relieved at not having to expend so much of their resources on advertising in order to capture a larger piece of a shrinking pie. Re-investing those huge advertising budgets elsewhere was a net gain for the companies (and perhaps for society).

(Although advertising is not exactly an example of rent-seeking, it does share one important trait with the latter: aside from a few rare cases, advertising produces little or no net social benefit.)

So far we have described cases where rent-seeking causes economic agents to misallocate resources, thereby losing out on the opportunity to become more efficient. But there are also cases where the prospect of gaining economic rents not only causes firms to ignore investment in increased efficiency, but can also cause them to purposely “invest” in decreasing their efficiency. After all, if you propose to distribute a large amount of money as charity, there will always be those who will make the effort to become an object of that charity.

Tullock’s best example of this has to do with local government. When various US state governments propose to distribute funds to local governments to fix and upgrade roads in bad disrepair, it has been demonstrated that many local governments purposely allow their roads to fall apart in order to qualify for the funding. Less money would have been spent in the end if the roads had been maintained in the first place, so this rent-seeking by local governments represents a net social loss.

(I suspect a similar phenomenon has been going on in the city in which I live for some time now. Its entire infrastructure is crumbling away while it awaits funding from the federal and provincial governments, and yet, there always seems to be money lying around for whatever new hare-brained scheme the mayor cooks up, while never seriously contemplating cuts to the city’s profligate budget.)

In Tullock’s memorable words, “The local community that allows its road system to deteriorate in order to qualify for state subsidies or that runs down its hospital system in the expectation that the federal government will replace it is in exactly the same situation as the Chinese beggar who mutilates himself to obtain charity from passers-by. In both cases, the action is rational. In both cases, the effect is to lower the welfare of those involved” (p. 25). (Tullock is not being racist here. The passage follows upon an anecdote he tells about his experience while stationed in China with the US Foreign Service.)

Governments do not only seek rents from other levels of government. They may also seek them from the private sector. An example of this is where a legislator moves to introduce legislation that would hurt some private interest, in the expectation of being offered a rent for killing the legislation. Here it is government that is the rent-seeker, while the private interest is more properly a rent-avoider. And in case you think the scenario is far-fetched, Tullock cites studies and insider accounts to the contrary — though the examples are mostly from the US political system.

Sometimes the relationship between government and private interests is so symbiotic that the distinction between rent-seeking and rent-avoiding becomes blurred. For example, a government might grant a tax exemption or monopoly to a firm in exchange for a share of the future profits, to be used as a source of government revenue. No doubt the firm has extracted a rent, but so too has the government. Who is the seeker here, and who is the avoider?

The political dimension of rent-seeking is important to emphasize. When distributing rents, the goal of a politician is to make sure that they are distributed to those who can influence voting in his electoral district, while having the costs borne by those outside of it. Unfortunately, when all politicians are doing the same thing, we must all be the losers. Even if, in the best case scenario, the various redistributions of wealth via rents were to cancel each other out, it would still represent a net social loss, for we would have been better off still if the resources spent in rent-seeking had been allocated to countless better uses.

I hope to explore some possible remedies for rent-seeking in a future post.

1 comment:

  1. And sort of a propos of this, here are the Fish articles I was trying to remember the other day.