D72 - Rent-Seeking
J41 - Internal Labor Markets
L22 - Firm Organization and Bureaucracy
D23 - Organizational Behavior
Rent seeking occurs not only between firms or other organizations, but also within them. If the contest is only between organizations, the situation studied in most of the literature, then the organization would benefit from appointing staff who are highly effective in rent seeking. A person, however, who is effective in rent seeking on behalf of the organization (I call this external rent seeking) may also effectively rent seek within the organization, appropriating assets to himself (I call this internal rent seeking). The tension between these two effects may induce the leader of an organization to appoint staff who are ineffective rent seekers.
External rent seeking takes many forms: pharmaceutical firms may race for a patent, defense contractors may invest in design and development in an effort to win a lucrative contract, firms may lobby to induce Congress to levy tariffs. Rent seeking also appears outside firms: a symphony orchestra may desire to be viewed as the world's best, a president may seek to win a war, or a political party may aim to win a parliamentary majority. Despite all these possibilities, it is convenient to speak of a specific situation. I shall therefore consider a firm which can increase its profits by external rent seeking.
Internal rent seeking involves a transfer from the owner to the worker. For example, a knowledgeable worker may embezzle from his employer or engage in insider trading. An employee may learn of the firm's trade secrets, which he uses to establish a competing firm.1 Staff may take credit for the successes of the organization, reducing the glory of the employer.2 Or, in government, an able worker may gain access to levers of power and to other staff which allows him to stage a coup.
The literature on external rent seeking is extensive, including studies of how the abilities of rent seekers affect the equilibrium outcomes. Nitzan (1994), for example, considers the effects of an increase in a firm's unit cost of rent-seeking. In choosing a particular function to represent the results of rent seeking, I make use of the classic function introduced by Tullock (1967); Skaperdas (1996) shows this is a special case in the class of functions which meets such plausible conditions as homotheticity.
The seminal study of internal rent seeking is Milgrom (1988), who terms the behavior influence activities. Rajan and Zingales (2000) examine optimal hierarchical organization when a manager has to be given access to information, but also has to be limited in his appropriative activity. The spirit of my analysis resembles Carmichael's (1998) explanation for tenure: members of an academic department may fear that hiring high-quality faculty will reduce the future income of current members. Relatedly, Garfinkel and Skaperdas (2000) and Skaperdas and Syropoulos (1997) show that when economic agents can choose to allocate resources between production and conflict, the agent who is more productive can earn a smaller income. They do not ask, however, as I do, the quality of a team member one member would prefer.
The firm consists of two people, the owner and the staff person (or worker) he appoints. I assume, as is common in principal-agent models, that the owner is risk neutral. The effort of the worker and of the owner are fixed; their effectiveness in rent seeking varies with their ability. The reservation utility of the staff is invariant with his ability (perhaps because his skills are useful only to the owner in question).
Since internal rent seeking involves a pure transfer, the owner might be thought to be indifferent about the level of internal rent seeking-whatever the staff gains the owner could recoup by reducing the wage. But that may sometimes be infeasible. If the worker is sufficiently risk averse, then his expected utility from the internal rent seeking may be low, and the owner may be forced to pay a wage equal to the staff's reservation utility. Moreover, credit constraints and imperfect credit markets may make a person unwilling to work for a low wage. If the staff person's expected monetary gain is larger than his reservation utility, calling in a first-best solution for the staff to pay the owner, then enforceability can become a problem: the owner may take the payment and then refuse to hire staff, or refuse to give him a position where rent seeking is possible. So such side payments may be impractical.
Another complication is that the owner may attempt to reduce internal rent seeking by firing his staff after the firm won external rents. But such firing may often be infeasible. First, the two rent-seeking games may be simultaneous. Second, once hired, the staff person may have information that allows him to rent seek whether he is employed by the owner or not. Third, the game may be a repeated one, where the owner needs the staff in the future. Thus, the problem addressed here appears plausible.
Let the quality of the owner or manager be exogenously set at qm. The quality of the staff person is qs; the parameter l translates his quality into effectiveness in rent seeking for the firm. This parameter allows the staff's effectiveness to differ in internal and external rent seeking. The prize is worth Z. For simplicity, the behavior of only one firm is studied. The behavior of all other external rent seekers is captured by the parameter K. In contrast to most models of rent seeking, which focus on the efforts in rent seeking chosen by each firm, I highlight the tension between internal and external rent seeking by taking effort as fixed, and instead considering only the abilities of the owner and of the staff.
The fraction of the external rents the firm wins3 is
Internal rent seeking determines the fraction of the firm's appropriable wealth (the sum of F and of the firm's share of Z) retained by the owner. For simplicity, I suppose all workers engage in internal rent seeking. But a similar model would hold if only some do. What is critical is that internal and external rent seeking be positively correlated. The fraction of assets retained by the owner is
The owner must choose a quality of his staff, qs, which maximizes the owner's expected wealth. Since, for simplicity, the wage does not vary the worker's ability in rent-seeking, it is a constant that can be ignored. Thus, the owner maximizes
The first-order condition for a maximum with respect to qs is that
Table 1 below gives some numerical solutions that show how qs varies with the values of the parameters.
|Optimal quality of staff for various parameter values|
Note that in some intervals qs increases with qm but that in other intervals it declines. Thus, an increase in the owner's quality may induce him to choose a lower-quality staff: the high ability of the owner makes him worry less about internal rent seeking, but also makes it less important to have effective staff for external rent seeking. The combined effect can be that the owner prefers a lower quality staff. Note also that in an increase in F, the wealth of the firm exclusive of gains from external rent seeking, induces the owner to hire lower-quality staff: the greater wealth of the firm makes internal rent seeking more costly to the owner.
The results show more than that an owner avoids hiring workers with low marginal product. For marginal product in this model depends in part on the quality of the owner. Some owners will hire high-ability staff and others will not. Of course, saying that marginal product depends on other factors of production is unsurprising; one need only think of capital and labor as factors of production whose quantities affect each other's productivity. Determining this relationship, however, can be non-trivial and enlightening. And in the context of rent seeking it can explain how rent seeking can be constrained, how rents are distributed, and whether the best and the brightest will be employed to engage in rent seeking rather than in other activities.
Analytically, consider how the optimal qs varies with the owner's own ability in rent seeking:
For l > 1 and for sufficiently high Z this expression is positive: better owners will hire better staff.
Consider next the simpler case in which F=0. Then
For l > 1 this derivative is positive if
I also want to compare qs to qm. Of course, for Z=0 and F > 0, the value of qs is zero, and so qs < qm. Can the opposite occur? We have
Consider next an increase in the importance of external rent seeking, as given by an increase in Z. For general values of F,
Some simpler cases of (10) that are analytically solvable can be instructive. If F=0 and Z > 0 then ¶qs / ¶Z=0. And for general values of F, limZ®¥ ¶qs/ ¶Z = 0. It thus appears that an increase in the prize cannot induce a reduction in the quality of the staff, but can induce an increase.
Clearly, an increase in F, the appropriable assets of the firm additional to those arising from current external rent seeking, reduces the quality of staff the owner desires. Consider then an organization which won a large prize from external rent seeking, and is therefore wealthier in the following period. That will reduce qs in the following period, and thereby reduce the organization's success in external rent seeking in the following period.
If we think of a country as the organization, with the political elite or the decisive voter as the owner, then we may have some explanation for the relative decline of nations. As a nation becomes wealthier, internal rent seeking or redistribution becomes increasingly important, leading to less effort on such activities of external rent seeking as military conquest or industrial innovation. The observed behavior reflects that discussed by Olson (1982), but the explanation differs-instead of claiming that special interest groups become more powerful, it claims that the incentive to appoint aggressive, highly able, leaders declines.
As just suggested, the interpretation of an owner and his staff can be broad. Consider the public in a country as an owner who may wish to appoint a strong leader. A strong leader may be attractive when the stakes are large, but the danger is that the leader will exploit the public who chose him. The Old Testament (I Samuel 8:4-19) well explains the problem:
Then all the elders of Israel gathered themselves together, and came to Samuel unto Ramah, And said unto him, Behold, thou art old, and thy sons walk not in thy ways: now make us a king to judge us like all the nations. But the thing displeased Samuel, when they said, Give us a king to judge us. And Samuel prayed unto the Lord...And Samuel told all the words of the Lord unto the people that asked of him a king. And he said, This will be the manner of the king that shall reign over you: He will take your sons, and appoint them for himself, for his chariots, and to be his horsemen; and some shall run before his chariots. And he will appoint him captains over thousands, and captains over fifties; and will set them to ear his ground, and to reap his harvest, and to make his instruments of war, and instruments of his chariots. And he will take your daughters to be confectionaries, and to be cooks, and to be bakers. And he will take your fields, and your vineyards, and your oliveyards, even the best of them, and give them to his servants. And he will take the tenth of your seed, and of your vineyards, and give to his officers, and to his servants. And he will take your menservants, and your maidservants, and your goodliest young men, and your asses, and put them to his work. He will take the tenth of your sheep: and ye shall be his servants. And ye shall cry out in that day because of your king which ye shall have chosen you; and the Lord will not hear you in that day. Nevertheless the people refused to obey the voice of Samuel; and they said, Nay; but we will have a king over us; That we also may be like all the nations; and that our king may judge us, and go out before us, and fight our battles.The model also suggests that leaders would prefer to appoint staff, or other officials with power, who may be good at external rent seeking but poor at internal rent seeking. In politics that would suggest appointing officials who are unlikely to be political threats. Thus, an elected official may appoint cabinet officers and other officials who could not win an election on their own. Members of disliked minority groups may be attractive for that reason: The Muslim Ottoman Empire relied on the Janissaries, who were originally staffed by Christian youths from the Balkan provinces.
Similar reasoning shows the constraints faced by dictators. The same appointed officials who keep the regime in power may have the ability and skills needed to lead a coup against the current dictator.4 Stalin understood the problem, and was infamous for his purges. Secret trials in the late 1930s found many prominent Old Bolsheviks guilty of treason and executed or imprisoned them, thereby eliminating the major real and potential political rivals. In addition to these show trials, a series of closed trials of top Soviet military leaders was held in 1937-38, in which prominent military leaders were eliminated. At the time external threats were relatively small (or in our terms K and Z were small), so that the benefits of high-ability officials to Stalin were low. Of course, during World War II, when the external threat was high, purges of top officers were uncommon. The history of the Janissaries is corroborative. The Janissaries frequently engineered palace coups in the 17th and 18th centuries, and in the early 19th century they resisted the adoption of European reforms by the army. In 1826 they revolted, leading Sultan Mahmud II to declare war on the rebels and direct cannon fire on their barracks. Most of the Janissaries were killed, and those taken prisoner were executed.
The model assumes that a worker's effective marginal product should be measured not simply by the increased output of the firm, but also by the losses to the firm's owners from the worker's internal rent seeking. This view may explain some of the data reported by Frank (1985) showing that highly productive automobile salesmen and professors are paid far less than the revenue they generate. Frank interprets such underpayment as indicating a taste for high relative status by workers. Though status is important, my model offers a different explanation: those workers who generate much income for the employer are also adept at redistributing resources to themselves at the expense of others in the organization. A professor may demand more office space, more secretarial support, a more convenient teaching schedule, and so on. Even if the countervailing efforts of his colleagues results, in equilibrium, in little such redistribution, the increased rent-seeking within the organization can be costly, and therefore the net productivity of the worker may be less than at first appears.
Nevertheless, the threat of internal rent seeking does not always mean that low-ability staff will be appointed. As already indicated, large external threats may justify hiring high-ability staff. But under these conditions, managers may have to institute inefficient procedures that constrain internal rent seeking. Thus, Franklin Roosevelt maintained his power over the federal government in part by inducing competition among his staff and cabinet members; the influence activities by staff were directed against one another rather than against him. Ranjan and Zingales (2000) show how the hierarchical organization of the firm can limit internal rent seeking, although at some cost. A manager may appoint family members to his staff. Such family members may appropriate little both because they are altruistic towards the family member who owns the firm, and because they recognize that a mechanism similar to Ricardian Equivalence may cause the owner to reduce his bequest in response to internal rent seeking, thereby reducing its attractiveness. Family-run firms may therefore have higher ability managers than other firms.
1 Indeed Bhide (2000, p. 94) reports that 71 percent of the firms included in the Inc 500 (a list of young, fast growing firms) were founded by people who replicated or modified an idea encountered in their previous employment.
2 See Mayhew (1974) for a discussion of credit claiming by congressmen.
3 I modify the Tullock (1967) function only by introducing the factor l.
For wonderful discussions of dictatorship, see Wintrobe (1998) and Wintrobe