(This essay was published in Hong Kong Economic Journal on 15 June 2016.)
Rent seeking is one of those economic ideas that quickly entered the vocabulary of public policy and mass media. The idea appeared in the 1960s and soon became the central analytical tool that ties history, politics, and economics together. It is one of the core pillars of the study of political economy. Its use in economics is negative and denotes detrimental political and economic activity.
Under most circumstances the owners of an input of production—land, labor, machines, and capital –– will only be able to earn a normal profit because competition in the market place will equalize their returns. This will remove any abnormally high profits among firms and individuals, and those with negative profits will be eliminated from the market. This is Adam Smith’s invisible hand theorem.
The only way for owners of an input of production to extract more profit than they would get in a competitive market would be to cartelize and monopolize. For example, banks may seek to monopolize the supply of credit, labor unions monopolize the supply of workers, and so forth. The most effective way to do this is to lobby government to set up regulatory and legal barriers to market entry.
The process of lobbying government is a political process. This process may also be highly competitive because there may be different groups lobbying for the same things, as well as for opposite things. Economists call such lobbying “rent seeking” because the objective is to secure economic rents that are higher than the normal profits obtainable by competing in the economic market place.
Rent seeking limits market competition
In the economic market, competition drives down costs and promotes innovation. Economic competition is very intense because both incumbents in the market and newcomers can constantly challenge successful firms and individuals. Innovators may earn higher profits at the beginning because they have a new or better product, but others will challenge them and the higher profits will be eliminated over time as these competitors catch up.
In the political “market,” the purpose of competition is often to secure government authority to limit market entry by newcomers. This would allow industry incumbents to earn higher returns than they could get from market competition, through cartelization. Limiting market entry is not the only outcome rent seekers pursue, but in the long run it is usually the most effective measure to secure higher economic rents.
Under economic competition, consumers are the final arbiters of success. Market competition drives innovation and efficiency, promotes growth, and enhances consumer free choice. By contrast, political competition aims at limiting market entry, which reduces economic competition, lowers efficiency and innovation, and lessens consumer free choice.
Rent seeking is political competition for higher returns. It differs from profit seeking through economic competition because it lowers efficiency and innovation. For this reason, rent seeking is economically unproductive and detrimental to growth.
Rent seeking creates cartels and monopolies through political lobbying in order to extract economic rents. The result is a less competitive economy, a more divided society, and a less inclusive polity that curtails freedom. Barriers to market entry are identical to creating privilege. In traditional societies barriers to entry were formed through fostering hereditary rights.
State and the economy
The late Professor George Stigler revived the idea that the benign view of the state as correcting market inefficiencies and promoting a better distribution of income has been too one-sided and wishful thinking. Another more realistic approach is to see state regulatory behavior as responding to lobbying efforts to create and capture economic rents for one’s own interest.
Sometimes self-interested lobbying activities have to be camouflaged as public interest in order to be successful. Stigler urged that government behavior should be examined not only for the stated intentions, but the actual consequences. Empirically, cartels, monopolies and most government regulations that limit market competition are the product of rent seeking activities. For this reason, Stigler believed that small government was usually preferred to big government for promoting competition and growth, except during times of war and unrest.
Stigler’s view is of course Adam Smith’s old view that government rather than business conspiracies is the source of monopoly power. Businesses everywhere are always plotting to cartelize and raise prices, but usually they are successful if government steps in to shield them from future competitors. Market competition is a businessman’s worst enemy.
Industries that are heavily regulated by government, where business has to constantly work closely with government, are much more prone to rent seeking activities. Building, construction, development, transportation, mining, energy, communications, and so on are often characterized by a high degree of government regulation. The extent of government regulation varies from country to country and sector by sector, and so does the amount of rent seeking activities in those countries and sectors.
Rent seeking is more pervasive in less market-oriented economies because the government allocates a large share of the resources (or inputs of production) in society. Societies with big governments and planned economies have more rent-seeking activities and are less efficient and innovative. China’s high economic growth rates in the past three and a half decades are a product of either curtailing and monetizing rent seeking through successful reforms that limit the reach of government and expand market competition.
Hong Kong’s “small government and big market” approach to economic development is in sharp contrast with China’s development strategy before 1979. In the decades after World War II, Hong Kong soared ahead while China stagnated by pursuing an industrialization strategy that gave priority to capital-intensive heavy industries.
As a labor abundant economy, this development strategy worked against China’s comparative advantage. China had to rely on the coercive hand of the state bureaucracy to suppress market competition, with dire consequences for efficiency, innovation, and economic growth. To a large extent, the unprecedented economic growth rates China experienced are the result of correcting gross past state misallocations and creating new institutions to facilitate market competition, with rent seeking activities curtailed and monetized.
Despite the rise of bribery and corruption in the new semi-reformed Chinese economy, rent seeking activities have been substantially curtailed and monetized when compared with the old economy . To understand why bribes and corruption have not retarded economic growth, it is necessary to understand the role of rent dissipation in rent seeking activities.
Rent dissipation catastrophe
A profoundly devastating issue in rent seeking is the dissipation of economic rent. The purpose of rent seeking is to earn higher profits, i.e., monopoly or cartel profits above normal competitive levels. This requires individuals and businesses to commit some resources to lobbying government officials and politicians in order to secure these higher profits.
The resources spent in politicking can take many forms – hiring lobbyists to persuade officials and politicians, launching an advertising campaign to influence public opinion, funding writers and opinion makers to drum up public support, organizing protestors or advocates to stage rallies in support or against an outcome, and so on. These resources cut into the higher economic rents to be gained if the lobbying is successful. The resources would be wasted if the lobbying effort fails.
Moreover, other interested parties may also be spending resources to lobby government to secure the potential economic rents, and not every party will be successful. These parties may include those who wish to prevent the creation of such economic rents and their capture by certain groups. Indeed, it is possible that the total amount of resources devoted to securing higher rents is larger than the total amount that would be targetted in the first place.
Spending on rent seeking efforts is also unproductive spending because it is focused on income transfer rather than the creation of income. The lobbyists, advertisers, writers, persuaders that are hired could have spent their time and effort in other more productive activities. By allowing market competition, the Chinese economy reduced rent seeking and prevented vast amounts of unproductive resources from being spent.
The diversion of valuable resources into unproductive rent seeking activities, like lobbying, advertising, persuasion and so on, is called rent dissipation. It is pure waste that is lost to society, and because it can be quite substantial in size, it is also detrimental to the economy. Society becomes divided because returns are not earned through innovation and honest work. And a polity that allows this to happen becomes corrupt and loses legitimacy with its people. Catastrophe reigns if such conditions persist in society, as had happened in China before the reforms in the 1980s.
Professors Kevin Murphy, Andrei Shleifer, and Robert Vishny showed that the most devastating aspect of rent seeking behavior is that it creates incentives for individuals to choose careers specializing in rent seeking work. This results in a waste of the efforts of the most talented members of society.
Using enrolment in law studies as a proxy for rent seeking work, and enrolment in engineering studies as a proxy for entrepreneurial work, and applying that to a sample of 55 countries during 1970-85, they found that higher enrolments of law students were associated with lower growth rates, while higher enrolments of engineering students were associated with higher growth rates.
Rent seeking also encourages bribery and corruption. If bribes were legal, then lobbying efforts might be conducted more efficiently and in a less wasteful manner. But while open corruption through the transparent sale of political favors might at times be economically more efficient, it would create social division and delegitimize government. This happened during China’s reform years when some economic rents became monetized in “open” bribes.
For these reasons, less regulation is often better for the economy, society and polity. Some regulations are indispensable for the economy to operate, but they should not be excessive nor excessively politicized.
Asymmetric rent seeking success
One of the arguments in favor of democracies is that in an open society, everyone can lobby government. If the steel industry lobbies for import protection against foreign steel manufacturers, then the construction industry can counter-lobby. If employers conspire to lower wages and lobby government for favorable legislation, then labor unions can counter-lobby.
Political competition among different interests just might achieve a dynamic shifting balance of interests to limit excessive rent seeking. This is called countervailing power by some democratic theorists, and it is claimed that this could allow sensible policies to eventually prevail.
In practice, few countries attain a symmetrical organization of all groups with a common interest and thereby an optimal outcome through comprehensive democratic political bargaining.
Organizing groups to become successful lobbies takes time, effort and resources. It also has to overcome the difficulties of the free rider problem that inflicts all such groups, in which members of a group piggyback on the efforts of other members so that they put in as little contribution as possible but still collect the full benefit of the successful lobbying outcome.
Groups that are small in numbers have a natural advantage over large groups. First, the per capita share of benefits varies inversely with the number of members in the group. These benefits must be collected from non-members, who regard them as costs. So the larger the number of non-members, the smaller will be their per capita share of the costs and the less likely they will resist these costs.
Say 100 businesses conspire to raise the price of a product by $1. If there are one million customers, each of whom buys one unit of the product, then each business will earn $10,000 but each customer will lose only $1. The incentive for the 100 businesses to become organized and lobby government will be much larger than the incentive of one million customers to organize and mount a counter-lobby.
Furthermore the cost of organizing 100 businesses is much smaller than organizing one million customers. Such cost-benefit calculations imply that the incentive of small groups to organize rent seeking activity is very different from large groups.
Interest groups who are successfully organized to further their own interests would likely be those that chose policies that are inefficient for society, where benefits fall on themselves and costs on the unorganized. This implies organized political groups are necessarily narrow, special interest groups that are small in size. It explains why producers are usually better organized than customers. And it explains why many successful social advocacy groups are small in number, but successfully capture most of the benefits they lobby for in the name of the larger population.
In conclusion, rent seeking harms economic growth by reducing competition and innovation. It leads to the wasteful use of valuable resources in unproductive activities that merely transfer income from one group to another, and often to themselves. It wastes the efforts of the most talented people in society in the pursuit of such unproductive activities.
Successful rent seeking activities invariably redistribute resources from large unorganized populations to small organized groups. The asymmetric incentives associated with the sharing of benefits and the cost of organizing people imply rent seeking activity almost always originates from concentrated narrow special interest groups and the cost is borne by the larger population.
Rent seeking reduces market competition and limits freedom of choice. It is not only bad for economic growth because most rents are ultimately dissipated, but produces divided societies and non-inclusive polities.