Do Politically Connected Firms Undermine Their Own Competitiveness?

Publication Date: January 2008

Publisher: Brookings Institution

Author(s): Raj Desai; Anders Olofsgard

Research Area: Business; Politics

Keywords: competitiveness; economic development; cronyism; politics

Type: Report

Coverage: United States

Abstract:

This paper is about cronyism, or the arrangements by which influential firms receive economic favors. This phenomenon has been documented in numerous case studies, but rarely formalized or analyzed quantitatively. We offer a formal voting model in which cronyism is modeled as a contract where politicians deliver a better business climate to favored firms who, in exchange, protect politicians from the political consequences of high unemployment. From this perspective, cronyism simultaneously lowers the firm's fixed costs of doing business while raising its variable costs by tying the extent of extra employment to the size of the firm, and thus to the level of capital investments. We test several of the implications of the model using a cross-country firm-level database generated from the World Bank's Enterprise Surveys. In accordance with the theory, we find that more influential firms indeed face fewer administrative and regulatory obstacles, and carry bloated payrolls, but they also invest and innovate less. All these results hold up when we use propensity score matching models to adjust for the fact that influence is not randomly assigned.