Slides5 - Parasitic Enterprises and The Allocation of Talent

PhD Course: Development Economics – Macro Aspects Chapter 5.
The Allocation of Talent
Parasitic Enterprises and the Allocation of Talent
Halvor Mehlum, Karl Moene, and Ragnar Torvik, 2003, Predator or Prey? Parasitic
Enterprises in Economic Development, European Economic Review 47, 275-294.
So far:
Assumption: the state is too weak to enforce property rights.
Social conflict about appropriation of resources.
Yet, why not protect property privately?
→ This lecture shows: this may actually not improve the situation.
Entrepreneurs who specialize in the protection business:

The Guerillas
The Mafia
The Mafya
The Mapogo a Mathamaga
...
Professor Dr. Holger Strulik 1 / 20

PhD Course: Development Economics – Macro Aspects Chapter 5. The Allocation of Talent
End of Cold War: large supply of talented men for protection:

demobilized troops → paramilitary squads / bandits
This is in particular true for countries who where part of the former USSR.
But also: Ethiopia, Eritrea, Uganda, Mozambique, Namibia, Liberia, etc.
Our model: a contribution to the Allocation of Talent literature:
Talented people are scarce (compared to opportunities).
They can be producers or predators ( → or corrupt bureaucrats).
The career decision is interdependent:
I It’s attractive to be Mafioso if there are relatively few other Mafiosos around
(obvious).
I Yet, it’s attractive to be producer if there are relatively many others producers
(not so obvious)
2 Equilibria conceivable.
The predator-prey model:

production sector
extortion (predation) sector

Production Sector: M goods can be produced in either

a traditional, competitive sector with c.r.s. where
I 1 unit of labor produces 1 good
I wage = 1 → supply price = 1.
or a modern (industrial) sector with i.r.s. and fixed start-up costs.

y = A(` − F ), A > 1. (1)
If a good is produced in the modern sector

price competition has driven all but 1 competitor out of the market.
the monopolistic supplier sets p = 1 to deter entry from traditional sector.
Profits:
π = 1 · A(` − F ) − 1 · ` = A(` − F ) − (` − F ) − F

1
= A(` − F ) 1 − −F (2)
| {z } A
y | {z }
≡γ
γ: marginal profits
number of modern firms: na
number of workers in economy L
Aggregate income of economy:
Y = na · π + 1 · L = M · y . (3)
Insert (2) in (3):
L − na F
My = na γy − na F + L ⇒ y= . (4)
M − γna
Observe special case: no modern sector ⇒ Y = My = L
A natural assumption: production in a completely modernized economy is higher than in

a completely traditional one:
MA(` − F ) > M` ⇒ A(L − MF ) > L
and thus
1
A 1− L − MF > 0 ⇒ γL − MF > 0. (5)
A

Differentiate (4)
∂y −F (M − γna ) + γ(L − na F ) γL − MF
= =
∂na [·]2 [·]2
to see that demand for each good is increasing in the number of modern producers.
Insert (4) in (2)

L − na F γL − γna F − MF + γna F
π = γy − F = γ −F =
M − γna M − γna
and thus
γL − MF
π= >0 (6)
M − γna
Observe:
∂π/∂na > 0. Profits increase in the number of modern firms:
I every new firm generates profits
I increases income and demand for all other goods
I generates profits for all modern firms.
Profits are positive. Yet these are potential profits. Not included:
I predation
I expenditure for protection from predation.
The Predatory Sector.
Number of predatory entrepreneurs: nb

Scarcity of entrepreneurial talent (relative to industrial capacities):
n = na + nb ≤ M (7)
Allocation-of-talent literature.
Self-protection against theft costs φy .
The state is weak.

Parasitic enterprises (the Mafya) charges φy protection money (or φy − )
Protection is effective (φy is paid not more than once).
Thus, no self-protection in equilibrium.
At each t one parasite approaches one firm. ⇒ prob. of being approached by a parasite:

nb
µ = min 1, . (8)
na

Expected profits net of protection:

πa = π − µφy = γy − F − µφy = (γ − µφ)y − F . (9)
Cost of providing protection:

The Mafya has entrepreneurial and organizational skills.
It can provide protection at lower cost than self-defense.
For simplicity: no extras costs.
Prob. of being detected/punished = 0
Prob. to (be the first to) approach a firm:
extortion cases µna
= .
number of parasites nb
Thus, expected profits of a parasite:
na
πb = µ φy . (10)
nb
Congestion in the protection business if
nb ∂πb
>1 ⇒ < 0,
na ∂ nnba
otherwise ∂πb /∂(nb /na ) = 0. We assume: no costly (violent) conflict among parasites.
Insert (10) into (9):

nb
πa = π − πb ⇒ na π = na πa + nb πb . (11)
na
i.e. gross profits are distributed to productive and parasitic entrepreneurs (without
further loss)
In a non-trivial equilibrium πa > 0. This requires:

1. Necessary condition for πa > 0 under all circumstances:
min πa = min(γ − µφ)y − F = min(γ − φ)y − F > 0.

µ,na µ,na na
Insert lowest bound for y when na → 0 (traditional society): My = L:
L F
(γ − φ) −F >0 ⇒ γ> + φ. (12)
M L/M
2.
πa = πb or
πa > πb .

Simple case: Equilibrium without exit and entry

n given
wanted: the equilibrium allocation of talent.
Diagrammatic exposition:
1. na and πa
from i.r.s.: na ↑ → πa ↑
if na ≤ nb → µ = 1 and constant.
if na > nb → µ ↓ → πa further increasing.
[Insert: Producers and Profits]

2. nb and πb
if nb < na : nb ↑ → na ↓ → πa ↓ → πb ↓ .
if nb > na : additional congestion effect: nb ↑ → (na /nb ) ↓ → πb ↓ .
[Insert: Parasites and Profits]

Putting the pieces together (noting nb = n − na )
[Insert: Predator - Prey Equilibrium]

Observe:
The kinks are where na = nb
There are either 2 or 0 intersections.
For 2 intersections: 2 “stable” equilibria: e1 and e2 :
if na > n(e3 ) → πa > πb → na ↑ until na = n.
if na < n(e3 ) and
I n > n(e ) → π > π
a 2 b a → nb ↑ until πa = πb .
I n < n(e ) → π < π
a 2 b a → nb ↓ until πa = πb .
Result:
A sufficiently productive economy ends up in an equilibrium with
I no crime / no extortion
I high profits and income
A developing country starting with low income/profits may end up in a predatory

trap with low income and high crime (extortion) rate.
Yet, there may be no interior equilibrium: πa > πb for all na :
[Insert: Absent Predator - Prey Equilibrium]

Observe from (12) this is more likely if
marginal profits (γ = 1 − 1/A) are high.
general productivity A is high.
Start up costs for modern firms are low → corruption.
marginal protection/extortion costs are low.
L/M is large (large market, large country).
By the same token: If the trap exists, increased efficiency in production

F
γ− −φ ↑
L/M
improves both
profits in production.
profits in extortion.
“Whatever harms the thief is beneficial for the producer and the thief.”
Algebraically, there exists no trap if πa > πb where na = nb = n/2, i.e.
(γ − µφ)y − F > µφy .
Since µ = 1 where na = nb :
L − na F
(γ − 2φ)y > F ⇒ (γ − 2φ) >F
M − γna
Insert na = n/2:
n n n n
(γ − 2φ) L − F > F M − γ ⇒ (γ − 2φ)L > F M − γ + γ − nφ
2 2 2 2
Thus
(γ − 2φ)L
> F.
M − nφ
Conclude:
If F is sufficiently low (γ, A sufficiently high) it is always more profitable to produce
than to predate.
The higher the number of entrepreneurs (talented people) the less likely is the
extortion trap...

If
(γ − 2φ)L − FM > −nφF
i.e.
FM − (γ − 2φ)L
n > ñ = (13)
φF
there exist no trap. (Of course, in the long-run n is not given.)
For later use: an alternative representation of equilibria:
[Insert: Predator - Prey Equilibrium: The Funnel]

Observe:
E2 -curve: na and nb combinations that support an equilibrium e2
E3 -curve: na and nb combinations that support an equilibrium e3
45◦ -line: possible combinations of na and nb : nb = n − na .
For high φ there exists always an equilibrium e2 :

[Insert: Predator - Prey Equilibrium]

For low φ there exists never an equilibrium e2 :
[Insert: No Predator - Prey Equilibrium]
Dynamics with entry and exit. Analogy: predator-prey models in biology

(Lottka/Volterra):
Inflow of new entrepreneurs: θ
Exit rate (death rate) δ
Population dynamics:
ṅ = θ − δn (14)
Simplifying assumptions:
entrepreneurs choice of which sector to enter is made once and for all.
no forward looking expectations. → later
πa ≥ πb : new entrepreneurs enter production.
πb > πa : new entrepreneurs enter extortion.
Thus for πa ≥ πb :
ṅa = θ − δna
ṅb = −δnb
And for πa < πb :
ṅa = −δna
ṅb = θ − δnb
Note from (14):

θ
ṅ = 0 ⇒ n∗ = ≤M
δ
and n ↑ if n < n∗ and n ↓ if n > n∗
Suppose: n < n∗ initially.
Phase Diagram: Note: only within the funnel: nb ↑ , na ↓ .
[Phase Diagram]
Recall: Y = y (na )M and observe:
[Alternative Development Paths]

Observe: Club-convergence:
Predator’s club starts out with high nb : vicious cycle of underdevelopment.
Producer’s club: na is initially high: virtuous cycle of development.
Relative level nb /na crucial for development.
Note: Take-over possible.
Yet, it always helps if initial income is high:
then na is absolutely high
and a trap is “less likely” since E3 is concave.
A country may “grow out of the development trap:
θ ↑ (better education)
δ ↓ (better health)
⇒ n∗ ↑ and n∗ > ñ eventually.
[Figure: Growing out of the trap]

Why is this possible?
Recall that there are i.r.s. in production.
The larger n∗ the larger the scale advantage of production against extortion for any
given na /nb
[Figure: Implied Growth Paths]

Observe:
Phase 1: Divergence
Phase 2: Convergence

Law Enforcement.
Suppose: revenue for law enforcement is financed by income tax in modern sector
(a VAT).
Z = t · y · na
Law enforcement lowers private expenditure for protection.
φ = φ(Z ), φ0 < 0.
Now
π = (1 − t)A(` − F ) − ` ⇒ π = (1 − t)A(` − F ) − (` − F ) − F
i.e.
1
π = A(` − F ) 1 − t − −F
A
| {z }
γ−t
And net profits (after extortion):

Z
πa (γ − t − µφ)y − F = γ − − µφ(Z ) y − F .
yna

Observe:
Tax base yna is higher in developed countries.
Degree of law enforcement is higher in developed countries.
Producers in developed countries may prefer law enforcement while producers in
LDC may not.
FOC:
1
−φ0 µ − ·y ·Z =0
yna
Conclude:
Interior solution for −φµ = 1/(yna ) (marginal return of protection equals marginal
cost of taxation).
otherwise: corner solution: Z = 0.
yna ↑ → − φ0 (Z ) ↓ → Z∗ ↑
Extensions:
1. Free career choice at any time:
Without entry: the economy is always in e2 or e1
With entry of new n: movement along E2 –curve (or E1 –curve)
i.e. economies to the right of E3 jump on the E1 –curve.
2. Self-fulfilling expectations
If entrepreneurs are optimistic and anticipate movement towards e1 → this may
lift economy out of the trap.
Likewise of course v.v. for pessimistic guys.
Overall conclusion: predation (extortion) as a cause and a consequence of
underdevelopment.
Note: this is just a further piece of a recurrent general pattern:

high fertility
bad health
low savings
high crime
as a cause and consequence of underdevelopment.

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PhD Course: Development Economics – Macro Aspects Chapter 5.

The Allocation of Talent

Parasitic Enterprises and the Allocation of Talent

Entrepreneurs who specialize in the protection business:

Professor Dr. Holger Strulik 1 / 20

End of Cold War: large supply of talented men for protection:

The predator-prey model:

Professor Dr. Holger Strulik 2 / 20

Production Sector: M goods can be produced in either

I wage = 1 → supply price = 1.

or a modern (industrial) sector with i.r.s. and fixed start-up costs.

If a good is produced in the modern sector

Aggregate income of economy:

Insert (2) in (3):

A natural assumption: production in a completely modernized economy is higher than in

MA(` − F ) > M` ⇒ A(L − MF ) > L

Professor Dr. Holger Strulik 4 / 20

Insert (4) in (2)

The Predatory Sector.

Number of predatory entrepreneurs: nb

The state is weak.

Professor Dr. Holger Strulik 6 / 20

Expected profits net of protection:

Cost of providing protection:

Insert (10) into (9):

In a non-trivial equilibrium πa > 0. This requires:

min πa = min(γ − µφ)y − F = min(γ − φ)y − F > 0.

Insert lowest bound for y when na → 0 (traditional society): My = L:

Professor Dr. Holger Strulik 8 / 20

Simple case: Equilibrium without exit and entry

[Insert: Producers and Profits]

[Insert: Parasites and Profits]

Putting the pieces together (noting nb = n − na )

[Insert: Predator - Prey Equilibrium]

I high profits and income

A developing country starting with low income/profits may end up in a predatory

Yet, there may be no interior equilibrium: πa > πb for all na :

[Insert: Absent Predator - Prey Equilibrium]

By the same token: If the trap exists, increased efficiency in production

Algebraically, there exists no trap if πa > πb where na = nb = n/2, i.e.

(γ − µφ)y − F > µφy .

Professor Dr. Holger Strulik 12 / 20

For later use: an alternative representation of equilibria:

[Insert: Predator - Prey Equilibrium: The Funnel]

For high φ there exists always an equilibrium e2 :

Professor Dr. Holger Strulik 13 / 20

[Insert: Predator - Prey Equilibrium]

[Insert: No Predator - Prey Equilibrium]

Dynamics with entry and exit. Analogy: predator-prey models in biology

And for πa < πb :

Note from (14):

Recall: Y = y (na )M and observe:

[Alternative Development Paths]

[Figure: Growing out of the trap]

[Figure: Implied Growth Paths]

Professor Dr. Holger Strulik 17 / 20

And net profits (after extortion):

Professor Dr. Holger Strulik 18 / 20

Note: this is just a further piece of a recurrent general pattern:

Professor Dr. Holger Strulik 20 / 20

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