Lecture 2 The Briber‘s Dilemma

Lecture 2

The Briber‘s Dilemma

Prof. Dr. Johann Graf Lambsdorff

Anticorruption and the Design of Institutions 2008/09

ADI 2008/09

Lambsdorff, J. Graf (2007), The Institutional Economics of Corruption

and Reform: 164-189.

Case Study: BAE-Systems and the OECD-convention:

2007 TI Progress Report: Enforcement of the OECD Convention on

combating bribery of foreign public officials:

http://www.transparency.org/global_priorities/international_conventions/projects_conventions/oecd_convention

Further Reading:

Brunner, K. and W.H. Meckling (1977), ”The Perception of Man and the

Conception of Government," Journal of Money, Credit and Banking, IX

(1), 70-85.

Friedman, M. (1970) ”The Social Responsibility of Business Is to

Increase Its Profits,” New York Times Magazine, September 13. Reprinted

in L.P. Hartmann, Business Ethics, (Chicago: Irwin/McGraw-Hill), 246-51.

Literature

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Decision tree for a potentially corrupt businessperson

Pay bribe

Do not pay a bribe

No corrupt service

r

1-r

- Penalty - Bribe(Corrupt service confiscated)

The Bureaucrat’s Choice

Corrupt service - Bribe

ADI 2008/09

Similarly, to the calculus of public servants (see lecture “The

Economics of Corruption”), the following condition states whether a

risk-neutral business person will pay a bribe:

V (rPd+B+Td)/(1-r),

with V being the value of the corruptly provided service and r the

probability of detection. B is the value of the bribe. Detection results

in confiscation of the favor and a penalty on the side which

demanded it, Pd. There might be transaction costs arising, Td.

A high risk of detection, r, or severe penalties, Pd, induce

businesspeople to abstain from paying bribes.

Another approach would be to increase transaction costs or to

make sure that public servants have little to distribute. If V is

sufficiently small, the calculus would equally lead businesspeople to

prefer legality.

1. The Prisoner‘s Dilemma

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There exists a controversy as to which side has greater responsibility.

In a seminal contribution Friedman [1970] argues that the sole

responsibility of business is to increase its profits.

Brunner and Meckling [1977: 82-4] consider it defendable for business

people to disregard morality and pay bribes, when this is part of a

maximizing strategy.

Industrial bodies of exporting countries often point to high levels of

corruption in less developed countries when defending their strategy to

condone bribery. Some even claim a cultural acceptance of these

practices abroad.

By contrast, people from less developed countries point to the

difficulty of establishing an honest administration and a transparent

political environment when low-paid public servants are constantly

offered side payments by business people from industrial countries.


ADI 2008/091. The Prisoner‘s Dilemma

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A crucial question regards the interaction between competition

and morality: Can a high standard of ethics survive? Is it the bottom

line of the moral code that wins out?

Assume that two equally qualified firms compete in a public

tender, yielding a profit of 100. The tender board consists of 7

members. Each firm has the possibility to pay a bribe worth 10 to

one of them in exchange for a favorable vote. The resulting

probability of winning can be depicted from following matrix.

Probability of

winningCompetitor

Firm Bribe No Bribe

Bribe 50 | 50 65 | 35

No Bribe 35 | 65 50 | 50


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Considering the probability of obtaining the profit (100) and the

costs of bribing (10), the following matrix determines the

expected profit.

Expected

profitCompetitor

Firm Bribe No Bribe

Bribe 40 | 40 55 | 35

No Bribe 35 | 55 50 | 50

The matrix reveals that bribing emerges as the dominant

strategy.


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Also in reality bribing may sometimes be the individually

dominant strategy. One obtains an edge over competitors who do

not pay, and looses by rejecting a payment when all others bribe.

But jointly the firms are worse off, because the costs of bribing

lower their overall profit.

The overall decrease in profit arises because each firm disregards

the damage that its bribing strategy imposes on the competitor.

There are two solutions to the problem.

Corporate liability: the payoff to the matrix is changed by

penalties imposed on the firms.

Collective action: Firms unite in their efforts to fight corruption.


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Imagine the calculus of a firm’s employee who is given a bonus

payment if he secures the contract for the firm.

Such a payment would act as an inducement to engage in

bribery.

In an NBER paper (http://www.nber.org/papers/w12274) Bertrand,

Djankov, Hanna and Mullainathan (2007) investigate the effect of

bonus payments on the behavior of Indian applicants who wanted

to obtain a driver’s license. One group was given free driving

lessons, another a bonus payment for obtaining the license within

32 days.

Those who were given a bonus were less qualified in driving, less

often participated in the official test and more often engaged local

agents to arrange things.


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Table 1: Obtaining a License, By Group

Comparison Bonus Lesson

(1) (2) (3) Obtained License 0.48 0.71 0.60 Days to Obtain Permanent License 48 32 53 Took RTO licensing exam 0.29 0.38 0.51 Failed Independent Exam 0.61 0.64 0.15

Total Expenditures 1120 1140 964

Paid Direct Bribe 0.01 0.02 0.01

Hired Agent 0.78 0.80 0.59

Notes: Sample includes the 409 individuals that obtained a license.


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Codes of conduct are at risk of “window dressing”: While they

present the official policy, unofficially firms sometimes

communicate that acquisition of a contract is all what counts.

The promise of a bonus supersedes moral considerations.

This inofficial culture of bribery can only be changed by imposing

corporate liability.

Once the risk of detection and fines exceeds 5, bribing ceases to

be the dominant strategy.


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Once firms have an incentive to

allow bribery, penalties must

concentrate on penalizing firms, not

only individuals.

While quite often blacklisting of

firms and threats of contract

cancellation are mentioned in this

context, in the lecture “The

Economics of Corruption” it was

shown that monetary fines are

superior.

Hints for Reform


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International multilateral approach

Unilateral approach: Foreign Corrupt Practices Act imposed in

1977, the USA: End tax deductibility and impose legal sanctions.

Most trading partners did not follow the US lead, because

imposing stricter national regulation was seen to hurt their export

industry.

This well resembles the problem of a prisoner's dilemma: while

all export nations may profit from transparent procurement and

good codes of conduct it is profitable to be the only one deviating

from such behavior.

2. Collective Action

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A CIA report claimed that between 1994 and 1995 the US lost $

36 billion worth of business deals due to bribery and corruption by

its competitors, inducing public complaints.

About that time talks at the OECD started for a multilateral

approach.

In May 1997, an agreement was signed by ministers of the 29

members of the organization (and further non-member countries)

to enact laws by April 1998 making bribery a punishable offence.

All major countries have meanwhile ended the tax deductibility of

bribes and made bribing of foreign officials a legal offence.


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Will these laws be effective?

Will firms start to understand the new rules?

Will prosecutors start investigations in case of malfeasance?

Will firms invent new methods for making payments which are

accepted under the existing legal standard, or which cannot be

prosecuted and appropriately penalized?

Will firms just delegate the bribery to local agents or middlemen

and claim ignorance when this is uncovered?

Will firms arrange deals via subsidiaries and off-shore companies

to keep them off their books?


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Transparency International’s Integrity Pact (IP)

The IPs are developed for individual government (or

subdivision) contracts and should enable the bidders to abstain

from bribing.

All officials involved commit to abstain from requesting or

accepting bribes or to unduly favor one bidder over another. This

commitment is assisted by disclosure of all relevant information

and potential conflicts of interest.

The bidders commit to not offer or hand out bribes or other

favors and to not accept any inappropriate advantage.


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Sanctions (to be negotiated) may include disciplinary or criminal

sanctions against officials, cancellation of contract, forfeiture of the

bid and blacklisting of bidder for future government contracts.

But: Sanctions and regulations exist anyways

An IP will only be effective if further sanctions can be tailored to a

certain project.

Further actors (CEOs, Civil Society) can be involved.

Trust among participants can be created.

Assessments of effectiveness of IPs are biased because its

implementation already suggests a political will to contain

corruption.


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Sometimes paying bribes is not the dominant strategy. Various

reasons suggest that paying bribes is a costly approach:

A firm engaging in bribery might be exposed to denunciation and

extortion. It fears legal sanctions or a bad reputation and may be

forced to pay hush-money.

Corrupt agreements cannot usually be legally enforced. A

potential risk is that public servants may fail to deliver after

receiving a bribe. Some firms may be more reluctant than others to

run such a risk.

Bribes requested may rise with the propensity of a firm to pay.

3. Unilateral Approaches

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The Wall Street Journal, Jan 31 2007, cites from the prosecutorial

investigation of M. Kutschenreuter, an executive manager at the

German Siemens: A former Saudi-Arabian local representative,

whose contract had been cancelled by Siemens, is supposed to

have blackmailed the firm. He requested more than 900 mio. US$ as

hush-money and threatened to pass on documents about

corruption in telecommunications contracts to the SEC otherwise.

In negotiations both sides agreed on a payment of 50 mio. US$.


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A Hong Kong employee of the German Mannesmann was in

charge of paying bribes to Chinese officials in exchange for

contracts. It was later detected that he embezzled parts of the

money. But the firm did not bring the case to court, because the

employee threatened to expose the names of Chinese officials.

Being confronted with the death penalty in China, this would have

brought operation of Mannesmann in China to a standstill.

A staff member of the Christian Democratic party in Hesse,

Germany, was alleged to have embezzled 1 Mio. DM of party funds.

But he was given impunity due to fears he may denounce the

party's illegal hidden accounts. The party even paid for his

gambling debts.


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In a recent study about truck drivers in Indonesia, Bolken and

Barron (2007: 9-10) www.nber.org/papers/w13145, find that truck

drivers do not truthfully report to their companies about the bribes

they have to pay at checkpoints:

“By exaggerating bribe payments, drivers may be able to extract

more money from their bosses to pay bribes than they actually

need, and pocket the difference. In fact, we compared the amount

of bribes we observed on 40 trips between January 25th, 2006 and

February 20th, 2006 with twelve interviews we conducted around

the same time with drivers who had just completed their trips, and

found that on average the bribes drivers reported in interviews

were more than double the amount of the bribes we recorded by

direct observation.”


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I have not taken any bribe

and I swear I’m not hiding

any money from you.

Those are false allegations

usually made during

elections to discredit our

party!

Laxman,

Times of India,

Nov. 13 2003


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Slush funds can be misappropriated by firm staff.

The secrecy surrounding corrupt side-deals can be used by firm

staff to take their share. Employees are thus seduced to betrayal,

for example, by requesting a share of the bribes to be sent to their

own offshore bank accounts.

Internal auditors can hardly distinguish between bribing in favor

of the firm and employee fraud. The red flags of the two misdoings

are similar:


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Red Flags Employee Fraud Red Flags Bribery

Extravagant lifestyle

Vices such as gambling, drugs, stress

Ego and status above hierarchical position

Short vacation and unexplained hours

Financial and organizational pressure

Ongoing transactions with related parties and middlemen or with firms whose sole

rationale is to do business with your own company

Believing that the firm does not prosecute or even tolerates secrecy and cooked

books

Excessive magnitude of decentralized and autonomous authority

Frequent cash transactions or payments to third parties other than the indicated

payee. Too many transactions in even thousands of dollars

Consultancy contracts are repeatedly negotiated per unit of sales/revenue

Commissions paid prior to sales or

incoming revenue


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Source: International Business Attitudes to Corruption – Survey 2006, Control Risks Group


ADI 2008/09

Source: International Business Attitudes to Corruption – Survey 2006, Control Risks Group


ADI 2008/093. Unilateral ApproachesFrom news.com.au, April 11, 2001:

For Jakub Bierzynski, the wake-up call was of a personal nature. Head of the

Warsaw-based media planning company OMD-Poland, a US-Polish joint

venture, Bierzynski was confronted by corruption last year when two big

international clients separately demanded bribes of "hundreds of thousands"

for two advertising contracts. "It was like a very cold shower. I asked myself

if I could do business in a corrupt environment," says Bierzynski, who had

incorrectly assumed his firm's US mother company afforded him a degree of

protection from kick-backs. The answer was no. "This is what scared me the

most (that despite OMD and the clients all being international companies),

they would dare to ask for a bribe," he says. "Leaving aside the moral

connotations of (giving bribes), I have no skills in giving bribes. I have never

done it before, I don't know how much, I don't know to whom and I don't

know in what situations I'm supposed to give bribes, so I am losing in that

competitive field and I am sentenced to death in the business world.”

Instead, the 34-year-old channeled his outrage into a proposal to launch an

anti-corruption business association unprecedented in central and Eastern

Europe, in which members would pledge not to offer or receive bribes.“

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Discussions

1) Disregarding ethics, how would businesspeople and public

officials determine whether to engage in bribery?

2) What forces the bottom line of the moral code to win out?

3) Which are the two strategies for overcoming the prisoner’s

dilemma?

4) Do “good ethics” survive in reality? Why?

5) Discuss the subsequent case study! Why didn’t H. Davidson

discuss the dilemma with his superiors?

Appendix

ADI 2008/093. Unilateral ApproachesThe Wall Street Journal Europe, Career Journal (03.12.2002):“In 1994, Howard Davidson faced his crucible. At the time, he was an investment banker, working in an Asian country. He was on the verge of pulling off a prestigious $500 million (502.8 million euro) stock offering for an Asian utility. "We invested $11 million in the deal and pre-sold the issue," recalls Mr. Davidson, now a financing consultant for the Institute, a management-consulting firm in Redwood City, California. "At the last minute, I was approached by a government official." The official's message: Give him a kickback or forget the deal. "To him, it was as logical as day follows night," Mr. Davidson says. It would have been simple to comply. He felt he couldn't even share the decision with superiors at the bank. What if they ordered him to pay up and push on with the offering? And with other people involved, how could he be sure the whole sordid mess wouldn't leak to the press? […] In the end, he declined and the deal was pulled, resulting in a lot of heat for his company from an unknowing public. Press critics wondered aloud if the company knew how to pull off a deal of that magnitude in a foreign land. The decision turned out well for Mr. Davidson, who finally confided in his superiors afterwards. The company's senior executives felt he'd made the right call, and he wound up with a promotion after his division went on to a "great year" anyway, he recalls. But it could have been a disaster. In another, less-ethical, get-the-job-done-at-any-cost culture, he could have been pushed aside, ignored or outright vilified by co-workers and his career could have come to a dead halt. […] In a highly competitive world, there's considerable pressure to adopt that point of view. When bosses talk about doing "whatever it takes" to make a sale, the salespeople see that as an easily decipherable code. Translation: "Do whatever you have to, as long as it doesn't come back on me." There's also social pressure to "go along with the gang." People who don't are ostracized. […]”

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Lecture 2 The Briber‘s Dilemma